Circle of Competence

I read David Einhorn’s speech at the TCF charity conference, and once again, I’m impressed.

In the first part of the speech, Einhorn goes through some thoughts on Allied Capital, recapping the trouble he’s felt since 2002. In one swift analogy, Einhorn crushes the Allied naysayers:

“When I speak of investors I am including hedge fund managers. An author on
Investopedia defined hedge funds as “lightly regulated, private investment funds that use unconventional investment strategies and tax shelters in an attempt to make extraordinary returns in any market…these factors have given them a secretive and shady aura in the financial community.” Forbes has called us “The Sleaziest Show on Earth.” Basically, according to some in the media, elected officials, government regulators and individuals, hedge funds are really gambling operations amounting to ticking time bombs with secret plans to destroy the galaxy. Good thing they don’t say what they really think. In truth, hedge fund managers at their core are simply investors.

The SEC seems much more interested in whether investors share analysis, particularly critical analysis, of public filings rather than whether management teams made accurate public filings in the first place. The SEC seems more interested in whether investors discuss investments among themselves on private phone calls than in whether management teams make truthful statements on public conference calls. The SEC seems more likely to bring a case against an individual investor over a small crime than it is to prosecute a large corporation that fudges its numbers for years on end and pays out management bonuses in the millions based upon inflated accomplishments.

Imagine what would happen if a whistle-blower made a detailed public presentation
showing a hedge fund cooked its books. Under no circumstance would the immediate
focus start by investigating the accuser. How long would it take for the SEC to arrive and how tirelessly would the media investigate and cover the story? What would the chance be that the SEC would take five years to find exactly the type of record keeping violations that were alleged in the first instance and, then, inflict no meaningful penalty on the offender? How likely is it that the SEC would permit additional sales of equity in that hedge fund to new investors? How likely is it that our most prestigious investment banks would line-up to introduce that hedge fund to new capital?

Imagine if a hedge fund operated a unit that defrauded the SBA federal lending program out of millions of dollars – engaging in what the SBA inspector general would call “the largest fraud in SBA history.” How long would that hedge fund be in business?

Imagine if a hedge fund hired a private investigator to impersonate the spouse of a CEO and obtained his home and business telephone records. Imagine if after making loud, public denials, the hedge fund admitted to obtaining the records, but did not explain or apologize, or even return the stolen records, when requested. How long would it be before someone was arrested?

Of course, I don’t know of a hedge fund that has done these things. Everybody now knows that Allied Capital has. The Allied situation persists only because of lax regulatory enforcement and Wall Street’s continued willingness to sell new shares to unsophisticated retail customers.”

The speech then moves to his newest target: Lehman Brothers (LEH), the august investment bank that once was a large part of American Express, until its spinoff in 1994 (profiled in You Can be a Stock Market Genius).

Einhorn’s thesis is that Lehman, who many talking heads have praised to this point for avoiding the death blows of billion dollar write-downs, is not being honest with its shareholders.

There’s a pretty simple, indicting, underpinning of the Lehman short: on $6.5B in CDO exposure they showed in Q1, they took a grand total of $200mm in write downs. That comes to a meager 3%. In a credit environment where CDO’s are being sold for .20 on the dollar in some cases, is it honest accounting to show a 3% loss? Are Lehman’s CDO’s so well built that they are holding up in this environment like no others have?

The short answer is “of course not.” Q2 probably won’t be very pretty for Lehman the company, and with the cat now out of the bag, the same goes for Lehman the stock. When the write-downs inevitably come, not only will angry shareholders probably sell, new questions will be raised. What else do they have that they are not telling us? Will they need to raise capital?

Secondly, Lehman seems to show some signs of “Allied Capital Syndrome,” the mis-valuation of illiquid assets. It wrote down its “Level 3″ assets, those with no ready market, a mere 3% again. Einhorn says comically:

“In the real world, illiquid assets carry a discount. In the current melee the opposite seems true: illiquid assets are more valuable because it is easier to convince the accountants that they have not declined in value compared to liquid assets where there is more transparent pricing data.”

If you’re a Lehman shareholder, I’d advise you not to stick around and find out the results of this potential disaster.

Disclosure: No position.