Circle of Competence

My friend Sivaram Velauthapillai, who writes the terrific Can Turtles Fly? blog, responded to my article on Einhorn and Lehman yesterday with some of his thoughts. He brings up good points, though I disagree with many of them, and I’d like to try and give my perspective on his thoughts, and let my readers see a contrarian view on my own. Keep in mind that Sivaram and I have mutual respect for each other, and the comments are not personal in any way.

Here’s what Sivaram said, in response to my post, “CoC Battles an Insurgent Columnist”

“I have to disagree with this (but admittedly I may be biased given that I’m long Ambac (poor bet no doubt) while Einhorn is short))… before I post, just know that I’m a fan of yours so this isn’t anything personal

I don’t know about the rabble rouser characterization but Einhorn has nothing concrete. He is cherry picking some stuff which may or may not have anything to do with the losses. Even Einhorn doesn’t know how much the CDOs he is flagging should be marked down (if at all). Since he doesn’t know what is in the CDOs, and since Lehman won’t release what’s in them, how does he know they are understating the losses or that there is soemthing illegal going on?

Furthermore, the CDO issue is so minor (only something like $6 billion total) but Einhorn is bringing it up because the market doesn’t is scared of any type of CDOs. I’m not too sure about his other points (level 3 assets and such) since that’s all vague stuff as well.

I think you are wrong when you say that short-sellers only make money if the fundamentals are right. I would argue that is not the case. Just like how longs can make money on hype, short-sellers can make money on bogus accusations as well. They don’t have to do anything illegal or make up lies; all they have to do is introduce doubt.

In addition, short-sellers can make money by taking down firms that depend on the capital markets, or where customers are influenced by stock prices. That is definitely the case with investment banks. Bear Stears went down, not because it defaulted on any of its payments, but because everyone stopped doing business with it. Who knows if Bear Stearns would have ended up insolvent but it clearly was not when it collapsed.

Another good example of where short-sellers can make money even if they are wrong is with some aspects of the monolines. I will be the first one to say that some of what William Ackman was saying was correct (particularly the subprime mortgages). However, his original thesis was completely wrong. That’s why he never made money on his original bet for more than 5 years. Ackman originally claimed that (i) muni bond insurance doesn’t make any sense, and (ii) insurers can’t price risk better than the market (i.e. impossible to charge lower spread than what the market was demanding). He was completely wrong on those points. Warren Buffett entered the market and he would be the last one to do so if he didn’t believe the market made sense. If bond insurers can’t price better than the market spread then how come Buffett is willing to write muni bond insurance? Ackman was completely wrong on the original point he was arguing.

He also said that the bond insuers were overleveraged (typically 100x), given the small spreads they charge, but he was wrong on that as well. Again, Berkshire Hathaway Assurance’s leverage is something like 100x (we don’t know for sure but that’s what the intial capitalization was) and Buffett is fine with that. The fact of the matter is that you can charge low spreads on muni bonds (i.e. end up with super-high leverage) and insurers can price risk better than the market.

Einhorn, who was also short the monolines, argued that muni bond insurance is a scam and rip-off for the government. No doubt the government loves to hear that thought and some are now planning to go without insurance (I think California is even floating the idea of insuring its muni bonds (similar to how Florida insures against hurricanes)). Ambac et al may not exist in 5 years but I’ll bet that the governments are going to a rude shock when they find out that they can’t price risk better and that the market would be willing to pay a small fee for some insurance.

The reason William Ackman, David Einhorn, and Whitney Tilson, are right regarding the monolines has little to do with their original investment thesis. Almost all of their gains are due to a narrow portion of the structured product insurance (essentially subprime CDO-squareds, CDOs, direct RMBS, HELOCs, and CESs).

Anyway, getting back on topic, Einhorn is accusing Lehman Brothers of hiding a lot of stuff but he is just throwing out ideas out there. He can turn out to be right (although I don’t think he will) but he will most likely be wrong on most of the things. Einhorn will make money, not necessarily based on fundamentals (although that can help), but because he causes a panic of some sort.

Finally, I think it is reasonable to lob some grenades at David Einhorn because is an ACTIVIST hedge fund manager. Some people don’t like him because he is a short-seller but even if he were long-only, I think he should take some blame because he gets in people’s faces. Very few like Carl Icahan because he is an agitator. I think David Einhorn usses similar tactics. There are many short-sellers but they don’t get in the media or personally take on CEOs or CFOs. He is very articulate and if his ideas are right, he may end up being a great investor. But I don’t think he will get much respect because is an activist investor.”

Obviously, we disagree on these issues. However, we both have our opinions, and you should take what Sivaram said seriously. My follow up thoughts are thus:

Sivaram,

I appreciate the comment and I’m glad you enjoy my writing. I absolutely don’t take the response personal.

I’ll address your points as I see them. Keep in mind I have no position in any securites mentioned here, so I’m not in the market to profit from this right now. I’ll be sure to let you all know if that changes.

“I don’t know about the rabble rouser characterization but Einhorn has nothing concrete. He is cherry picking some stuff which may or may not have anything to do with the losses.”

I think it’s unfortunate that you believe Einhorn has nothing concrete. I believe he found some substantial discrepancies in their financial reports. I suppose that, yes, he doesn’t know exactly what comprises the CDO’s. Einhorn, in the speech, merely points out that they are fishy.

25% of their CDO exposure is sub investment grade, which were trading in Q1 no higher than .50 on the dollar.  Knowing this, there’s simply no way their 1Q mark was correct. It doesn’t matter what is in them. They all fell much more than 3%, even the investment grade ones.

Callan even said, in a response to Einhorn:

“In a follow-up e-mail, Ms. Callan declined to provide an explanation for the modest write-down and instead stated that based on current price action, Lehman “would expect to recognize further losses” in the second quarter.”

If you “expect” to show further losses, they needed to be shown in Q1. Plain and simple, they are either smoothing or manipulating if this is true.

What’s certainly not debatable is the discrepancy between the level 3 assets from the earnings release to the 10Q. Einhorn points out that in the release, they showed a loss of $875mm or so. However, in the 10Q, there was a movement that created a $228mm gain on its Level 3 assets. What changed in the days in between? Einhorn asked and their answer was “the movement between the conference call and the 10-Q is “typical” and the change reflects “re-categorization of certain assets between Level 2 and Level 3.” This created a 1.1B swing from a loss to a gain. No 8-k filing? No announcement? Nothing? Just a $1.1B swing in the numbers. That’s not immaterial.

Here’s another point I didn’t even mention, from the speech:

“Lehman had $39 billion of exposure to commercial mortgages at the end of the year. The index of AAA CMBS declined about 10% in the quarter. Lower rated bonds fell even 9 further. Since Lehman’s portfolio is less than AAA, it would seem its write-down probably should have been more than 10 points. Lehman wrote its exposure down less than 3 points gross.”

How did Lehman, over and over, avoid all of these marks in Q1? Are they that good? All of this paints a very fishy scenario. Like I said, of course he was cherry picking. He picked the ones that looked like flat out lies. I don’t see any good explanations coming from Lehman to refute Mr. Einhorn. There’s no factual release out to show why these things occured. They stick to the “he’s lying” or “he’s cherry picking.” Where are the facts?

The CDO issue is not a small one. Billions of dollars in lies is not small, regardless of the size of your portfolio. Lastly, their profit for the quarter was less than $600mm. A better mark on the CDO’s would wipe that out and thensome. Add in the other potential problems, and Q1 would have been rather horrendous. They showed profit.

Regarding the short seller quote, sure you’re right, the stock can go down based on rumors. However, Lehman is a large, liquid stock, and no single investor can drive it down materially, sustainably, with a speech or letter. How come Berkshire didn’t stay down when Doug Kass said he’d shorted it in Barron’s? It came down a bit then bounced back as investors looked more deeply at his analysis, and disagreed. If Einhorn was/is wrong, the stock will be fine. He’s still holding his position, and I’m sure he will, too, until the company either hits major turbulence or clears the problems and turns out OK (I’m guessing the former).

If Einhorn came out with a bunch of lies no one believed, the stock would be just fine. But, so far, he has been correct, and people believe the analysis, thus the stock is down. (Thanks to Whitney Tilson for pointing this out to me).

Regarding Ackman, he has been sketchy on the bond insurers for a long time, as you mentioned. His theses were numerous, and in the end, he was correct. Even though his doubt of their business model was not proved correct, he eventually predicted that their structured finance insurance would come back to haunt them. Well, it did, and the stocks are down 90+%. I’d say that’s pretty correct no matter how you look at it. By continuing to follow the situation and dig deeper, he found more reasons why the companies would break, and he publicized them well in advance of their actual demise. I don’t see how it is a mark on him that his original thesis didn’t prove to correct. Rather, it is to his credit that he continued to flesh out his analysis. By doing so, he was able to hold on and ended up with an extremely successful investment.

I’ll give you an example here. I’m sure you’ve read the Dhando Investor by Mohnish Pabrai. Now, in the book he gives the example of his investment in Stewart Enterprises. He lays out the initial thesis, what he thought could happen in the proceeding months to ensure the equity value would be double or more his price. He came up with 3 or 4 possible scenarios.

Guess what? None of them occurred. However, he stuck with it and management was able to keep the company alive by structuring yet another solution that Mohnish hadn’t originally considered. He doubled his money in short order. Now, is it a mark on him that his original analysis was not correct? I’d say no, because he simply knew the investment well enough that it’d work out, somehow, and it did in the end for a good reason, but one he hadn’t originally thought up. The situation with Ackman and the bond insurers is similar to that in many ways. He had a good thesis to start, began publicizing it, but he continued to analyze the insurers as he held the investment. As he went along, he discovered more and more to like about the short, and held on while it stagnated. In 2007 he was vindicated.

Regarding activism, I agree that Einhorn can expect to receive some flak there. In fact, he knew he would get some flak for this speech, I’m sure of that much. However, that doesn’t give the right for NYT journalists to smear him with incorrect articles. I say again, where is the analysis in her article of his points? Where does she bring up the thoughtful analysis that Greenlight did? Where does she highlight his points and ask the readers to consider them? It’s simply not in there.

I even left out some awful quotes from my article. Here’s one:

“These recent criticisms also seem will-timed to take advantage of the market’s concern around weak second-quarter results that we expect for Lehman,” the Buckingham analysts wrote in a report.”

How could Einhorn control the timing of the Ira Sohn Investment Conference? That quote insinuates that he timed his analysis with the problems that the public began to raise concern about.

Here’s another:

“Many on Wall Street still wonder if hedge funds like Greenlight helped bring down Bear Stearns and spread false rumors about the bank, a possibility the Securities and Exchange Commission is investigating.”

How could you claim that he’s spreading rumors when he is making public speeches disclosing his short positions and analyses? That’s not rumor mongering. He’s laid out analysis, with facts and numbers, in a highly public forum. He’s given them every opportunity to respond, and they have not come back with facts to rebut him. This quote insinuates the Greenlight has been involved in market manipulation behind the scenes. Where is the basis for that?

I appreciate Sivaram’s comments, but I tend to disagree here. The NYT article could have been written in numerous ways, but she chose language that smeared Einhorn by insinuating illegality and immorality without basis to do so. People have every right to question, even lob criticism, but it is supposed to be in a factual and balanced way in the general media. Ms. Story writes for the New York Times, not a internet blog.

Check out this article from Fortune for an example of what a more responsible and balanced article looks like about this situation.

Thanks again to Sivaram. I hope he responds again, because his points are good ones. I’m glad to get another view out there for you to read beside my own.