Chapter 8
The Cynical Sleuth
Shorting is not a criminal trial. It doesn’t have to be beyond a reasonable doubt. There just has to be a preponderance of evidence.
—James Chanos, February 2011 interview
There’s a lot about Enron that still hasn’t been fully explained or written about,” Jim Chanos says earnestly one February afternoon in his office. Snow falls on Madison Avenue as Chanos searches his memory for details. He is tanned, having just returned from a conference in Miami. With wavy light brown hair and glasses, Chanos looks at home behind his gargantuan circular chestnut desk in a deep blue suit. The 54-year-old head of Kynikos Associates LP was the first to uncover the shocking accounting scandal after a friend flagged a “Heard in Texas” story in the Wall Street Journal in September 2000. He thought the article was right up Chanos’s alley.
The story by Jonathan Weil was about energy companies using accounting ploys. “Much of these companies’ recent profits constitute unrealized, noncash gains,” Weil found.
“Almost immediately after reading the article I pulled up the financial statements for Dynergy, Enron, Reliant, and Mirant. And it was very clear from them that the biggest and baddest was also the murkiest—Enron,” says Chanos. So he first dug into the quarterly (10Q) and annual (10K) financial statements.
“I remember the numbers had gotten worse over nine months,” says Chanos. “We looked at insider selling, which was a huge pattern of Ken Lay and other top officials selling hundreds of millions of dollars worth of stock before the implosion. As our research read the situation, they were admitting Enron is a black box. We couldn’t figure out how they were making their money, yet there was a very low return on capital.” The company had 80 percent of its profits allocated towards energy trading, and was charging 10 percent to get access to capital, which struck Chanos as pretty high. “The more I looked,” he says, “the more things didn’t make sense. How could they be producing 7 percent return on capital while the cost of that capital exceeded 10 percent?” Gradually, it came out that Enron had many maneuvers. “One partner suggested then that Enron was ‘a hedge fund in disguise’—and not a very good one,” says Chanos. “Investors were crazy to pay six times book value to own the stock.”
One scheme Enron used was its accounting approach for its contracts to sell future delivery of natural gas as a security. They took advantage of “gain-on-sale” accounting rules allowing a company to estimate the future profitability of a trade made today, and book a profit today based on the present value of those estimated future profits. Enron immediately recorded all anticipated “profits” on these delivery contracts as profits. Since no markets existed for these delivery contracts, Enron aggressively valued them at “mark to model” based on highly favorable assumptions that went undisclosed. Enron, Chanos says, was addicted to the crack of “gain-on-sale” accounting, taking on bigger and bigger deals. This helped Enron to pump up revenues, which explains how Enron rocketed so quickly into the ranks of ExxonMobil, Walmart, IBM, and other $100 billion revenue companies.
Enron also used complex dubious energy trading schemes, such as the “Death Star,” initially routing energy to “congested” lines but then rerouting power to uncongested lines to collect a congestion fee from California.
Another ploy: more than 4,000 off-balance sheet partnerships were created as “special purpose entities” (SPEs) to hide massive losses and debts from investors while enriching senior managers, artifices even the board neither saw nor understood. Neither did analysts and investors. “We read the footnotes in Enron’s financial statements about these transactions over and over again but could not decipher what impact they were having on Enron’s overall financial condition,” Chanos says. “They seemed to be selling parts of themselves to themselves.” Since at least 3 percent of the SPE total capital was owned independently of Enron, they escaped consolidating these liabilities onto Enron’s balance sheet. Enron would hide bad bets by selling these “assets” to the partnerships in return for IOUs backed by Enron stock as collateral. The SPEs helped Enron reduce tax payments while inflating income, profits, and credit ratings.
Throughout, Enron was violating the matching principle of generally accepted accounting principles (GAAP), which requires that expenses be matched exactly when revenues are incurred. Enron would sell its energy assets at a loss and then stick them into discontinued operations first—for a while. Proof, Chanos says, of the tremendous leeway GAAP allows dishonest management to mislead investors far more than inform them. (It is a point he’d made in an op-ed in the Wall Street Journal in 2006, writing that “I can think of no major financial fraud in 25 years I’ve been on Wall Street that did not have audited financials that confirmed to GAAP!”)
About a year later, the company would sell the assets so it could put them below the line. The crux of it was when it was selling them for a profit; it would keep them in the merchant banking division and report it as an operating profit. “The winners were always being put in operating profits and the losers were being placed in discontinued operations. So within a few weeks, it was pretty clear something was wrong but it wasn’t clear this was such an extensive fraud,” Chanos recalls. He tells his analysts to follow this general rule: if you can’t figure out what a company does after three readings of their annual financial statements, open a file on it. For long-biased value investors, he suggests something else: run the other way.
The Kynikos chief remembers concluding, at first, that Enron was just overstating earnings, which was a more typical ruse. And for 16 quarters since the first quarter 1998, Enron never failed to meet or just beat analysts’ estimates. That was one red flag. Another, of many others, was the sharp increase in sales revenue between 1995 and 2000 while growth in profits was anemic at best.
It wasn’t until Jeffrey Skilling, president of Enron, unexpectedly left on August 14, 2001, citing “personal reasons,” that Chanos knew something was very wrong. For Skilling, the architect of the whole operation, to leave so abruptly was the real red flag. A few paragraphs into a Wall Street Journal article, Chanos read that Skilling admitted the declining stock price had a big bearing on his decision to leave. Chanos wondered why a high-flying CEO would hit the parachutes because of a declining stock price. “Most CEOs dig in their heels when that happens,” Chanos says.
At that point, Kynikos increased its position. “We found out six weeks later they were using the stock price as the insurance mechanism for all the offshore funds that were doing business with the Raptor fund.” Enron had told investors that if they lost money in the deals they bought into from the company, they would be issued more stock to make up the difference. But the company didn’t tell anyone else. Enron’s own shareholders didn’t know that they were on the hook for issuing billions of dollars’ worth of shares. “So that’s when I realized,” recalls Chanos, “just as the whole world did—this company was going to collapse.”
On October 16, 2001, in the first major public sign of trouble, Enron announced a huge third-quarter loss of $618 million. From there, it was a sharp, rapid descent as one revelation after another showed the scale and complexity of Enron’s deceptions.
Enron was not the only company Chanos was investigating in 2001 for possible accounting fraud. Tyco, the Bermuda-based conglomerate that operated in more than 100 countries and manufactured everything from health care products to electronic components, had also caught his eye. At one time worth more than AT&T or Morgan Stanley, compensation deals and related-party transactions had turned Tyco into a piggy bank for its executives. Internal investigation would later reveal the excess of former CEO L. Dennis Kozlowski and other senior executives, from the forgiveness of tens of millions of dollars in loans to a $15,000 dog umbrella stand, a $6,000 shower curtain, and a $2 million birthday party on Sardinia. Tyco manipulated earnings and cash flow through many stratagems, booking bogus revenue, gaming cash flow through acquisitions and disposals, and hiding losses and expenses. Tyco was a serial acquirer, buying more than 700 companies between 1999 and 2002. It would ask its target companies to hold down results before the takeover date; after ownership was secured, those takeovers’ revenues would explode.
Chanos plunged into Tyco in 1999 but had to wait three years before being vindicated. He questioned, for example, how Tyco accounted for goodwill charges, minimizing the charge-offs taken after mergers by stretching them out for decades so they didn’t devour profits. Chanos charged that it was a classic case of “spring loading.” Before the acquisition closed, the purchased company was made to look worse than it was. After the deal was completed, the new unit’s “growth, profitability, and cash flow are stronger than would otherwise be the case,” as Chanos said at the time. In other words, Tyco would mark down the value of tangible assets but inflate “goodwill,” the premium above the fair value of net assets. An acquirer can recognize goodwill as an asset, albeit an intangible one, in its financial statements. In Tyco’s case, they allocated nearly the entire purchase price to goodwill, spending $30 billion on acquisitions between 2002 and 2005 and creating the same amount of goodwill. The company then wrote down that goodwill, as accounting rules require, to boost earnings by sweeping expenses away. And to pump up profits, Tyco would sell those assets marked down during the acquisition. Tongue in cheek, Chanos told New York Times columnist Floyd Norris in 2002, “The fact that these guys are alleged to have looted the company on that scale does not mean they would have overstated earnings or cash flow or done anything else nefarious to the company’s financial statements.”
“Tyco had many more moving parts than Enron,” he remembers. “The accounting games were much more ingenious and much more creative.” Chanos took a big position in the company and felt it played beautifully into author Malcolm Gladwell’s point about “financial puzzles” versus “financial mysteries.” “In mysteries, the clues aren’t there for you to find. In puzzles, they are,” says Chanos. “In the case of both Enron and Tyco, there was missing information. The smoking gun with Enron was the stock issuance scheme. With Tyco, you could see that the balance sheet was going crazy and the footnotes held all the interesting information. Tyco wasn’t showing the financial statements for the target companies in the months prior to acquisition and the consolidated balance sheets on the day of acquisition. But still, there was no smoking gun until Kozlowski left and the acquisition strategy backfired. Then the whole company imploded.”
Chanos founded Kynikos, who were the cynics in ancient Greece, in 1985, just five years after he graduated from Yale University with a degree in economics. Chanos had grown up wanting to be a doctor but destiny had other plans. He stumbled into short-selling by accident when, while working for Gilford Securities as an analyst in Chicago, he issued his first stock report in the summer of 1982. The company was Baldwin-United Corporation, the piano maker turned financial services company. Chanos found that the company had a hefty debt load and what he called “liberal accounting practices,” a red flag that would come up throughout his search for investment opportunities time and time again. The stock kept climbing from $24, when Chanos first wrote the report, to about $50, before the inevitable tumble in early 1983, as Chanos’s thesis proved correct down to the T. The stock was trading at $3 by September 1983.
Eventually, industry legends Michael Steinhardt and George Soros wanted to know what other ideas Chanos had to short. He could see where the opportunities were and had the stamina to stand by his convictions. “I knew the problems inherent in being on the short side, but even when a stock was running up, it didn’t bother me much. I knew I was right,” says Chanos. It was a trade that few analysts could master so Chanos decided to strike while the iron was hot. If he could do institutional research—well documented and well researched—on flawed Fortune 500 companies, he realized, “people will pay me for this.” So he moved to New York to broaden his exposure at Atlantic Capital, a unit of Deutsche Bank. He quickly attracted clients like Fidelity Investments and Dreyfus Corporation. Chanos left Atlantic Capital after a “ridiculous” article in the Wall Street Journal, in which he had naively agreed to be quoted, had angered his bosses in Germany. The article painted short-sellers as evil speculators “specializing in sinking vulnerable stocks with barrages of bad-mouthing,” wrote Dean Rotbart, then a reporter for the newspaper. “They use facts when available, but some aren’t above innuendo, fabrications, and deceit to batter down a stock.”
At 27, Chanos decided to strike out on his own, getting backing from two venture capitalists, who wanted him to run a short portfolio for a wealthy family. Because it was relatively virgin territory, the playing field was very lucrative. “There wasn’t a lot of capital in the strategy,” Chanos recalls. The majority of the investors at Kynikos were wealthy individuals. Pension funds found it too risky even though the strategy was perfect for tax-exempt investors because profits from short-selling are treated as ordinary income. Short exposure also allowed clients to mitigate risk by giving them investments that weren’t correlated to the stock market. Kynikos’s Ursus Partners fund returned 35 percent before fees in 1986, compared with 18.6 for the S&P 500 Index. In 1987, it rose 26.7 percent while the benchmark index rose 5.1 percent.
Chanos’s view of the world has always been against the grain, and he runs his firm the same way. First and foremost, he identifies himself as a securities analyst, second as a portfolio manager, meaning, with Chanos, everything is bottom up. Despite what people might think when they see Kynikos making macro calls, all of it derives from work it does in companies. “That’s how we train our analysts and how we think about the portfolio. At the end of the day, we’re financial statement junkies. And we really enjoy digging into the numbers and looking at what makes the companies tick.”
Kynikos differentiates itself from other shops on the Street in many ways. Besides uncovering great ideas on the short side, Kynikos looks at its ideas with a longer time frame than many short portfolios. In one way, you could say Kynikos is a “value investor,” as Maggie Mahar suggests in her book Bull! Kynikos relies on its research in the fundamentals; he says the best bears are “financial detectives.”
But there’s a big difference: value investors profit from buying low and selling high, but short-sellers sell high and borrow low. The fund has been consistent over its 25 years, turning the portfolio over about once a year, which is slow by hedge fund standards. Chanos sees them as intermediate-term investments as opposed to short-term trades. But, Chanos explains, “there’s really a difference. In addition, we tend not to pursue small-cap ideas—and never have. We tend to always be in large and midcap ideas, which gives us liquidity in the short side that a lot of funds don’t have.” When Kynikos is long in its opportunity fund, it can be as hedges. For example, when the firm went short Chinese property stocks, it went long Macao casinos. “It could either be hedges or pair trades,” explains Chanos. “It could be where we’re long one auto company and short another. Or it could be intercapital arbitrages where we’re long the debt of a company and short the stock.” In other words, these kinds of hedges allow Kynikos to manage risks effectively.
On the management side, Kynikos stands apart from the pack as well by the way it has set up its research process for idea origination and processing. The typical hedge fund has a portfolio manager or several managers at the top. At the bottom are the junior analysts, the firm’s least experienced people, whose job is to find ideas for the portfolio managers.
According to Chanos, there are two types of ownership of an idea in an organization. There’s the intellectual ownership, which resides with the person who brought the idea to you, and then there’s economic ownership, which resides with the partners. When things go badly, you have a problem because the person with the intellectual ownership of the idea and the person with the economic ownership of the idea are in conflict. And there may be information flows that stop because the analyst doesn’t want to give any more bad news to the partners who had invested in the idea. So, there’s disproportionate risk and disproportionate reward. Chanos says: “We have a different approach, one in which the partners generate ideas—an investment theme, let’s say—and the analysts help to validate, build upon, or disprove those ideas. Our approach encourages intellectual curiosity, collaboration, and an openness.”
Chanos thinks pattern recognition is important and something that simply takes experience, which is one reason why he tasks the firm’s partners with originating the ideas. The partners have extensive experience in seeing patterns in odd-looking financial or press statements, for example. Through their mosaic of experience and wisdom, they are in the strongest position to decide what strategies to explore and not get distracted by the markets’ daily vagaries. Once a partner identifies an idea to pursue, the analysts process the idea, compiling the research to validate or disprove the thesis. Being financial detectives, Chanos says, is what short-sellers do. The analysts produce an idea memo and make a recommendation, either suggesting that the idea demands more research—or should be abandoned. “They may come back to me with an explanation for bad numbers,” Chanos explains, “or tell me the company has some great products coming down the line. They are never held accountable for price performance on a stock, but they are held accountable if they don’t provide the information needed. Our research team works very hard; they are key to the firm’s success.”
Chanos says the portfolio manager and the partners make the decisions over how money in Kynikos’s funds is invested; in this way, intellectual ownership and economic ownership are married. Kynikos analysts are compensated on a staff basis, or on the firm’s profitability, instead of on their ideas alone. That’s why Chanos believes they can feel comfortable telling it like it is. “It’s a much more rigorous and intellectually honest model,” says Chanos. “And, consequently, no one’s screaming at the analysts when a stock blows up. That’s our responsibility. We take the heat because we are the ones who made the investment decision.” That doesn’t mean the analysts aren’t held responsible for their end, though. “We expect our analysts to do as thorough a job as possible in getting us all the information, positive or negative, as the idea develops so that we can constantly make those decisions to trim a position for capital reasons, or add to it because the information flow makes the case for doing so,” says Chanos. He thinks it’s a much more stable format for the firm than the traditional model, where there’s more turnover and the least experienced people are initiating the firm’s ideas as opposed to deepening their expertise in processing the partners’ ideas. Because he’s up front about its model, the firm’s turnover isn’t very high. In a year or two he may lose one or two people on a team of 20 analysts. “Our analysts are analysts through and through,” he says. “We’re looking for people that love to do research.”
The Secret Sauce of Short-Selling
First, some basics about short-selling. It’s a tough business. In bull markets, where a rising tide lifts even the weakest performers to high valuation levels, shorts must be right more often than they are wrong. The stocks may be hard to borrow. Governments have been imposing restraints and bans on certain short-selling activity, using short-sellers as scapegoats for the implosion of investment banks and sovereign debt woes.
While a percentage of short-selling is directional, meaning the investor has an adverse view of a company’s valuation based on an analysis of its financial statements or a sector outlook and hopes to profit when the stock falls or the sector weakens, hedging is another reason. Investors may be long in a sector but believe one or two companies will underperform; taking short positions may boost overall performance. Market and options makers may take short positions to balance order flow or hedge their long exposures. For convertible bonds, investors may boost yields through shorting the underlying security. In both cases, these strategies are “market neutral.”
Academics, by and large, are on the short-sellers’ side. Their research shows short-selling to improve markets to the benefit of investors by enriching price discovery, deepening liquidity, and acting as a pressure valve to deflate investors’ irrational exuberance. For analysts willing to do the work, digging for skeletons in companies’ closets is a very important part of the equation. And for that, Chanos believes you cannot beat financial statements. “It’s still far and away the best predictor of future corporate performance. There’s nothing better than analyzing the company’s numbers themselves to find the anomalies because modern GAAP is as much of an art as a science, as any good accountant will tell you.”
A company’s profitability is not a concrete number, but one that involves estimates, guesses, and accruals. And, therefore, what Chanos and his team are looking for is a real discrepancy between economic reality and the reported numbers and, furthermore, where an unscrupulous management team is pushing the accounting envelope, most of the time, legally. The difference, Chanos points out, is that the economic reality is very different from what the companies are saying, and that will only become apparent after some rigorous financial analysis. “As an analyst, you have to be very comfortable with the balance sheet, flow of funds statement, and very comfortable reading the footnotes. That’s blocking and tackling 101.”
So when business school students or undergraduates ask Chanos what they should study, he doesn’t hesitate: accounting. “Take practical courses in financial and corporate accounting. Because, at the end of the day, the language of business is numbers,” he says. “And if you’re not very comfortable with understanding how companies can play games with their financial statements using GAAP accounting, you’re never going to be a good short-seller. That’s just the bottom line.”
Beyond knowing your financials backwards and forwards, there is a certain attitude required to being a good short seller. When Chanos started in the business, he thought the skill set for an analyst on the long side is the same as that on the short side. He also thought it was a learnable skill. He quickly realized that all of the ancillary headaches associated with being a short-seller throw a lot of behavioral finance roadblocks in your way, which is challenging for many. “There’s this constant drumbeat of bullish spin every single day. And a lot of people don’t handle that well. They like positive reinforcement.” Now he believes short-sellers are born, not made, and that most people don’t function well in an environment of negative reinforcement. That is why, in part, he doesn’t expect his analysts to go on the line with short call positions. “That’s why I rely on those who have gone through the bull markets and manias and bubbles,” says Chanos. “And still, they, too, sometimes get caught up in the positive hype.”
So where does he find people with this inborn talent? Analysts at Kynikos have different backgrounds than analysts at other hedge funds, where a rigorous completion of a two- to three-year investment banking analyst program is required after graduating from a top school. While there are some of those, undeniably, one of the best analysts in the firm’s history was an art history major who worked for a wealthy family in the art department but was intellectually curious. Kynikos has also had some good success with journalists. “Young journalists are just always very good at training and asking good questions,” says Chanos. “First and foremost, you need to be facile with numbers but the second most important quality for our analysts is intellectual curiosity.”
Chanos stresses the importance of not taking anyone else’s word. He expects his analysts to come forward when they have hit a wall, too. “I love it when my analysts say ‘I don’t get this. Why is this number doing this?’ and ‘Is this normal?’ Those are the questions we love.” Chanos recalls with a chuckle the results of a 1998 Business Week survey that asked Standard & Poor’s (S&P) 500 CFOs if they have ever been asked to materially falsify financial results by their superior. Fifty-five percent said they had been asked and never did it. Twelve percent said they had been asked and had done it. And 33 percent said they’ve never been asked. “What that told me was that two-thirds of the S&P 500 had asked their CFOs to materially falsify financial results at some point,” he says switching to a very serious tone. “So there’s a lot of agency risk in financial statements and relying on what somebody else is saying is very fraught with danger.”
Structurally flawed accounting is one of the four areas Chanos advises in lectures before business students, including his class at Yale’s School of Management. Another is booms that go bust. Throughout history, he shows how investors rushed into overvalued investments based on a “new” idea that “old” methods of valuation and analysis failed to understand. The Mississippi Company in the 1700s, the start of railroads in the United Kingdom and the United States in the nineteenth century, and more recently, dot-com companies—all experienced unsustainable run-ups that fraud, bubble physics, and investor guile facilitated. Consumer and corporate fads, too, drive companies to excessive valuations; remember the 1980s when leveraged buyouts (LBOs) were used frantically to acquire or expand? Investors like to extrapolate growth too far into the future than they should. And technological obsolescence can create short opportunities. Digitization of music and video overnight changed business models, for example, to take advantage of the Internet’s cost efficiencies for distribution. Everyone thinks, though, that the old product will last longer than it does.
Defending an Investment Strategy
As they have been throughout financial history, short-sellers are an easy scapegoat for government leaders when investors suffer losses. The rapidly unfolding financial crisis from 2008 onward saw the implosion of such investment banks as Bear Stearns and Lehman, and exposed the frailties of mortgage behemoths Fannie Mae and Freddie Mac. As the real estate market and mortgage business collapsed, the contagion spread to all sectors of the economy, ushering in the worst era for capital markets since the Great Depression. Private investment companies—including hedge funds—were also under fire.
Chanos was called to testify before Congress several times in 2009 as an expert witness on behalf of the Coalition of Private Investment Companies. In each appearance, he made several points. He showed how hedge funds enable qualified investors to more effectively manage risks with the potential to achieve above-average returns. He noted that hedge funds did not receive bailout funds from taxpayers as investment banks had during the financial crisis. He also endorsed the drafting of a “special ‘Private Investment Company’ statute, specifically tailored for SEC regulation of private investment funds.” This legislation, he said, “should require registration of private funds with the SEC; provide that each such fund and its investment manager be subject to SEC inspection and enforcement authority, just as mutual funds and registered investment advisers are; require custody and audit protections to prevent theft, Ponzi schemes, and fraud; should also require robust disclosures to investors, counterparties, and lenders; require that private funds provide basic census data in an online publicly available form; require that they implement anti–money laundering programs, just as broker-dealers, banks, and open-end investment companies must do; and, for larger funds, require the adoption of risk management plans to identify and control material risks, as well as plans to address orderly wind-downs. The Coalition of Private Investment Companies believes that these statutory requirements would benefit investors by putting into place a comprehensive regulatory framework that enhances the ability of regulators to monitor and address systemic risks while providing clearer authority to prevent fraud and other illegal actions. Our approach strives for the highest standards of prevention without eliminating the beneficial effects of responsible innovation.”
In the end, the SEC toughened antifraud provisions and tightened custody requirements, while Congress cleared registration requirements for investment advisers along the lines that Chanos had proposed.
As to the “un-American, unpatriotic” short-sellers, he noted how they were responsible for uncovering many infamous financial disasters during the past decade. They often are the ones wearing the white hats when it comes to looking for and identifying the bad guys. During the financial crisis, Chanos recounts a phone call from Bear Stearns’s CEO, who asked him to make calming public statements that the then nation’s fifth largest investment bank was fine and that Kynikos had funds on deposit with them. “Here they were trying to co-opt a short seller to tell the market everything was fine. Talk about misdirection,” he told the press then. Bear Stearns was one of the biggest underwriters of complex investments linked to mortgages. Investors had grown increasingly skeptical that it could continue repaying its loans or honor its counterparty obligations in complex agreements with other financial institutions.
But a groundswell of antishort initiatives emerged. Then SEC Chairman Christopher Cox imposed an unprecedented three-week ban in September 2008 on short-selling of 799 “financial” companies’ stock. Worldwide, regulators also imposed various constraints, a pattern that has continued with the euro-debt crisis. Cox later confessed to the Washington Post that that decision was the biggest mistake of his tenure, pointing to the pressure from Treasury Secretary Henry M. Paulson, Jr., and Fed Chairman Ben S. Bernanke.
Many academic studies bear out Cox’s regrets, showing that the bans reduced liquidity, slowed down price discovery, widened spreads, and failed to support stock prices. Another consequence: legitimate trading strategies, including long trades, were impeded.
“We certainly weren’t the first on this idea,” Chanos tells me at his offices in April of 2011 about the biggest short position of his life: The People’s Republic of China. Chanos first spoke publicly about his grand stake in China over a year and a half ago on CNBC’s Squawk Box in December 2009. “Right now, we’re as bearish on China as we’ve ever been,” he says. He followed that with a presentation at St. Hilda’s College, Oxford in January 2010, “The China Syndrome: Warning signs ahead for the global economy.”
Chanos argued that China, fearing a sharp slowdown from the financial crisis, pumped credit into asset growth—mainly real estate but new roads and high-speed rail, too. There were “classic pockets of overheating, of overindulgence” he said in his presentation. Fixed asset investments as a percentage of China’s gross domestic product (GDP) were exceeding 50 percent—a “sh-a chén bào” (sandstorm) of money, he said. The stimulus was massive: $586 billion, or 14 percent of GDP (the U.S. package was $787 billion, or 6 percent of GDP). With state-owned enterprises controlling 50 percent of industrial assets, and not being driven by the need to make profits, and local party officials dictating the real estate development process, large-scale capital projects were growing “sillier by the day,” including rising industrial and manufacturing overcapacity. There were empty cities, such as Ordos, and lonely malls, such as the New South China Mall. News reports showed new buildings toppling from shoddy construction. It was the latest chapter in China’s history of credit-fueled booms and busts. China was “letting a thousand Dubais bloom,” he quipped. “Go to Dubai and see what happened. It was . . . what I call the ‘Edifice complex.’”
This all raised questions in Chanos’s mind. Would generational savings be destroyed, exacerbating a ticking demographic time bomb? Another roadblock to developing China’s consumer economy? What would happen as a consequence of the unfunded liabilities and government guarantees? Is the $3.0 trillion “security blanket,” the foreign reserves, full of holes? And what would the global consequences be, such as the impact on prices of construction materials and interest rates for U.S. and other sovereign debt?
At first, Chanos saw immediate backlash against his thesis, with many saying there was no real estate bubble in China. A year and change in, the Central Bank of China has acknowledged there’s a real estate bubble and that the country is facing issues. So, too, has the International Monetary Fund. “What people don’t realize is that China papered over its last two credit bubbles, those in 1999 and 2004. The banks were never bailed out—they just exchanged their bad loans for questionable bonds from quasi-state organizations. The Chinese banking system is built on quicksand,” he says.
The country’s capital markets have failed to modernize to meet the demands of China’s domestic economy and role in the international economy. Political pressure to stimulate the economy during the financial crisis resulted in massive loans to local governments and real estate developers. These loans are turning increasingly insolvent as the borrowers find it hard to repay them as a consequence of the stagnant or failing demand for housing, declining prices, and the evaporation of land sales, a principal source of cash for local governments. Alternative banking networks are collapsing. Given the lack of transparency and inadequate, if nonexistent, corporate governance, it’s hard to determine the enormity of the debt and the likelihood of its repayment. This means untold risks for China’s banks, and that deep government reserves are keeping things afloat—at least for now.
“The question, now, is how is China going to manage its way through it,” he says. “The excesses that we saw a year and a half ago have only built up since then.”
Presently, Kynikos is short the property developers in China through the H-shares in Hong Kong as well as most of the larger Chinese banks, which the firm believes are going to need ongoing injections of capital, much of which will come from Western investors. The fund has been short an oddball collection of one-off Chinese companies, such as Chinese Media Express, that have floated issues in the United States. Chanos has dubbed casinos “long corruption, short property.” But his overall short in China stands as one of the highest exposures he has had to a single theme. China is one thing he’s betting against in a big way—it currently stands as the highest exposure he’s ever had to a single theme in the portfolio.
Although one economist estimated that 64-million apartments are empty, “what we do know is that if you drive by all kinds of tier one, tier two, and tier three cities at night in developments that are completely sold out, most of the buildings are dark at night, so there are a lot of empty apartment buildings in China. We just don’t know how many,” says Chanos.
So Chanos’s team developed a proprietary index of property transactions in the first-, second-, and third-tier cities. It was the first time they turned around a time series and made an index out of it, and Chanos explains the process. “Interestingly, the problem is not the amount of data available about China. It’s the quality of the data in China.” Even though the data may be flawed, the firm finds it a useful indicator. “If we keep it consistent by using the same data, we can at least get an idea of some trends,” says Chanos. For the last few years that they’ve been tracking this across 50 percent of China’s urban population, this reasonably significant statistical sample was at first flat and more recently (late 2011 to early 2012) has turned down. So for all the increase in development, by unit sales, transactions have been flat to falling. Chanos deduces, “If you’re not selling the same number of units with more and more coming down the stream, there are going to be many units stacking up in the system. And that is a major warning sign.”
What they’ve seen recently for the first time is that price cuts have not been met by an increase in sales whereas historically, every time price dips in the market, activity has usually spiked a little bit. “We’re keeping an eye on that pretty closely, too,” says Chanos. “Because if that continues, there’s going to be a real problem.”
The question everyone asks, however, is when. “If I were good at timing, I probably would have retired a long time ago,” says Chanos with a chuckle. “It’s certainly happening though. Inflation is bubbling through the economy there faster than I think anybody thought. And now you’ve got the authorities that are behind the eight ball on two fronts.”
Added onto the credit expansion and property bubble, consumer and wholesale prices experienced a sharp rise. It’s a situation where China scrambled from behind to tighten credit before signs of a slowdown since the summer lead to credit easing in November. “We’re hearing stories of hoarding and shortages and inflationary behavior like rapidly rising wages. It’s another wild card we didn’t expect a year ago.”
What Chanos sees about China though is a two-fold story of credit-driven excess in the country as well as potentially dangerous situations for investors in many Chinese companies. Drilling into individual companies, Chanos is amazed at just how dicey almost every company they analyze looks. Some examples include odd transactions—lots of profits never show up in cash and/or suspicious-looking affiliated deals with third parties. “Almost every company we look at exhibits one or more of those characteristics,” says Chanos. “So I think it’s very problematic for Western investors to make money in the share market in China. Not only because I think the macro’s bad, I think the micro’s bad, too. You’re basically being fleeced as the Western investor in many of these companies.” Chanos points to examples of companies that suddenly stop trading, or corporate headquarters that don’t exist when Westerners fly out for a visit. “If you can borrow the stocks and get short them, it’s basically a field day for the short-seller over there because many companies look like they are fraudulent.”
Part of the problem in understanding China, Chanos says, is the prevailing myths. One is that the country’s balance sheet is healthy in that it doesn’t show much debt. That’s because the state-owned enterprises and local governments use special off-balance-sheet financing vehicles, with borrowing that has been growing very quickly, he says. “We estimated that China’s total debt reached about 180 percent of GDP in late 2011. If we assume that China will grow total credit this year between 30 percent to 40 percent of GDP, and half of that debt will go bad, that is 15 percent to 20 percent. Say the recoveries on that are 50 percent. That means that China, on an after write-off basis, may not be growing at all. It may have to simply write off some of this stuff in the future so its 9 percent growth may be zero.”
Back to Business School Basics
When Chanos is not busy looking into China, one of his other targets is the for-profit education sector, what he deems “a national shame.” Chanos predicts the industry will face continuing pressure over the next few years with dramatic cutbacks in federal loan guarantee despite the Republicans’ rear-guard battle to support the industry. “I think it’s just a national scandal that all these kids are getting degrees from these ‘universities’ and they are no more employable than if they had a high school diploma and they’re leaving with $20,000, $30,000, or more in debt they can’t repay,” says Chanos. “And then the burden is left on the taxpayer to repay.”
These days, Chanos has been spending some time inside the classroom himself. Teaching his first class as Visiting Lecturer at Yale’s School of Management titled “Financial Fraud throughout History: A Forensic Approach” over a series of eight lectures, he ventures up to New Haven every Monday afternoon to impart his financial wisdom to a room of about 50 graduating seniors.
Chanos spends half of the three-hour class giving a lecture; his students prepare case studies on fraudulent scenarios between 1992 and 2005 for the other half. At the final class in early May, the last student presentation is on Harken Energy Corporation and its limited partnership, Harken Andarko Partners.
A tall female student with glasses stands and begins loading her presentation at the front of the classroom. After a few slides, she gets to the meat of the first transgression. “A single capital transaction accounted for 50 percent of its operating profit in 1994. Disclosed or not, this is a clear financial misrepresentation of the company finances and tantamount to fraud,” she declares.
“Harvard’s asset management entity, Harvard Management Company, extended a loan, increased stock purchases, etcetera, to support Harken’s share price,” she continued. “Harvard sold out its interest while the price was solid and made a profit—about $20 million or a 3 percent annual return for a period when it held Harken stock.”
Chanos interrupts. “So what do you think was potentially fraudulent about any of these activities by Harvard?”
The student mumbled an answer that Chanos dismissed, and the student continued.
“The SEC probed Harken board chairman Alan Quasha’s ownership interests, but did not have any issues to charge him with.”
Chanos interjected, now addressing the class. “Remember one of our points, class. Even a transaction that looks immaterial to an entity may be material to one person in that entity. What was the key here? What was the connection? Why? Material circumstances. Always remember, what is immaterial to one entity can be very material to a key person.”
Chanos continues. “Why did Harvard keep throwing money at this company? How unusual is it for a company with a $150 million market capitalization to have involvement with such investors as Soros and Harvard. A company this small normally wouldn’t be on their radarscope. It appeared like the asset manager was doing everything to salvage the investment.”
A great case study for all of the cynical sleuths in training.