Mr. Chanos inspired Mssr. Goldfinger in his youth, great article!: "The Bear That Roared. How short-seller Jim Chanos helped expose Enron
By Jonathan R. Laing, Barrons
Over the past 20 years, short-seller Jim Chanos has had a volatile career of
exhilarating highs and gut-wrenching lows. As a callow 24-year-old analyst in
1982, he made the call that's still the stuff of Wall Street legend. In August of
that year -- "the day before the great post-1982 bull market began its epic
ascent," he laughs -- Chanos put out a sell recommendation on
Baldwin-United, then a highflying annuity company. He declared the firm a
"house of cards" doomed to collapse from over-leverage, kinky accounting
and negative cash flow.
The young analyst stuck to his guns over the succeeding months in the face of
withering criticism by fellow Wall Street analysts, virtually all of whom were
wildly bullish on Baldwin, and threats of lawsuits from the company. He was
vindicated, however, when 13 months later Baldwin filed for Chapter 11,
vaporizing some $6 billion in stock value and leaving the holders of billions of
dollars in annuities in the lurch.
Chanos received deserved star treatment in the financial news media, as a
result. A front-page story in The Wall Street Journal in the fall of 1983 hailed
him as a David who'd slain Goliath by "defying the experts."
His hot streak in selling short
continued into the early-'Nineties
despite the severe head winds of a
bull market. He exploited the serial
collapse in the late 'Eighties of
commercial real estate in Texas,
Arizona, California, New England
and finally Canada, making millions
off short positions in the stocks of
various regional banks, savings
and loans and real-estate
development companies.
Moreover, he presciently saw
Mike Milken's junk-bond kingdom
for what it was, a daisy chain of
Drexel Burnham-financed holding
companies that were able to loot heavily-regulated insurance companies and
S&L subsidiaries of funds by buying each other's junkbonds. He rode the
stocks of such Milken-financed companies as Integrated Resources,
Southland Financial, Columbia S&L and First Executive all the way to their
oblivion. His Ursus Partners hedge fund -- ursus being Latin for bear -- more
than quadrupled in value between its formation in October 1985 through the
end of December 1990. That was twice the rise in the Standard & Poor's
Index over the same time span.
But as so often happens, early success seemed to breed subsequent failure.
For Chanos was brutalized by the torrid bull climb in stock prices in early
1991 that kicked in following the onset of the Allied invasion of Kuwait, and
continued with only a few interruptions through the end of 1999. The net asset
value of Ursus Partners dropped nearly 75% over that period, virtually wiping
out all the gains the fund had achieved over the previous five and a half years.
At various times during the 'Nineties, the fund was down nearly 85% from its
high-water mark achieved in late-1990. Over the same 15-year period, the
S&P rocketed up a cumulative 12-fold.
Sitting recently in his cramped office on the 44th floor of the Citigroup Center
in midtown Manhattan, the tall and lanky Chanos clinically analyzed his
problems during the 'Nineties. He had missed the sea change that had
occurred in the financial markets after Federal Reserve Chairman Alan
Greenspan had begun to flood the economy with liquidity to bail out Citicorp
and other then-shaky major banks in the early 'Nineties. Salubrious stock and
bond markets during the decade had allowed even companies with
overstretched balance sheets and dubious business plans to heal themselves
and finance their dreams.
He admitted to making a number of analytic errors that cost Ursus dearly. A
large short position in McDonnell-Douglas blew up in his face after a series of
large contract awards by the Pentagon after the Gulf War bailed out the
troubled company. America Online was another disaster. He thought that the
way it accounted for marketing costs by putting them on the balance sheet
rather than running them through the income statement was suspect. What he
missed, he now admits, was the dimension of the Internet boom that ensued,
turning AOL into an impregnable brand name.
And his short positions in mutual fund company Franklin Resources and
brokerage firm Charles Schwab in 1995 and 1996 went south because the
stock market mania wasn't ending as he thought. It was just going into
overdrive. "We were making a market-timing call which is not something our
investors pay us to do," he concedes with obvious chagrin.
And just perhaps, Chanos was laid low by an element of hubris. At least that's
what a hedge-fund competitor and admirer claims. He elaborates: "Jim is a
spectacular analyst, a straight-up guy loaded with integrity and ability. He
deals in facts rather than innuendo, unlike so many shorts. But he was typical
of the ball player who bats .400 in his first season in the majors and assumed
that it would be easy to repeat it every year. Success may have gone to his
head. He allowed Mr. Market to take away way too much of his money by
staying with losing positions too long and ignoring the market forces arrayed
against him."
The bull market ultimately brought a certain pragmatism to Chanos' business
strategy, however. In late 1996, he reduced the leverage on Ursus Partners.
And his firm, Kynikos Associates, opened the Beta Hedge fund, which was
designed to take the risk of raging-bull markets by offsetting every dollar of
short exposure with a dollar of long exposure. The fund's long positions are
selected quantitatively by another manager solely to mimic the volatility of the
fund's short selections. Beta Hedge has delivered a compound annual growth
rate of over 13%. Today, it comprises about half of Chanos' more than $1
billion under management.
The flagship Ursus fund is now leading the revival of Chanos's fortunes. Ursus
posted a gain of 47.4%, before fees, in 2000 and 18.2% in 2001. The big
money came from anticipating the collapse of Internet stocks -- Chanos
thought their business plans were screwy -- and telecom stocks, which he
reasoned would be felled by overcapacity. Among his winning shorts were
Amazon.com, Priceline, Williams Communications, along with McLeod USA.
Finally, Chanos seems to have his groove back.
The bursting of the tech bubble
also put Chanos back in the media
limelight after a decade or more in the shadows. The searing bear market of
the last two years has helped raise his profile. And perhaps most important,
he's now widely credited with being the first on Wall Street to blow the
whistle on the biggest bankruptcy in U.S. history, Enron. It was surely the
market call of the decade, if not the past 50 years. And made by the very
same analyst who had wowed the investment world with Baldwin-United
some 20 years ago. Not bad coups in anyone's career.
In a wide-ranging interview with Barron's, Chanos chronicled the tale of what
led him to first short Enron in late 2000, when the company was trading near
its all-time high of 90 and enjoying near universal acclaim on Wall Street. He
continued to short the shares in early 2001, when soaring electricity prices in
California seemed to only strengthen the likelihood of profit growth for
wholesale energy marketers like Enron.
He concedes that, initially, he thought the energy-trading concern was viable,
but that its stock was wildly overpriced. But further research convinced him
that Enron had been engaging in fraudulent accounting and that the company's
condition was likely terminal. The resignation of Enron Chief Executive Jeffrey
Skilling in August for half-baked reasons only solidified that conclusion in
Chanos's mind. Skilling sensed big trouble ahead. (Friday, J. Clifford Baxter,
a former Enron vice chairman, was found shot in the head in a car. Initial
reports described his death as a suicide.)
Chanos' interest in Enron was first piqued in October 2000 when he
chanced upon an article that had appeared the previous month in the Texas
regional section of The Wall Street Journal, penned by the paper's current
accounting writer, Jonathan Weil. (Barron's and The Wall Street Journal are
published by Dow Jones.) The writer asserted that Enron and other leading
marketers of electricity and natural gas were artificially boosting their profits
by reporting unrealized, non-cash gains on long-term energy deals that
wouldn't be actually booked for years to come. Some of these contracts
extended out more than 20 years. And whether these profits would ever be
realized depended on seeming unknowable, difficult-to-hedge assumptions
such as the future course of natural gas and electricity prices stretching out
over decades, interest-rate trends and importantly, it turned out, Enron's
maintenance of its non-junk credit rating.
The article resonated with Chanos. Abuses of so-called "gain-on-sale"
accounting over the years had led to some of his biggest investment coups.
Baldwin-United, for example, had gunned its reported earnings by making all
sorts of fraudulent assumptions on the present value of its future profits on its
annuity sales. Chanos had also made a bundle on such avid gain-on-sale
exponents as the mobile home-financier Conseco, the sub-prime auto-finance
company Mercury Finance and the sub-prime mortgage company First Plus.
All used faulty assumptions in their securitizations to gin up fancy profit
growth.
"It has been our experience that gain-on-sale accounting creates an irresistible
temptation on the part of managements heavily incentivized with options and
heavy stock ownership to create earnings out of thin air," he says.
At the same time, Chanos and an associate began to pore over Enron's
financials. Selling at the time for some 60 times earnings, the stock seemed
"priced for perfection." Yet another picture emerged in the company's 1999
10-K and 10-Q filings with the SEC for the nine months ended September
30, 2000.
Instead, the company seemed to be "a hedge fund in disguise," relying on
energy trading for more than 80% of its current earnings. And not a very good
hedge fund. By Chanos' calculations, Enron was only able to churn out a
paltry 7% return on its capital, while its cost of capital was over 10%. In other
words, Enron would require more and more capital just to eke out continuing
modest returns, let alone enjoy any profit growth. At the time, neither Chanos
nor any outsiders suspected that two-thirds of Enron's debt resided off the
balance sheet in the now- infamous partnerships and other special-purpose
entities.
Chanos concluded that investors were crazy to pay six times book value to
own the stock when other far-better-performing hedge-fund portfolios could
be purchased for their net asset value.
The 10-K and 10-Q also revealed other tantalizing clues. He remembers
being "baffled" by a flurry of "related party" transactions detailed in various
footnotes. Mentioned were two outside partnerships, headed by an unnamed
senior officer of Enron, that seemed to be engaged in a flurry of transactions
that took assets off Enron's books and yielded lush pre-tax gains and
revenues to the parent.
The revelation in October 2001 that the manager of these partnerships was
Enron's chief financial officer, Andrew Fastow, and that he made more than
$30 million on the side running the entities, created the crisis in confidence that
ultimately drove Enron into bankruptcy proceedings. But Chanos had no way
of knowing this in late 2000, or fully grasping the import of the convoluted
disclosures in the SEC documents. His original copies of these filings bear his
notations made at the time, a series of exclamation points and question marks
in the margins. "We're pretty good at deciphering footnotes and other
disclosures, but these reports left us scratching our heads," he recalls. "We did
decide, however, that it's rarely good news when a company is engaged in
deals with an outside entity run by one of its senior officers. How could it be
an arm's-length transaction?"
Chanos continued to add to his short position in early 2001, but as a
precaution he talked to a number of sell-side analysts on Wall Street, almost
all wildly bullish on Enron's prospects, to get the bull's argument for the stock.
He was heartened to find that many were pinning their hopes on Enron's entry
into trading in excess fiberoptic bandwidth capacity. No less than Jeff Skilling
had asserted to analysts in January 2001 that bandwidth trading would likely
add as much as $35 to the stock, which was then trading in the low 80s.
Chanos knew differently. From his reading of the opaque footnotes, he
realized that Enron was dumping its unused fiber and other physical
broadband assets on the partnerships. Moreover, he had shorted a number of
fiberoptic-network companies, correctly judging that the industry was going
into free fall as a result of gross overcapacity and a collapse in pricing. "Didn't
the energy analysts touting Enron ever bother to talk to any of the telecom
analysts?" he still wonders.
Chanos and his associates also talked to several energy traders at leading
financial institutions. They expressed incredulity at the trading profits Enron
was reporting. They described the business as a fairly blue-collar, low-margin
affair of matching buyers with sellers. He deduced from this that Enron must
be making a lot of directional, unhedged bets, and with the bull market in
natural-gas prices and electricity rates starting to turn, Enron might suffer
severe losses.
At this point, Chanos began to publicize his views on Enron. In February
2001, at the "Bears in Hibernation" meeting he hosts annually in Miami, he
made Enron one of his two short picks. He counted on the fact that many of
the attendees, including other well-known bears and hedge-fund managers,
would be intrigued by his Enron story and assist him in much of the heavy
lifting in researching such a complicated situation.
A reporter from Fortune magazine called him later that month to query him
about his latest investment ideas. He methodically took her through the Enron
story. Though the resulting story in March was somewhat pallid, it did raise
questions about Enron's valuation, promotional style and opaque financials for
the first time since the Weil effort the previous fall.
As the year wore on, Chanos dug more deeply into accounting issues at
Enron. By then, he and other hedge-fund managers were scouring documents,
often from anonymous sources, relating to various secret Enron
off-balance-sheet partnerships with names like Osprey, Marlin Water and
Yosemite Securities.
There was a certain invariable pattern to the flurry of transactions between the
partnerships and Enron. Millions of dollars in Enron assets and attendant debt
would dance off Enron's books, and the parent would reap lush benefits from
sale revenues, trading profits and merchant banking gains. What Chanos
didn't know was that Enron had created literally thousands of partnerships
and other special-purpose entities to shield losses from investors' view.
But the odor of the deals was unmistakable. For one thing, some of the assets
being transferred, such as parts of Enron's broadband system,
water-company holdings and various stock investment holdings, were
plummeting in value.
And Chanos realized after a close reading of the partnership documents that,
though the partnerships were technically independent entities, Enron was still
on the hook for any losses in value the partnerships suffered. These "make
good" arrangements required Enron to contribute additional Enron shares to
the partnerships to make them whole in the event of losses.
Likewise, the partnership debt was not non-recourse to Enron. In the event of
a downgrade in Enron's credit rating, to below investment grade, the company
would be on the hook for much of this supposedly off-balance-sheet debt.
With the stock steadily falling, from over 70 to the mid-40s during the
summer, the potential for a China Syndrome meltdown in Enron's balance
sheet loomed. "We could see the partnerships becoming insolvent and this in
turn causing a financial death spiral for the parent," Chanos recalls. "We knew
we were right when Skilling quit the company in August. In our opinion, he
saw that Enron's declining stock price meant the game was over for Enron."
The rapidity of Enron's collapse left Chanos agog nonetheless. And he is
stunned by the scabrous tales of document-shredding at Enron's accounting
firm and company headquarters.
It will take months of forensic accounting effort to fully plumb the depths of
the apparent fraud at Enron. But he suspects that far more will be discovered
than just Enron's apparent attempt to use the now infamous partnerships to
hide debt. He contends that Enron also used the partnerships to boost Enron
profits by acting as a dumping ground for losing trades, bad long-term
investments and busted Enron investment-banking deals. Moreover, he thinks
that millions of dollars in past- reported Enron profits will melt away once its
long-term energy trades are properly marked-to-the-market. "That's the next
big shoe to drop," he predicts.
But for a bear like Chanos, Enron's travails are hardly unwelcome. Especially
because, suddenly, Wall Street is zealously burrowing into the financials of
other companies with opaque financial statements. Trust-me managements are
coming under scrutiny as never before. And the stock market appears to be
treading water.
In short, it's the best of all possible worlds for a confirmed cynic and
accounting-whiz like Jim Chanos. The stock market is now in his dojo. |
