Jim Chanos, the founder and managing partner of Kynikos Associates, is likely the most successful pure equities short seller in global markets. Kynikos’ flagship Ursus short bias fund has grown steadily for over two decades and now manages over an estimated $4 billion. The recent bear market has helped the fund earn strong returns, furthering a reputation that was very publically enhanced by Chanos’ successful shorting of Enron earlier in the decade.
Yet Chanos is much more than a shrewd short-seller and a brilliant securities analyst. In recent years, he has built an impressive public profile speaking out on regulation, corporate malfeasance and accounting standards to governments, trade bodies and regulators. These interventions have benefitted the broader hedge fund industry and for that Chanos deserves the respect and gratitude of managers around the world.
For some years, Kynikos has also operated a UK and European research arm in London called Axia Advisors. It provides the New York-based portfolio management and trading operation with the research capacity Kynikos needed to create as its investment focus grew to be global in scope.
Bill McIntosh, editor of The Hedge Fund Journal, recently spoke at length with Chanos about the ongoing deliberations among financial authorities to regulate short selling. The conversation also extended to the importance of reforming accounting standards and of getting hedge fund managers to actively lobby politicians at a time when far reaching changes are being considered in how financial markets are regulated.
On the macro level, where do you think the US is in terms of the fallout from the mismanagement at banks and other financial institutions?
On a macro level we are still trying to assess exactly what happened and why it happened. I think more specific blame is still down the road a bit. We are worried more about policy decisions to get the economy going than prescriptive efforts which will hopefully be further down the road.
Concerning the situation in the US and how it has developed, how would you contrast that with what has happened in the UK?
In the UK, there is a little bit of a different situation. As it relates to financial institutions in the US, there is more specific outrage about individual situations and banks and AIG. In the UK, it seems to be a more general outrage. The anger seems to be vented in slightly different ways. As it relates however to the hedge fund industry, I think the public’s anger is probably greater in the UK, though I don’t know why, than it is in the US.
On Wall Street firms you have said: “I believe there was criminality in the executive suites. I believe they materially misrepresented the financial shape of their companies” while out raising capital. Do you believe a similar case can be made about some UK banks?
I made a broad statement about criminality, global banks and financial firms last September. I do believe these firms misrepresented their condition while telling investors either a) things were fine, or b) things were good enough at least to be raising capital and subsequently disclosed much greater losses than originally expected. In my way of thinking that is either deceiving people with malicious intent or criminal negligence. You either were stupid or lying. Both of them had horrible consequences for the global economy.
Moving on to short selling, I think you are aware of the Archbishops of Canterbury and York saying short-sellers amounted to being ‘bank robbers’: what’s your response to their analysis of this?
I don’t want to address their response specifically. I think a lot of investors, particularly in the UK, have a different attitude toward hedge funds and short selling than they do in the US. Keep in mind it is short sellers who are the real time financial detectives whereas the regulators are often financial archaeologists. By curbing short selling you are curbing people who are pointing out a lot of the problems that subsequently occurred: whether it was Bill Ackman (of Pershing Square Capital Management) on MBIA and Ambac, or David Einhorn (of Greenhorn Capital) on Lehman or with what I did with Enron, and others. I briefed the G-7 in May of 2007 on the coming crack up in structured finance and the problems that banks and brokers were going to have. This was at a meeting the Germans were chairing and were concerned about hedge funds. You had short sellers who have been on the record trying to warn government regulators that this was coming and was ignored and are now being vilified. Short selling should be encouraged not discouraged in this environment.
There is one other point. A lot of commentary in the US and UK is based on alleging manipulation of pricing by short sellers, that short sellers are creating conspiracies to drive stocks down and that this needs to be stopped particularly in the financial shares where confidence is so paramount. Yet whether it is the HBOS investigation by the FSA last spring or the SEC investigations following Bear Stearns and Lehman Brothers we have seen not one case brought, nor one shred of evidence that this was true. And still people are going off on a set of policy prescriptions based on allegations that have never been shown to be anything other than simple speculation. It really is amazing that people believe that and can get away with it without any evidence being shown. They wouldn’t take that on any other set of facts but when it comes to short selling it is taken as a given that there is manipulation going on. And it is just simply not the case.
I have two related points: the FSA has issued a discussion paper on short selling and the second thing is that the FSA and others are trying to put in place a global framework to regulate short selling. What is your view of the FSA paper and how do you see this global approach playing out?
The FSA paper seems to address short sellers more than short selling. For example, it wants to disclose individual short positions over a very low threshold – much lower than the long side – yet it doesn’t want to aggregate short positions to the market place. That is somewhat puzzling to us because we think the better data for the market place is the aggregate amount of shares shown to the market that is short as opposed to individual managers’ positions. The logic they use for showing the individual managers’ positions I’m having a hard time coming to grips with. There seems to be more willingness to show individual short positions by manager in a way that they think will deter short selling. But as we saw in the fall (the time when the initial disclosures of short positions was made to the market in the UK, Ireland and elsewhere) when investors saw fund managers with good track records and good reputations for doing their work were short certain banks – the bank stocks plummeted and that wasn’t exactly what the regulators had in mind. Once again we have the good old law of unintended consequences raising its ugly head. They thought that having a disclosure regime might stop people from shorting stocks (because they would have to disclose it.) In fact, those investors still felt the risk/reward was appropriate and shorted the banks because they did work on them and realised that the stocks were completely and utterly overvalued and that managements were not telling the truth. That had the impact of causing other investors and depositors to get scared. So a much more logical approach – if the regulators need to know what is going on for enforcement purposes and overall market regulation purposes is that investors should simply disclose it to the regulators. The industry does not see what public purpose is served by disclosing individual positions by individual managers. (Disclosing) to the regulators, not a problem; to the public, lots of problems.
Do you think there will be some kind of global framework to regulate short sellers or do you think it will remain a piecemeal system of oversight?
I really at this point can’t gauge that. I don’t know.
You have said that there may be some innovations coming out to restrict short-selling. Is there anything additional you could comment on about this?
Never underestimate the ability of regulators and legislators to come up with new and interesting ways to handle the public’s outrage. I think it is misdirected here. Short sellers were not the bad guys. If anything they were the good guys in this drama. The industry needs to do a better job in getting that message across. We are still being completely, unjustifiably vilified and that is playing into public policy prescriptions without any shredof evidence of any wrong doing by the hedge fund industry in this area. If anything the hedge fund industry was trying to play a public policy role by warning policy makers at their invitation of some of the things that were happening and were going to happen. And we were ignored. I think that is a very important part of the narrative that the public doesn’t really appreciate. Hedge fund managers briefed government regulators routinely on the coming problems in structured finance and real estate lending, and were routinely ignored.
You have mentioned that there would be a two prong approach to market regulation: one being a broad regulatory overview featuring the Senate and the House; as well as an overall market risk regulator being set up. Can you expand on this?
It looks like the US government is settling on a plan to let the Federal Reserve be the market risk regulator. We fully expect that hedge funds will come in under that umbrella as they probably should. I think the industry expects that and is ready to cooperate. Then there is a going to a broad overhaul of the securities laws in the United States going back to the Securities Acts of 1933 and 1934. I am guessing we are going to see a pretty good legislative overhaul whereby Congress gets quite involved writing specific legislation on a new regulatory framework. That may be introduced soon but probably won’t be voted upon until 2010.
Why have short sellers been more able to expose financial fraud than say regulators or institutional investors who obviously have their money on the line with a lot of these companies?
Institutional investors should be able to do the same things that short sellers do. But remember it is a sin of omission, not commission. If an institutional investor finds something wrong with a company they simply won’t invest whereas a short-seller will take a position attempting to profit form their work. There is more of an incentive for short sellers to do that kind of work and to point out when they believe they are right about what the problem is. That is why we believe the hedge fund industry should be encouraged in that way. There hasn’t been one major financial fraud in the US in the last 25 years that was uncovered by anyone other than an internal whistle blower, a journalist or a short seller. Outside regulators, outside accountants and outside council have discovered none of them. That is a pretty sorry track record.
On the latter point, with regard to the public and politicians, how should short sellers and hedge funds present the case for short selling?
I think we have done a poor job. The industry needs to do a better job and we are working on that in the US and I know AIMA is working on that in the UK. I think part of the problem is that hedge fund mangers have been reticent to actually meet with lawmakers and regulators. They have sent their representatives, their lawyers, but they have been reticent to sit down with lawmakers and say ‘This is what we do’ and ‘Here is why we do it’ and ‘This is why it is important to the market place’. I’ve done that with lawmakers and regulators. Let’s face it hedge funds and short sellers are not the most beloved people by corporate America and others for lots of reasons that have nothing to do with investing. I think that when the industry as a whole gets its act together and does lay out why it’s beneficial to investors, why it’s beneficial to have short selling, why it’s beneficial to have changes in corporate control – generally they do a pretty good job in carrying the point because the facts are on their side. We need to do better getting industry people in front of lawmakers and members of parliament and regulators to explain exactly what it is we do and why there are so many misconceptions about it.
In Europe, particularly France and Germany, the anti-hedge fund forces see activist funds challenging national sovereignty. Is it ever possible for a hedge fund or the hedge fund industry to challenge the sovereignty of a country and come out victorious?
It’s tough. Over there, there is a longer history of state ownership in large companies. Corporate control has been a much bigger issue in those markets than in the US and UK. It is a different kettle of fish and presents its own unique challenges. I’ll leave it at that.
Obviously you think the current juncture of where we are with the regulatory situation and the incredible pressures in markets provides an opening for the hedge fund industry. What is the best way for the hedge fund industry to take advantage of that opening in terms of lobbying the SEC and Congress as well as the FSA and the UK government?
Certainly my organisation – the Managed Funds Association in the US – understands the challenges and I think are doing a better job than they have done historically in getting the story out. I don’t think there is any doubt at this point that the industry will be invited in to discuss regulatory events and in effect will be given a seat at the table. It behoves us to take advantage of that and be constructive about that. Understand we are going to be regulated. The industry has tended to have a sense of ignore Washington and they’ll ignore you for too many years. I think that has changed and I think people understand that’s changed and are acting accordingly. We understand we are going to be regulated. We know that. The important point is to be constructive about it and bring forward good points to the overall regulatory structure and our role within it.
I’d like now to discuss the debate about accounting rules. To your mind, what impact have short sellers had on this debate?
Short sellers have been pointing out the failures in specific companies’ corporate accounting for years and years. That’s what we do. Early on when FAS 157 was implemented, we began to see the levels of various illiquid securities on banks’ and brokers’ balance sheets. That really started concurrent with my briefing to the G-7 in the spring of 2007. When we began to get good data on that from the FAS 157 regime in the US short sellers began sounding the alarm about the types of long term illiquid assets that the banks had loaded their balance sheets with. The industry has been pretty vocal about that. In addition, the industry has gone further than the banks and brokers in its recommendations in how to implement FAS 157. The recommendations to the President’s Working Group by the hedge fund industry in January ‘09 (a manager group and investor group both put forth reports and Chanos was part of the valuation sub-group of the manager’s group) put in the best practice suggestions the idea that not only should hedge funds indicate their financial assets on a balance sheet basis as to their level (1, 2 or 3) depending on their liquidity and market pricing mechanisms but should also, and the banks and brokers don’t do this, indicate the profits and losses from those areas both realised and unrealised over the periods that are comparable. In other words, tell your investors how much money you are making from these various types of securities. That is something the banks and brokers don’t do and have a feeling they don’t want to do. We felt it was important to give our investors more transparency not less in this area. Accounting is an area where hedge funds can hold their heads up pretty high. That, and the industry’s unwillingness to take tax payer money to cover its losses which we can’t say for other actors on the financial stage.
Obviously the reported profits many banks earned in 2006-2007 proved pretty illusory. Do you see that this is going to lead to the banks being forced to operate under more transparent standards or do you see the risk profile of the large banks being ratcheted down and more closely regulated?
Let’s look at it another way. What were the two things the US bankers asked for in the post Bear Stearns collapse? They did not go running to Washington to ask for more capital, or forbearance, or to ask Congress’ pardon in terms of apologising for their behaviour. The two things they asked for were: curtail short selling in our shares and loosen the accounting standards. What does that tell you? It’s remarkable that that’s what the banking industry thought were the problems: people like me and too tight accounting standards as opposed to lax lending, horrible internal and external accounting systems, bad risk management. In short, all the things we know or any rational observer would know that really led us to this crisis. They wanted to shoot the messengers if you will: the accountants and the short sellers. It is telling to me that an effort to loosen accounting standards would be coupled with complaints about short sellers. What short sellers do is look at the numbers; they tear these companies apart. They point out where there are anomalies and clear problems.
Do you expect public prosecutions in the US or indeed in Britain of bank executives?
I can’t see how we avoid it. Let’s look at one example. Look at Lehman. After it filed for bankruptcy the credit default swaps were settled out at 91 cents on the dollar. It meant that people who wrote the protection had to pay out 91 cents and the debt was only worth 9 cents on the dollar. That’s comparable to where it has been trading recently at 10-15 cents on the dollar (but) six months later. The amount of funded debt at Lehman Brothers at the time of its collapse was $150 billion. It means the debt was impaired by about $135 billion. There was also about $25 billion in equity and preferred equity at the time of the collapse which is now worth nothing. On a back of the envelope basis we can say with pretty good confidence that the hole in the Lehman balance sheet upon their collapse is and was somewhere around $150-160 billion.
To put that in perspective, the hole in the Enron balance sheet when the dust settled was about $60 billion. We might quibble about mark to market accounting – about this asset and that asset – but if you are off by $150 billion from what you’ve said your assets were worth, and what the market said your assets were worth when it got to take a look, I’ve got to think that there was some material misrepresentation: particularly as they were raising capital throughout most of 2008. I think we are going to see that at AIG and other places as well.
There have been some similar instances in Britain. Lloyds TSB, for example, issued shares at 270p and then three weeks later the government came in and bought £4.5 billion of stock at 173p. A big change in a very short period of time….
We both know that it really didn’t depreciate. They just didn’t give an accurate accounting at the initial point because they either didn’t know or they didn’t want to know. You really have situations here where there are either material misrepresentations or criminal incompetence. These banks either intentionally misled or didn’t have a clue as to what their financial condition was but stated otherwise with great certainty what it was. I don’t see how you can come to any other conclusion.
With regard to some of the changes we are likely to see in regulation and how the financial system operates, do you expect to see in the US any particular types of transaction or trading taxes?
That is beyond my purview. I’ll keep it to the hedge fund industry. Who knows where we are going to go in terms of public policy after this crisis. I don’t think anyone knows at this point.
In the reform of the US financial system there is obviously a role for hedge funds to play; are there a couple of areas that the industry should focus on?
Number one: be constructive to the process. Being obstructionist is not going to win you anything. Number two: offer policy prescriptions. Too often we are fighting this and fighting that and not offering up some constructive proposals of our own. One thing the industry is talking about is reform of the offshore fund industry. There is a real sense that US non-profits which go into offshore funds because of the UBTI tax issue … is just an anachronism and should be scrapped. We have been talking to institutional investors to partner up with a proposal to help reform that. Quite frankly the optics of the offshore fund business is not great for managers. It adds to the whole secret hedge fund mangers in the Cayman Islands PR non-sense. That would be one concrete example where the industry could come up with constructive ways that could streamline the financial system that will be good public policy.
You are chairman of the Coalition of Private Investment Companies. Please describe the organisation and explain what it is looking to do?
It is a lobbying organisation (30 members which at end-2008 had assets over $100 billion). It was started by me as an effort to jump start hedge fund involvement in public policy discussions. There was a strong sense that the hedge fund industry was not doing a good job of that three or four years ago. We didn’t want to be a trade organisation like the MFA, which does a great job, but on the other hand felt there was room for another voice in Washington to talk to regulators and try to be constructive and try to educate them. There still was and is a lot of misinformation and sometimes disinformation in Washington about what it is hedge funds do. Our role is simply advocacy. We haven’t asked for anything. We have a pretty good business model. We felt there was a need for an organisation to raise some money and hire people to go out and basically tell the story. We have talked to UK and European regulators from time to time when invited to do so but we are not pro-active there.
To conclude, let’s touch on your own business Kynikos where the flagship Ursus short selling fund has been around since 1985. How has it been able to negotiate market cycles and related to that, what do you see as the key reasons for its longevity?
I think one of the reasons we’ve added value – the SEC won’t let me speak about specific numbers – to our clients who were invested with us on the short side is that, despite what until recently had been a reasonably strong upward market environment, we were positive. It indicates that the alpha in the short strategy that we employed was considerable. I like to say I’m in the insurance business except that our policy is one that pays you small premiums as opposed to you paying us large premiums to protect your portfolio. That’s a good business proposition for us and for the client. Why has that happened and why the longevity? I think we have good people. My head of research (Charles Hobbs) has been with me for 15 years. My head trader (Robert Veninata) has been with me for 15 years. The six partners have an aggregate of over 150 years of Wall Street experience. This is a pretty experienced, battled hardened group. We have a terrific research staff of young analysts who do great work. We have stuck to our knitting in terms of being fundamental investors on the short side and just doing good old fashionedsecurities research and securities analysis to find opportunities. I think we kept the business plan pretty simple in that respect.
One technical question, how does a pure short-selling fund adjust net exposure?
It is a much more difficult issue on the short-side because the math works differently. You have to be much more willing to dynamically trade on the edge of your portfolio to keep within your risk exposures. There are two ways to do it: you can either use stop/loss orders in individual names to limit risk or you can target positions to per cent of capital and keep them within narrow bands on that. The latter is far more preferable and workable.
Jim, many thanks for your time.