China is in the midst of the biggest real estate bubble in human history—“Dubai in 2007 times 1,000.” And Sino-Forest, the less-than-meets-the-eye Canadian forestry play in China? That fits a pattern: Promoters “find a different investment hype, a story, to get people excited. In the 1990s, it was the Internet, and now it’s China. Unbridled growth.”
Why should we believe this prophecy of imminent calamity in the market that we were all counting on to buoy us for decades to come? Well, Jim Chanos—who uttered both of those quotes—has a pretty good record in doomsaying. And in profiting from that doomsaying.
Chanos, 53, is the most renowned, or, if you prefer, notorious, short seller on Wall Street. He runs Kynikos Associates, the world’s largest investment fund devoted exclusively to shorting. It manages about $6-billion (all currency in U.S. dollars except where noted).
Chanos’s fattest, juiciest-looking target for the past several years has been China. Yes, China’s GDP is still expanding by about 9 per cent annually, but embarrassing cracks are appearing in the official high-growth façade, particularly the evidence of boom-time overbuilding of condos, offices and infrastructure.
Chanos sees himself as a sort of watchdog. But others see short sellers as the undomesticated type of canine: jackals who wait for the stragglers of capitalism to show the slightest weakness, so they can attack in a pack and run them to death, profiting obscenely in the process.
It’s a debate almost as old as financial markets, and it cranked up to high pitch in early August as stock indexes around the world plunged. Shorts are a convenient scapegoat during a crisis, and France, Italy, Spain and Belgium quickly imposed temporary bans on short selling.
But the financial mainstream, both the big players and the rule makers, no longer enjoys a reputation for omniscience and infallibility. Is it now the smart thing, even the right thing, to run with the wolves?
As Chanos tells it, his career is one of those that had the benefit of an early epiphany. In 1980, the Milwaukee native, freshly armed with a degree from Yale in economics and political science, landed a job as a junior analyst at the Chicago office of the brokerage firm Blyth Eastman Paine Webber.
At the time, the firm was trying to convince McDonald’s, the most important company in the city, to issue bonds at 12 per cent to fuel its expansion. A veteran partner quietly suggested to Chanos that the fast food giant’s earnings per share would actually grow a lot more if it bought back some of its own shares instead of issuing a supersized portion of expensive debt.
Chanos ran the numbers. The veteran was right. McDonald’s would be better off with a buyback, although that would also mean lower fees for Blyth Eastman. Chanos presented his findings to the firm’s banking partner. “Who authorized this analysis?” the partner asked, then told him to shelve it.
“That’s when I knew I was not going to be a banker,” Chanos says. “They’re not interested in truth or what’s best for the client, but in making the sale with the least amount of work.”
Fortunately for Chanos, another long-time partner, Bob Holmes, left the firm and started his own outfit, Gilford Securities. Chanos followed him. In early 1982, the pair started probing Baldwin-United Corp., a venerable manufacturer of keyboard instruments that, during the conglomerate mania of the 1970s, had mutated into a $9-billion insurance giant.
Baldwin-United was issuing annuities that offered fat annual returns of up to 14.5 per cent. Wall Street investment dealers were selling hundreds of millions of dollars worth of them. But when Chanos looked at Baldwin-United’s accounting, he couldn’t make head nor tail of it. “I now call it the Rule of Three,” he says. “If you read a company’s financial statements three times, and you still can’t figure out how they make their money, that’s usually for a reason.”
Chanos concluded that Baldwin-United wasn’t earning enough on its investments to support the annuities. To conceal the gap, he deduced, the company was making overly optimistic projections about the proceeds from the annuities years into the future and then booking the current value of those estimates as revenue.
In August, 1982, Gilford issued Chanos’s report, along with a “sell” recommendation. It was no bombshell. In fact, Baldwin-United’s share price climbed from about $20 to almost $50 in November.
Then, as has often happened since, Chanos got a critical assist from a journalist. Forbes reporter Dick Stern flew to Chicago, and Chanos spent three days walking him through the numbers.
A few days before Stern’s story appeared, news reports warned that it would be critical. Baldwin-United’s share price dropped $9 in two days—and kept going. The following year, the company set a new record for the biggest bankruptcy in U.S. history.