Politics & Policy

Not-So-Smooth Returns

David Einhorn's long short story is a sobering, monitory tale.

Hedge-fund manager David Einhorn’s new book, Fooling Some People All of the Time: A Long Short Story, has won critical acclaim in the financial press for its insights into value investing and its readable style. But the book is about more than Wall Street strategy. It offers an insider’s view of how financial markets are regulated by federal agencies and gamed by unscrupulous insiders. Free-market conservatives should pay close attention.

The chaos at Lehman Brothers last week is the latest consequence of what Einhorn calls the “free fraud zone” that regulators have helped create by failing to police securities fraud. Einhorn’s book came out before last week’s debacle at Lehman, but the experiences he writes about help explain why regulators’ reluctance to hurt ordinary investors has let rulebenders run wild on Wall Street.

Fooling Some People looks at Allied Capital, a company Einhorn accuses of engaging in a fraudulent practice called “smoothing returns.” A company is said to be smoothing returns when it refuses to write down the value of floundering assets on its books until it can cover the losses in some other way.

Allied got help, Einhorn writes, from a government bureaucracy that fell prey to a classic case of mission creep. The Small Business Administration (SBA), he writes, backed some of Allied’s shadiest investments because of incentives at the agency to keep growing its portfolio. It’s a sobering and monitory tale.

In 2002, Einhorn gave a speech at a charity event in which he presented his analysis of Allied’s disturbing accounting practices. Allied countered by accusing Einhorn of badmouthing the company in an attempt to profit from shorting its stock. (Einhorn still shorts Allied, and he has announced that he will give any money he makes from that sale — and his book — to charity.)

Einhorn spent the next six years investigating Allied, uncovering more accounting problems and presenting his findings to the SEC. Instead of cracking down on Allied, however, the SEC and then-New York attorney general Eliot Spitzer decided to investigate Einhorn, on the basis of Allied’s allegations of stock-price manipulation (an investigation that has since been dropped.)

The experience left Einhorn convinced that somewhere along the line, securities regulators stopped doing their jobs. As his book tells it, the SEC has become accustomed to prosecuting fraud only after companies have already imploded and the money is gone; but when it discovers fraud in progress, it is hesitant to act. Einhorn theorizes that the SEC doesn’t want to be held responsible for putting companies out of business and thereby costing innocent employees and shareholders jobs and money:

This thinking may be politically expedient in the short term, but creates a classic moral hazard — a free fraud zone. If regulators insulate shareholders from the penalties of investing in corrupt companies, then investors have no incentive to demand honest behavior and worse, no need to avoid investing in dishonest companies. . . .

The same moral hazard exists regarding workers. If employees of a dishonest firm believe that its poor ethics jeopardize their respective futures, they will act more aggressively to fight misbehavior. If managements know lying on conference calls will be prosecuted, they will tell fewer lies.

In an interview with National Review Online, Einhorn gave reasons why people on both sides of the political spectrum should find this moral hazard problematic. “The liberal perspective says it’s government’s job to make everything safe for everybody — not only the belief that they should do it, but that they can do it.” he says. “Conservatives say government can’t do it effectively, so we should let everybody figure it out on their own, and buyer beware.” Unfortunately, the regulatory regime we have now represents the worst of both worlds: “there’s the appearance of protecting people, but in fact people are not actually protected.”

And when companies like Allied get away with shady accounting practices — or even outright fraud — Einhorn says, everyone on the Street notices.

“As my book explains, Allied promised their investors that they would generate steady returns; but the bonds they held were riskier than they thought or were willing to admit to their investors,” Einhorn says. When the securities didn’t generate the returns expected, “Allied said, ‘Look, these things are illiquid, they’re hard to value. We’re going to hold them for 10 years, and we’re not writing them down.’ ” Among those securities were government-backed SBA loans issued to worthless companies — e.g., a group of shrimp-boat operators with no experience or ability to repay their loans who defaulted within a year. Think Forrest Gump, without the dumb luck.

Einhorn says that the SBA continued to back these loans because it has a bureaucratic impreative to maximize the number of loans it extends. “If you have a measure of success that says how much money you lend,” he says, “the answer is always, ‘lots.’ ” Consequently, there were “absolutely no anti-fraud measures” because “anything that polices fraud reduces the potential amount of loans.”

Long after it was clear that the loans to the shrimpin’-boat captains and other questionable assets were no longer worth as much as Allied said they were, the company refused to revalue them. Instead, it simply raised more capital so that when the write-downs occurred, the company would appear to be in better shape than it was. “So what happens to Allied?” Einhorn asks. “Nothing happens to them. The SEC says, ‘Alright, that’s ok, but try not to be so obvious about it next time.’ ”

Einhorn says the same thing happened at Lehman Brothers. “They bought a portfolio of stocks and they convinced themselves it was more stable than it actually was. They set up their business model so that they would say that these things delivered smoother returns than they actually did.” Making matters worse, once Lehman’s managers convinced regulators and investors its portfolio of mortgage-backed securities was worth more than it really was, they leveraged it 30 times in an attempt to maximize their returns.

Sooner or later, Lehman was going to have to face a choice: either write down the value of its shady securities and possibly go bankrupt, or go to new investors and raise new capital before the write-downs “so the new investors wind up sharing the pain with the existing investors.” Like Allied, Lehman took the latter course — the same day last week when it announced its massive $2.8-billion loss, it also announced that it had raised $6 billion in new capital.

Lehman was only heeding “the message that the SEC delivered with Allied Capital,” Einhorn says. “The SEC allowed them to raise a billion dollars of new equity, so that the problems Allied had in 2002 were spread into an additional class of investors.”

Einhorn says that Fooling Some People is not about calling for new laws or new regulations. “The topic of the book is a lack of law enforcement,” he says. “Someone breaks the law: Are we going to penalize them for breaking the law, or are we going to decide that it’s OK?” Fixing the problems in our financial markets “would not require any act of Congress, would not require any rulemaking by any agency. It would require only a different philosophy toward dealing with rules that currently exist.”

That’s a message Einhorn thinks should resonate with conservatives, and it’s one worth pondering as policymakers continue to grope for an appropriate response to the credit crunch.

 – Stephen Spruiell is an NRO staff reporter.

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