David Einhorn at the 3rd Annual New York Value Investing Congress reported by Marcelo Lima
David Einhorn at the 3rd Annual New York Value Investing Congress reported by Marcelo Lima
David Einhorn of Greenlight Capital gave a great talk on the Lehman Brothers black box, which was essentially his short thesis on the stock. His talk began with the Value at Risk formula, and proceeded to show how it’s essentially useless when it comes to capturing the risk actually taken by market participants.
The major banks have been reporting about 40 basis points of value at risk across their asset portfolios, so on the face of it, they’re not exposed to much risk. David’s next presentation slide showed the actual losses which, of course, were orders of magnitude greater than the amount estimated by the VaR formula and disclosed in the companies’ financial statements.
The root of the problem has to do with the fact that a normal or lognormal distribution doesn’t capture what, in reality, is a fat tail phenomenon: that events at the tail ends of these distributions (the so-called 5 or 6-sigma events) really happen a lot more often than one would expect, implying that these aren’t really the appropriate distributions to use in the first place.
Interestingly, David seems to have become interested in this because his reinsurance business (publicly traded Greenlight Re) also used a measure similar to value at risk. He and the board decided to scrap it because they considered it the “FMOW” or “Failed Measure of Whatever.”
David then spoke about FAS 159 (The Fair Value Option for Financial Assets and Financial Liabilities), a new accounting standard, which he called “Profiting from your own demise.”
This new standard allows companies to update the fair value of both their assets and liabilities. Previously, if interest rates moved, only the assets were revalued, so companies would report a gain or a loss based on that move. If your assets are properly funded by matching liabilities, however, both should move in lockstep and offset each other, so this new standard makes sense.
However, suppose a company’s debt is being severely downgraded. Suppose further that the market hasn’t changed, so the value of the assets remain the same. Now the company will record a gain and increase its apparent book value, or equity, when in fact it is in recognizably worse financial shape due to the downgrade. It is an entirely absurd outcome.
According to David, the investment banks have been early adopters of this standard and this has had the absurd effect that the worse their credit, the more money they’re making (because of the gain in book value that goes through the income statement). The logical extreme of this is that the most lucrative day in the history of your company will be the day you go bankrupt.
Bear Stearns, in its conference call, has defended these gains as real. Sell-side analysts have followed suit.
FAS 159 underpins David’s short thesis on Lehman. He goes on to show that he believes the majority of Lehman’s earnings in 2007 have been derived from credit spreads widening and the effects of FAS 159. One perverse aspect of this is that as your company’s credit deteriorates, compensation bonus pools tied to earnings become fatter and you are essentially incented to report these fictitious earnings.
Furthermore, in 1998 Lehman marked their portfolio to model and when the market recovered, they emerged unscathed. The difference is that this isn’t a liquidity problem that we’re facing today: it’s a credit problem. You can’t just sweep these mark-to-market losses under the rug because there are real defaults happening within these credit structures. Lehman refuses to disclose what David thinks are hidden losses.
Lehman has said that their portfolio is hedged, but these hedges are completely black box. Nobody understands how they work, not even the ratings agencies, according to conversations with them.
According to Lehman, its main objective is to underwrite CDOs to move, not to own them. But in reality, a lot of this toxic junk is getting stuck on the balance sheet because the company can’t sell it. Its exposures are increasing each quarter as leverage also ratchets up. Finally, there’s significant impairment being done to Lehman’s franchise value, since it’s made so much money recently from acting as a manufacturer of so much of the toxic junk that is now moving against it.
David’s long idea was Criteria Caixacorp, a Spanish investment company. It is trading at a 26% discount to ascertainable net asset value. The company is today a collection of shareholdings in listed companies, for the most part, and a few unlisted businesses. Expenses are being held at under 10 bps of assets under management. The parent is a very large, well managed and conservative Spanish bank. David believes that over time these holdings will be sold and the company will be converted from a holding company to an operating business in the financial services sector.