Review: Fooling Some of the People All the Time, by David Einhorn

Fooling Some of the People All of the Time, A Long Short Story, by David Einhorn. Hoboken, NJ: Wiley, 2008. 380 pp. $29.95 (cloth).

The scene is the offices of Donaldson, Lufkin & Jenrette (DLJ) in late 1991. Analysts here are regularly given deadlines requiring them to work through the night; hundred-hour workweeks are the norm, and the environment is extremely hectic—even by Wall Street standards. It is three o’clock on a Sunday morning, and a young David Einhorn sits at his desk trying to finish the job he was given. A few months into this position, he has lost fifteen pounds due to the stress (p. 12).

Two years later, Einhorn takes a job working for Siegler, Collery & Company, a mid-sized hedge fund with about $150 million under management. He learns “how to invest and perform investment research from Peter [Collery], a patient and dedicated mentor” (p. 12). He spends weeks “researching a company, reading the SEC filings, building spreadsheets and talking to management and analysts.” He then turns in his work to Peter—who, having read everything, makes a detailed list of questions that Einhorn wishes he had asked (p. 12).

In 1996, confident in his own abilities, Einhorn resigns from the firm to start his own. The original business plan is written on the back of a napkin. The original office is a 130-square-foot, windowless room. He names the firm Greenlight Capital, as suggested by his wife, who also gave him the green light. As Einhorn explains, “When you leave a good job to go off on your own and don’t expect to make money for a while, you name the firm whatever your wife says you should” (p. 12).

Greenlight Capital is a “long-short” hedge fund—which means a fund that “goes long” on investment opportunities that it thinks are substantially undervalued and “short” on those it regards as substantially overvalued. Einhorn succinctly explains these terms:

Short selling is the opposite of owning, or being long a stock. When you are long, the idea is to buy low and sell high. In a short sale, you still want to buy low and sell high, but in this case the sale comes before the purchase. It works this way: Your broker borrows shares from a stockholder who lends them to you, and you sell them in the market to a new buyer, thus establishing a short position. To close out the position at a later date, you buy shares in the market and return them to your broker to “cover” your short, and the broker returns them to the owner. Your profit or loss is the difference between the price you receive when you sell the shares short and the price you pay to buy them back. The more the stock falls, the more money you make—and vice versa (p. 5).

For instance, on the long side, Greenlight invests 15 percent of the fund in C. R. Anthony, “a small retailer that had recently emerged from bankruptcy and returned to profitability. The market valued the company at $18 million despite its having twice that in net working capital (current assets less all liabilities).” When other investors (finally) notice the discount at which it is selling relative to net working capital, the stock increases substantially. And when they start to value the company based on its future earnings potential, the stock shoots up 500 percent from Greenlight’s initial investment (page 19–20).

On the short side, Greenlight sells Sirrom Capital, a business development company that Einhorn considers overvalued. “By tracking performance of [Sirrom’s] loans from the year of origination, we determined that although the overall portfolio statistics appeared appealing, rapid asset growth masked poor results. . . . We estimated that from inception to final maturity, 40 percent of the loans went bad” (p. 29).

After researching how Sirrom has accounted for bad loans in the past, Einhorn predicts that the company will have to recognize a significant loss on its loans in the near future. If this is correct, the market will lower its estimation of both Sirrom’s current assets and its future earnings potential; the company will be unable to sell new stock in amounts large enough to mask past errors; and the price of its current shares will decline accordingly. Einhorn’s prediction proves accurate. Sirrom is able to sell shares to the public only one more time before reporting disappointing results, at which point the shares collapse from a high of $32 to just under $3 (p. 30).

The foregoing are just two of Greenlight’s many such successes. By figuring out the true state of a company, comparing it with the state of the company as reported by its management team or as judged by the market, and then going long or short accordingly, Greenlight proceeds to earn spectacular returns for its clients. The company’s earnings and assets under management soar—as does peer respect for Einhorn himself.

Because of Greenlight’s success in shorting Sirrom, Einhorn is approached by a hedge fund specializing in financial institutions for his opinion on a company with a structure identical to Sirrom’s and with seemingly identical problems. The company in question is Allied Corporation (p. 43).

After performing in-depth research of Allied, Einhorn concluded that its management team is either incompetent or fraudulent. He “put[s] 7.5% of the fund into [an] Allied short sale at an average price of $26.25 a share.” And then, at a charity conference where investors are asked to give their best investment idea, he shares his reasons for Greenlight’s short on Allied (p. 52). The market’s reaction to that speech, as Einhorn later tells an aggressive SEC lawyer, is much, much greater than he could have anticipated.

The next day, after an unusual delay (due to so many people wanting to sell or short the stock), Allied opens almost 20 percent lower. Investors apparently were persuaded by the speech. Analysts, however, were not. In Einhorn’s summation, although they “didn’t know exactly what had been said . . . [they] were confident that whatever was said was wrong” (pp. 55–56). Allied itself responds with statements to the effect that whatever Einhorn said in his speech, the whole thing could be discounted because he was positioned short on the company’s stock and thus would profit if it went lower.

Partly because this strategy proves “successful” with investors (enabling Allied to continue selling new shares of stock at inflated prices), Greenlight’s short position turns into a long story spanning more than six years. Fooling Some of the People All the Time details the history of that investment. The book documents the “wrongdoing of Allied Capital, and as important . . . the indifferent attitude of regulators—our government representatives—towards that wrongdoing” (p. 4).

Einhorn performs the same sort of analysis on Allied’s loans as he did on Sirrom’s. He compares the reported default rates with the nationwide average. He looks at the reported value of different groups of loans on Allied’s books (which were held at full value) and compares them with the value of those same loans as decided by the market (where they were trading at pennies on the dollar). He talks to bankers who had bought some of the loans Allied once had on their books but resold, to former employees to learn about how loans were made and by what kind of people, to employees at the government agency that had guaranteed three-quarters of those loans, to analysts who covered the company, and to fund managers who owned shares in it. Einhorn starts with what he knows to be true and contrasts those facts with various reports and statements made by Allied’s management team. He compares what they said previously with what they say subsequently. And he makes explicitly ethical judgments along the way—particularly about the management team’s honesty or lack thereof.

We think that the Company’s approach now seems to be that it will attack the short thesis with a combination of ad hominem attacks, obfuscations, and specious syllogistic reasoning. A great deal of this approach has to deal with the integrity or lack of integrity in using language, and with the use of language to distort and confuse, in our opinion. In the past, we have seen this approach used to good effect in the political arena . . . the integrity of language used might have some relationship to the integrity of the speaker (p. 82).

One of the great values of Fooling Some of the People All the Time is that it is a case study in the practicality of observation-based thinking and moral judgment. The rise of Greenlight Capital from its start in a small, windowless office with less than one million dollars under management to a multibillion-dollar hedge fund with a long-term record of producing yearly gains of more than 20 percent demonstrates the fruits of rationality and justice.

Likewise, the failure of certain other businesses and government agencies documented in the book demonstrates the consequences of irrationality and injustice—on the part of both managers and bureaucrats.

For instance, Einhorn shows that, although the Securities and Exchange Commission (SEC) was patently aware of many of the fraudulent activities that have occurred in the past few years, it nevertheless ignored much of what it knew. The regulators were not “asleep” (as the media usually report); rather, they were selectively aware of what was going on. The SEC itself notes that it imposed a record number of corporate penalties over the past few years.* The question, however, is, whom did it penalize—and for what? The answer to that question is indicated by the fact that whereas the SEC blithely (and for years) ignored Einhorn’s detailed account of Allied’s corporate fraud, the Commission rushed to investigate Einhorn’s alleged crime of “manipulating” Allied’s stock price.

Similarly, when the Small Business Administration (SBA) was provided with a detailed exposé showing that taxpayers were being defrauded, it reacted in an equally disinterested manner. As Einhorn puts it:

I was naive enough to expect that the SBA would actually take an interest. Here, we had spent private resources and laid out an easy road map to an ongoing fraud that was costing taxpayers at least tens of millions of dollars in guarantee payments on loans that should never have been made and served no purpose other than to line the pockets of crooks. The SBA had limited resources; we were offering free help and were obviously willing to provide additional help, if asked. Most perplexing—the folks we were meeting with had presumably chosen careers in public service to root out exactly this sort of misconduct, yet seemed unwilling to do anything to stop it (p. 180).

Einhorn concludes in his characteristically just fashion: “The SBA’s lack of concern that taxpayers were being ripped off, are being ripped off, and will be ripped off—all in its name—is nothing short of appalling” (p. 281).

The ratings agencies, he observes, have displayed a similar lack of interest in the truth. After Fitch Ratings gave the “all-clear signal” on a now-bankrupt subsidiary of Allied, Einhorn got an email from someone at an independent research firm who covered the company: “I spoke with [the analyst] who wrote the Allied rating piece on Bloomberg, and told her that if she had more factual information she might come to a different conclusion, and I told her I could provide her with the research that contained this information. She said she was not interested. I told her that I was amazed at her response, if she was at all interested in seeking the truth. She remained unimpressed. What can I say?” (p. 289).

Einhorn catalogs similar evasions by many people across several industries and agencies, shows the consequences of their dishonesty, and thus concretizes the disastrous effects of pretending that facts are other than they are.

Although Fooling Some of the People is for the most part superb, it does contain some unfortunate concessions to illegitimate government activity (e.g., mentioning the profoundly rights-violating Sarbanes-Oxley Act in a positive light). But relative to its virtues, the book’s flaws are few.

By way of its virtues, Fooling Some of the People exposes many little-known truths regarding events that led to today’s financial crises. The book also conveys a moral and practical message to all investors and would-be investors: “Fraud can persist for a long time, and investors, analysts, and the SEC miss things. But, sooner or later, the truth wins. If you know you are right, all you need is patience, persistence, and discipline to stay the course” (p. 42).

* Joseph A. Giannone, “Hedge fund manager relates ‘short’ story,” Reuters, May 15, 2008.