The fraud detective
Jim Chanos saw through Enron, Tyco, and the subprime mortgage mess. And made money on them.
Richard Conniff ’73, a National Magazine Award winner, is the author, most recently, of The Species Seekers: Heroes, Fools, and the Mad Pursuit of Life on Earth.
On a muggy Thursday in the dog days of August 2011, the news broke that the American technology giant Hewlett-Packard was about to acquire British software maker Autonomy Corp. The offer price represented a 64 percent premium on the previous day’s close. At his office in mid-Manhattan, hedge fund manager Jim Chanos ’80 did not rejoice.
Only a few weeks earlier, his firm, Kynikos Associates, had put together a report on Autonomy, calling its chief operating officer unqualified, its customers unenthusiastic, its market share and growth numbers questionable, its financial disclosures “very poor,” and its margin profile “suspiciously high.”
“We thought this was one of the great shorts of all time,” says Chanos, who specializes in ferreting out corporate bad behavior and then short-selling the companies that indulge in it. (That is, he borrows shares in a company and sells them at the current price, in the expectation that he will be able to pay back the loan, or “cover the short,” with shares purchased at a much lower price when the truth comes out. See boxes, pages 41 and 43.) Autonomy was the firm’s largest short position in Europe. So Hewlett-Packard’s decision to more than double the value of the company was—and here Chanos laughs—“very painful.”
Chanos passed along a copy of his Autonomy analysis to a friend who had friends on the board at HP, saying, “You should look at this. This is going to be a disaster.” The deal closed anyway, and Chanos was soon shorting HP as enthusiastically as he had shorted Autonomy. Thirteen months later, in November last year, HP management woke up, said there were “serious accounting improprieties” at Autonomy—and handed shareholders an $8.8 billion loss on the deal. (Autonomy’s ex-CEO denied the charge.) By then, Chanos had already covered most of his short, pocketed the profits, and moved on.
You would think that by now financial types would stop to listen when Chanos says “Uh-oh.” He has been raising the red flag on companies—from the merely troubled to the outright fraudulent—for more than 30 years, often while corporate executives and Wall Street analysts were still eagerly flogging those companies to gullible buyers. “He’s been pretty much right about everything,” says Nell Minow, a leading advocate for responsible corporate governance. “He’s a smart guy.” The investments he has shorted constitute a nearly complete chronicle of bad business behavior in our time. The most famous among them landed Chanos on the cover of Barron’s in 2002 as “The Guy Who Called Enron.” But the list of his targets stretches from Michael Milken’s junk bond empire through the real estate boom of the late 1980s, the telecom bubble of the late 1990s, Dennis Kozlowski’s Tyco and Bernie Ebbers’s WorldCom at the turn of the century, subprime mortgage lenders and homebuilders in 2007, and most recently an entire nation. (China, he says, is “on an economic treadmill to hell.”)
Chanos has inevitably also been wrong about some companies—or right, but too soon, as with his first go-round on Autonomy. He has taken losses, sometimes for years on end, that, according to a longtime friend, would make an average man “go out and shoot himself.” Even so, he has managed not only to survive but to prosper and put an exuberant face on a notoriously treacherous line of work. “Jim Chanos,” International Business Times declared in 2011, “is the best short-seller in the world.” In certain circles, this is a bit like saying he is the world’s best agent of Satan. But Chanos turns out to be a more complex character than the labels “hedge fund manager” and “short-seller” might suggest.
“I hope you are here,” Chanos tells a packed classroom at the Yale School of Management, on a Monday afternoon in March, “for ‘Financial Fraud through History: A Forensic Approach’ and not for ‘How to Run a Hedge Fund 101.’” He’s just flown up from a weekend in Florida. His hair, still sand-colored at 55, sweeps down over his forehead. He wears thick-lensed rimless eyeglasses and a blue blazer over a purple cashmere sweater, which make him look at first like an Episcopalian minister gone astray. But he quickly shows himself a confident guide to the topic he will be covering for three hours once a week over the next eight weeks—“the rogues and charlatans” who have cheated investors through history.
Chanos has been teaching this class for three years, starting soon after he mentioned to then–Yale president Richard Levin ’74PhD that his fantasy was to come back to New Haven to earn a graduate degree in history. As an undergraduate, Chanos had been a student of Levin’s. (“He says the only reason I uncovered Enron was because of what I learned” in his class.) Levin countered that Yale’s fantasy was to have Chanos teach. Then, says Chanos, Levin heard the course description and joked that he’d had second thoughts: “He said, ‘You’re not going to teach them how to commit fraud, are you?’”
That’s not the plan, Chanos tells the class. But it is “almost inevitable that you will come across fraud in the course of your careers.” It has already happened to a former student, whose first job confronted him with a discrepancy that ended up in the corporation counsel’s office. Corruption is everywhere in the business world, he warns, citing a survey in which 45 percent of chief financial officers said their CEOs had asked them to falsify financial results.
The point of the class, Chanos says, is always to look beyond face value and to spot the fudging and the fraud in time to protect their employers, as well as their own wallets and reputations. Just such a moment of recognition, early in his own career, set him on a thin line between finding his calling and getting fired.
Chanos grew up in a Milwaukee suburb, in a Greek immigrant family that operated a chain of dry-cleaning shops. He helped pay his way through college with a summer job as a union steel worker. At Yale, he majored in economics and political science. His non-academic credentials included lightweight crew and two years as social chairman at Davenport College, where his roommate, Keith Allain ’80, now coach of the Yale hockey team, once inadvertently slapped a puck through the window of the master’s house. (Allain has described his former roommate as “one of those special guys who could light the candle at both ends and never get burned.” He had Chanos go inside to explain the puck.)
After college, Chanos got his start as a bottom-rung analyst for Blyth Eastman Dillon in Chicago, working 80-hour weeks at $12,500 a year. It began to dawn on him, he says, that “I could’ve made more money shoveling snow in Milwaukee.” But when a group of partners split off to start their own firm, Gilford Securities, they took Chanos along. And there Baldwin-United Corp. entered his life.
Baldwin was a piano company that had transformed itself, by a series of acquisitions, into an insurance giant and Wall Street darling. When it announced its latest acquisition in the summer of 1982, Chanos got the job of figuring out if the proposed deal would be good for Gilford clients, among them hedge fund titans like Michael Steinhardt. “And I started looking at this mess of a company and couldn’t figure out how they were making money and what their disclosures were saying. I was just simply calling up people and asking questions and trying to figure this thing out.”
Then one night when he was working late his direct line rang. “Is this Jim Chanos?” the caller asked. “You’re the guy asking all the questions about Baldwin-United?”
“Yes,” Chanos answered. “Who’s this?”
“It’s not important who this is.”
The caller proceeded to point Chanos to public files of correspondence between Baldwin and state insurance regulators in Arkansas. Those files turned out to be a beginner’s guide to financial shenanigans. The regulators had belatedly discovered, among other things, that Baldwin was improperly using insurance reserves to finance its acquisitions. Chanos put out his report—saying, sell Baldwin and sell it short—in mid-August, 1982, the start of what would become one of the longest bull markets in Wall Street history. Baldwin’s stock price promptly doubled. “So my sense of timing was impeccable,” says Chanos.
Steinhardt and other clients were soon flushing money down the drain on his advice “and not happy about it.” The firm’s New York partner wanted to hand them the 24-year-old analyst’s head, but the Chicago partner fended him off. Chanos went home for the holidays feeling miserable about screwing up on his first real job. Then, on Christmas Eve, the Chicago partner phoned to give him the news: Arkansas had just seized the assets of Baldwin-United.
Until then, Chanos had never felt any predisposition to be a short-seller. But Baldwin was a good early lesson, he says, “because it was painful as heck and I was almost fired, and yet we were sitting on all this evidence that the market was ignoring. And it was completely accurate and completely predictive.” Baldwin developed into what was then the biggest financial bankruptcy in US corporate history, and the question soon came filtering down from clients: “What else does Chanos not like?”
Today Chanos manages his hedge fund out of a not-particularly-grand office in a midtown neighborhood known more for art and restaurants than for high finance. (There’s also a London office, and for grandeur, Chanos, who was divorced in 2006, has an apartment on Fifth Avenue and a sprawling shingle-style house on the ocean in East Hampton, Long Island.) The conference room features a library of financial calamity—including such titles as Conspiracy of Fools and A Colossal Failure of Common Sense—bookended with bears, not bulls.
Though Chanos doesn’t put it quite this way, short-selling goes against some of the most basic proclivities of the financial marketplace—not to mention human nature and, some would say, God. It is an article of faith among investors that stock averages rise over the long term, and even market professionals tend to believe that their own chosen stocks will turn out, like children in Lake Wobegon, to be above average. Moreover, for those who go long—that is, buying and holding stocks—the potential gain is limitless (at least in theory), while the potential losses are limited: once a stock hits zero, you can’t lose any more on it than you’ve already lost. The really treacherous thing about short-selling is that it works the other way around. It’s the losses that can be limitless. And the agony can go on for months or even years as a bad company, puffed skyward by a charismatic CEO and a chorus of fawning analysts, ascends into the stock market heavens.
Beyond the financial pain, short-selling also exacts a psychological toll. Stock markets are “giant positive reinforcement machines,” says Chanos, and they’re built for the sole purpose of selling stocks. “So almost everything is positive, everything is bullish.” For short-sellers, that means the rest of the market is constantly shouting (sometimes literally and in the most personal terms) that they are wrong. And studies show “that people’s rational decision-making breaks down in an environment of negative reinforcement,” says Chanos. Good short-sellers “drown it out. It means nothing to them. But I think most people can’t do that.”
Chanos got his first public taste of the corporate world’s ill will in 1985, when the Wall Street Journal ran a front-page article about, as he puts it, “this cabal of evil short-sellers.” Corporate executives and investors told the Journal that Chanos “epitomizes all that is wrong with modern short-sellers.” The article alleged that Chanos and his ilk sometimes resorted to “innuendo, fabrications, and deceit to batter down a stock.” Chanos denied any wrongdoing and otherwise shrugged it off, telling the Journal: “People think I have two horns and spread syphilis.”
Soon after, Chanos and a partner put together $1 million of their own capital and $15 million from a single client to form Kynikos. The name came from the Cynics, philosophers in ancient Greece who stood for self-sufficiency, mental discipline, and proper judgments of value. Less conveniently, the Cynics also stood for poverty. One of them lived in a tub on the street. After a year of watching the stocks they had shorted rise in the continuing stock boom, Chanos’s partner couldn’t stand the negative reinforcement. He offered to sell his share for $1 so he could write off the tax loss and sleep at night. Chanos took the dollar bill out of his wallet on the spot. The crash of 1987—good news for short-sellers—came soon after. “It was the best purchase I ever made, ironically,” says Chanos. He jokes that the ex-partner’s wife “still wants to kill him over it.”
Kynikos went on, however, to lose almost everything as the markets recovered in the first half of the 1990s. Clients defected, the firm was on the brink of collapse, and Chanos was paying staff out of his own pocket, while also supporting four young children. He eventually reorganized the firm with his original clients and devised a compensation scheme that took overall market movements out of the calculation. Today, Kynikos has $5 billion under management.
The peculiar chemistry that enables Chanos to handle the stress is largely a mystery, even to him. “Good short-sellers have something in the DNA,” he offers. “Or maybe we were dropped on our heads as babies.” His friend James Grant, publisher of Grant’s Interest Rate Observer, quotes Bernard Baruch’s line about a celebrated financier being “all nerve—and no nerves.” It’s maybe not an absence of certain feelings, but an ability to set them aside. To blow off steam, in the 1990s Chanos started playing basketball, working out, and lifting weights. (He says he bench-pressed 340 pounds last year, but is down to 310 at the moment.) When his gym on the Upper East Side was going bankrupt, he bought the place and now runs it at a slight loss.
Another factor may be his sense of himself as a Wall Street outsider. This may seem improbable, given his wealth, his longtime position as board chairman of a coveted Upper East Side private school, his frequent appearances on CNBC, and his many Yale connections. But until the late 1980s, Chanos was probably the only hedge fund manager who was also still a dues-paying member of the Pipefitters and Boilermakers Union—a holdover from his summer job in college. He also often talks an anti-management line, and not just because he’s shorting a company’s stock. In 2011, he spoke out in defense of the Occupy Wall Street movement: “People are angry,” he told a reporter. “They feel the game is rigged, that they didn’t get their fair shake.”
His sense of moral outrage at financial chicanery has at times trumped his political loyalties. Chanos is a frequent contributor to Democratic candidates. (A right-wing website recently dubbed him “the president’s billionaire playboy bundler.”) But when Attorney General Eric Holder commented early this year that bringing criminal charges against some large companies is difficult because it might hurt the economy, Chanos lashed out, saying “too big to jail” would aggravate public mistrust of the markets. Then he declared that the last time the justice department showed real leadership on corporate crime was when it put away executives from Enron, Tyco, and WorldCom—under Attorney General John Ashcroft ’64, who served in the second Bush administration.
in his class, Chanos constantly nudges his students to challenge established opinion. When one of them remarks that a scandal-ridden firm had a reputable auditor signing off on its reports, he says, “They all have reputable audit firms. That’s one thing I want you to take away from this course: every big fraud had a great audit firm behind it.” He likens auditors and government regulators to archaeologists. “They’ll tell you what happened after the damage has been done.”
What Chanos tries to teach is how to predict the damage: look for tip-offs, look for patterns of bad behavior that repeat from one scandal to the next. Unlike some other hedge funds, Kynikos boasts no ingenious market model, no trademark quantitative analysis. Instead, Chanos’s brand of short-selling typically comes down to basic financial detective work. He seems to rely largely on a heightened instinct for bad behavior, a willingness to follow up with phone calls and legwork, and an inordinate appetite for hieroglyphic footnotes and disclosures buried deep in corporate 10-Q and 10-K reports.
Chanos also routinely invites analysts and other interested parties to lunch in the conference room at Kynikos. This is mostly to persuade them that the bad news he has dug up is accurate; if they’re convinced, his short-selling is more likely to succeed. But also, says his friend James Grant, “really successful investors, including Jim, make it a point to be open-minded and seek out opinions, all in the interest of knowing everything they can about a situation.” Chanos, he adds, would have made a good investigative reporter, “if only journalism paid as little as $25 million a year.”
As in journalism, good stories like Enron have often started with a seemingly trivial item in the news. In September 2000, an accounting column by Jonathan Weil in the Wall Street Journal noted that Enron traders were signing energy contracts that would deliver income over a standard 10- or 20-year term, but booking them as if the total anticipated profit were already safely in the bank. Enron was then one of the hottest stocks on Wall Street, but incredibly the item ran only in the paper’s Texas regional section.
A friend sent a copy to Chanos, and the “mark-to-market” accounting instantly caught his attention, partly because it echoed one of Baldwin-United’s favorite tricks. Chanos spent hours that weekend circling questionable items in Enron’s SEC filings. What mostly interested him were a few simple numbers available to anybody who took the time to look: the company’s ostensibly brilliant managers were earning just seven percent a year on capital that was costing them more than ten percent to borrow. Enron was bleeding itself dry.
Kynikos began shorting the company in November, when the stock was at about $60. Then Chanos exhibited the cabalist behavior that has gotten him labeled as a company-bashing trafficker in innuendo: he spoke to the press. (“And you know,” Chanos once mused to an interviewer, “there are ten thousand highly paid analysts and investment bankers and PR agents who are out shilling for corporations all day along and no one seems bothered by that.”) In January 2001, when Enron’s stock was at $80, a young reporter named Bethany McLean phoned up scrounging for story ideas, and Chanos told her what he knew about Enron. The resulting article, published in Fortune magazine that March, began to gently pull apart the loose threads of the Enron rat’s nest.
“There was no way to know then that this was a fraud,” Chanos tells his students at SOM. All he had was a suspicion that the company was overstating earnings. But over the next few months, the whole sordid tale emerged. It had all the telltale signs of ethical collapse that make up the theme of his class: the larger-than-life CEO (Jeff Skilling was still posing manfully on magazine covers as late as that February), the weak board of directors, the staff of loyal youngsters, the culture of fear, the conflicts of interest, the willful ignorance, and the willing suspension of disbelief by investors caught up in Enron euphoria.
For Chanos, there was “a great postscript,” he tells the class. “A me-too company called Dynegy” tried to buy Enron as it was spiraling down to bankruptcy. “Someone said, ‘Have you looked at Enron’s books?’ And Dynegy said, ‘That’s the good news. We’ve looked at the books and their accounting is exactly the same as ours.’ I backed up the truck on Dynegy at that point. We made as much on Dynegy as we did on Enron.”
And at that moment, you can begin to see why Wall Street insiders might just hate Chanos, why they might publicly praise him as a hero and privately wish him to be caught in a very bad, possibly terminal, short squeeze. You can even understand why ordinary investors, standing over the $62 billion black hole that used to be Enron, might sometimes share these misgivings. Revealing the ugly truth, while making lots of money at it, isn’t necessarily a great way to win friends.
But that evening at Pepe’s, where he regularly takes a group of students out for beer and pizza, Chanos is looking ahead, not back. There are other SEC filings in need of careful scrutiny, other companies to short, other forms of corporate entitlement and bad behavior to stoke his sense of outrage. The idea that he might give all this up to go back to Yale for a graduate degree in history is just a fantasy. Right now, he is too busy burning the candle at both ends, and still not getting burned.