One Hedger Who Passes the Sniff Test

Extraordinary behavior makes for a more captivating story than ordinary behavior.

This explains why a recent Wall Street Journal article detailing how some banks are redefining “nonperforming loans” was greeted with a collective ho-hum. (One bank, for example, reclassified loans as nonperforming when at least three payments were missed rather than two; the change “reduced” its volume of bad loans from $106 million to $68 million over a three-month span.) It also explains why hedge-fund manager David Einhorn has appeared in so many articles during the past six months.

Last summer, Einhorn, the head of Greenlight Capital, researched numerous financial services firms to select a few to short — betting that their stock price would fall — due to their exposure to subprime loans. Greenlight ultimately settled on Bear Stearns and Lehman Brothers.

Here's where the plot thickens: This past spring, Einhorn publicly announced that he was shorting Lehman Brothers — an extraordinary move in the hedge fund community, where taking short positions is almost never publicly discussed because of the stigma attached to profiting from a company's struggles or demise.

One fund manager told New York Magazine that publicizing a short position marks “a business decision that we'd never make. The unwritten code is that you don't talk about your shorts because it'll make it hard to get meetings with corporate management, which we need to do our job. Management is scared to death of short sellers.”

But it appears that Einhorn's frequent and vocal questioning of Lehman's risk management decisions (and how the firm accounted for and reported its financial results) was not a business decision at all. Instead, he maintained that Lehman's portrayal of its financial performance did not pass the sniff test and that he was simply stating the truth. A point that seems to really stick in Einhorn's craw is his contention that Lehman, like other firms, has an incentive to sugar-coat its problems because management compensation is largely tied to how its performance is reported.

And here's where the plot thickens some more: Einhorn squared off with Lehman Brothers and its CFO, Erin Callan, in particular, over his position and public comments. Lehman contended that Einhorn was “shorting and distorting” — that he didn't understand the complexity of the firm's balance sheet and was seeking to profit by helping to drive down the firm's stock valuation with his nay-saying at conferences, on television, and in articles.

What's more, Einhorn happens to be publicizing a new book that presents his investment views at a time when the SEC is investigating similarly public comments he previously made about another company that he shorted. However, Greenlight reportedly has twice as many long positions as short positions in its $6 billion-plus portfolio. And, in early June, when Lehman announced a whopping $2.8 billion quarterly loss — which reflected much deeper issues than a “shorter and distorter” could possibly have sparked — it appeared that Einhorn's analysis was on the money. Callan was reassigned in the wake of the painful earnings announcement, and Lehman's president and COO, a longtime friend of the firm's CEO, also was replaced.

Does this mean that Einhorn was right and Lehman was wrong? I'm not sure that this matters, but the story does offer a more important message related to how we behave and how we believe, or fear, that our decisions will be perceived.

Worrying too much about how we might be perceived often leads to “business decisions” that flunk the sniff test. The banks no doubt believed that they were making prudent business decisions by obscuring the extent of their financial pain from investors; however, investors who vigilantly scrutinized the banks' performances and statements still wrinkled their noses. Worse, when many organizations game the system while still technically operating within the letter of the law, what was previously defined as bad behavior becomes merely ordinary. And that stinks.

This is why Einhorn's public display of skepticism was so refreshing. He seemed more interested in responding to something that didn't pass the sniff test and less interested in worrying about how his actions might be perceived.

Here's hoping that this type of behavior doesn't become ho-hum in the months ahead.