Today we post part three of our three-part Q&A session with famed short-seller Jim Chanos.
Perhaps Chanos’ most famous trade of all time is his shorting of Enron before the company collapsed. That is what we focus on today.
Click here to read part one of the interview. Click here for part two.
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Business Insider: Let’s talk Enron. It’s known as your biggest trade. I heard that early in the 1990s, around ’93 or so, is when you first started to look into the company.
Jim Chanos: We had looked at it a few times because it was a rapid acquirer of companies but never saw anything well before our involvement that made us pull the trigger. It wasn’t until the 2000 time frame that we really got intrigued by this thing.
BI: Was there any catalyst in the 2000 time frame?
JC: Sure. A catalyst for our involvement was simply a phone call I got from a friend in Dallas who ran a hedge fund who asked if I had seen Jonathan Weil of the Texas Wall Street Journal’s Heard On The Street column if I had heard the accounting of the energy merchant banks. And I had not seen it.
So he faxed it to me – email was still not ubiquitous at that point – and it was a really interesting column about how the energy merchant banks had lobbied the SEC successfully for getting mark-to-model and mark-to-market accounting for their long term investing in energy derivatives. To take the present value of all the future profits that were written into the derivatives were sold as opposed to adjusting it pro-rata over the life of the contract. And they were celebrating.
The article if I can recall went on to say that there were a number of academics and accountants who were worried about this practice. That anytime you could front-load profits you’d really suspect that company of corporate abuse. We had experience with this in a number of areas in the first subprime fiasco in the mid-90s and then way way back going back to the annuity issuers – Baldwin United and others – back in the early-80s. They were selling insurance policies and cooking up all their future assumed income up front.
BI: Just to step in here for a second, when you refer to the subprime crisis in the 90s, are you referring to the late 1990s with second-tier mortgages?
JC: It was the time of the money store, so I’m going to say this was 1996 to ’98 as I recall.
BI: Kyle Bass mentioned this stuff to me around the same time.
JC: Yes. That was the Spanish Civil War to the subprime World War II that hit 2006 and 2007.
So immediately we got a little interested because over and over we’ve seen at the hands of unscrupulous management that kind of ability to in effect create instant profits by doing what were ultimately bad business deals, you know, was just too lucrative to give up. So we basically started analyzing Enron right then and there, which was the October-November 2000 time-frame. We pulled the 1999 10-K and 10-Qs and immediately there was red flags all over the place. There was the odd disclosure about the offshore entities that were set to do business with Enron.
BI: Like JLM?
JC: Yeah like with the Raptors and some of the others that where a senior executive of Enron was also the managing partner of the entities.
BI: A huge conflict of interest.
JC: Yes. There are other odd things that didn’t get as much subsequent press. For example: we saw a violation of the matching policy under GAAP, which is that in the merchant banking operations, they would sell assets for a gain and it would be above the line as merchant banking income. But when they sold something at a reasonable loss they moved it into discontinued operations and then when they sold it they put a loss on sale of discontinued operations. So, as opposed to booking both their profits AND their losses, they were putting that below the line so the analyst was disregarding that.
BI: Nice.
JC: Yes! So that was another thing that caught our eye. The next thing that caught our eye was even with what looked to be some pretty aggressive accounting, we calculated the company’s pre-tax return on capital including their derivatives book to be somewhere a little north of 6% but below 7%. And based on what Enron bonds were trading at and the equity risk premium, we realize this company wasn’t earning its cost of capital.
So it was a giant leveraged hedge fund as my partner Doug Mellon said at the time that was earning 6% a year if you would, on a leveraged balance sheet and you were gonna pay six to ten times book for it. It made no sense.
Then finally, there were the more interesting secondary issues like the insider selling through 2000. A lot of executive departures in 2000. So all these things for us were enough for us to start initiating a position in November of 2000.
BI: More red flags came up?
JC: Yes and then the more work we did and the more disclosure that started coming out, the more it became apparent that…
BI: Time was up?
JC: Yes. Well, we actually never thought it was a fraud. The “A-Ha!” moment for me that I suddenly knew that something was not in the grey area but the black area was when Skilling resigned. That’s when I knew.
BI: I see.
JC: When Skilling resigned abruptly at that point I knew that something was very very wrong that we couldn’t see. And what we couldn’t see of course was the gua ranted payments that they had made to the offshore entities should they sell them assets were suddenly loss-making. So in order to get these toxic assets off their books, they agreed to issue Enron shares as a “make-good” to the offshore entities. And they didn’t disclose that.
That was the hidden troll, in terms of an equity analyst.
BI: What about the Skilling analyst call in 2000, 2001?
JC: That was in 2001 with the analyst who asked him ‘Why no balance sheet? You’re a financial institution!’ and that was just another sort of qualitative red flag; this is a management team under a little bit of stress.
BI: Could you just give as briefly as possible, a description of mark-to-model accounting?
JC: Yes, there’s nothing wrong with mark-to-market accounting if there’s a liquid market in instruments. The problem really for Enron, and then as we found out later for the banking industry in the latest financial crisis, was really mark-to-model accounting. Mark-to-market for lots of derivatives is really, for the vast majority of them, looks towards something that’s liquidly traded, say something like a Treasury bond or IBM stock. And if it’s an option on IBM stock, or say it;s a simple mortgage-backed bond that trades off of Treasuries, it’s fairly easy to get a reasonable set of assumptions as to what your derivative might be worth by looking at the price of the “underlying” as they say.
But for Enron, and as we found out in some of the CDOs later in the current financial crisis, mark-to-model became much more problematic because if Enron has contracted with Intel to provide electricity to some Intel plant over a 15-year period based on certain weather factors or whatever….I mean there were so many moving parts that no one could simply point to an underlying and say ‘Well, a reasonable person would say this is the range of this security. There were 4 or 5 or 6 variables in some of these contracts, some with huge volatility in inputs.
BI: Similar to, say, weather derivatives?
JC: Yes. What is it worth? I don’t know. Can an auditor come in and disprove you? Doubtful.
BI: Right.
JC: So where was the incentive? The incentive of course was to ere on the optimistic side because that was in instant income and therefore instant bonus.
BI: So you think it was motivated by profits for the upper echelon of [Enron] management?
JC: Oh absolutely. It was an agency. They were gaming the shareholders.
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