The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (33 page)

This all raised questions in Chanos’s mind. Would generational savings be destroyed, exacerbating a ticking demographic time bomb? Another roadblock to developing China’s consumer economy? What would happen as a consequence of the unfunded liabilities and government guarantees? Is the $3.0 trillion “security blanket,” the foreign reserves, full of holes? And what would the global consequences be, such as the impact on prices of construction materials and interest rates for U.S. and other sovereign debt?

At first, Chanos saw immediate backlash against his thesis, with many saying there was no real estate bubble in China. A year and change in, the Central Bank of China has acknowledged there’s a real estate bubble and that the country is facing issues. So, too, has the International Monetary Fund. “What people don’t realize is that China papered over its last two credit bubbles, those in 1999 and 2004. The banks were never bailed out—they just exchanged their bad loans for questionable bonds from quasi-state organizations. The Chinese banking system is built on quicksand,” he says.

The country’s capital markets have failed to modernize to meet the demands of China’s domestic economy and role in the international economy. Political pressure to stimulate the economy during the financial crisis resulted in massive loans to local governments and real estate developers. These loans are turning increasingly insolvent as the borrowers find it hard to repay them as a consequence of the stagnant or failing demand for housing, declining prices, and the evaporation of land sales, a principal source of cash for local governments. Alternative banking networks are collapsing. Given the lack of transparency and inadequate, if nonexistent, corporate governance, it’s hard to determine the enormity of the debt and the likelihood of its repayment. This means untold risks for China’s banks, and that deep government reserves are keeping things afloat—at least for now.

“The question, now, is how is China going to manage its way through it,” he says. “The excesses that we saw a year and a half ago have only built up since then.”

Presently, Kynikos is short the property developers in China through the H-shares in Hong Kong as well as most of the larger Chinese banks, which the firm believes are going to need ongoing injections of capital, much of which will come from Western investors. The fund has been short an oddball collection of one-off Chinese companies, such as Chinese Media Express, that have floated issues in the United States. Chanos has dubbed casinos “long corruption, short property.” But his overall short in China stands as one of the highest exposures he has had to a single theme. China is one thing he’s betting against in a big way—it currently stands as the highest exposure he’s ever had to a single theme in the portfolio.

Although one economist estimated that 64-million apartments are empty, “what we do know is that if you drive by all kinds of tier one, tier two, and tier three cities at night in developments that are completely sold out, most of the buildings are dark at night, so there are a lot of empty apartment buildings in China. We just don’t know how many,” says Chanos.

So Chanos’s team developed a proprietary index of property transactions in the first-, second-, and third-tier cities. It was the first time they turned around a time series and made an index out of it, and Chanos explains the process. “Interestingly, the problem is not the amount of data available about China. It’s the quality of the data in China.” Even though the data may be flawed, the firm finds it a useful indicator. “If we keep it consistent by using the same data, we can at least get an idea of some trends,” says Chanos. For the last few years that they’ve been tracking this across 50 percent of China’s urban population, this reasonably significant statistical sample was at first flat and more recently (late 2011 to early 2012) has turned down. So for all the increase in development, by unit sales, transactions have been flat to falling. Chanos deduces, “If you’re not selling the same number of units with more and more coming down the stream, there are going to be many units stacking up in the system. And that is a major warning sign.”

What they’ve seen recently for the first time is that price cuts have not been met by an increase in sales whereas historically, every time price dips in the market, activity has usually spiked a little bit. “We’re keeping an eye on that pretty closely, too,” says Chanos. “Because if that continues, there’s going to be a real problem.”

The question everyone asks, however, is when. “If I were good at timing, I probably would have retired a long time ago,” says Chanos with a chuckle. “It’s certainly happening though. Inflation is bubbling through the economy there faster than I think anybody thought. And now you’ve got the authorities that are behind the eight ball on two fronts.”

Added onto the credit expansion and property bubble, consumer and wholesale prices experienced a sharp rise. It’s a situation where China scrambled from behind to tighten credit before signs of a slowdown since the summer lead to credit easing in November. “We’re hearing stories of hoarding and shortages and inflationary behavior like rapidly rising wages. It’s another wild card we didn’t expect a year ago.”

What Chanos sees about China though is a two-fold story of credit-driven excess in the country as well as potentially dangerous situations for investors in many Chinese companies. Drilling into individual companies, Chanos is amazed at just how dicey almost every company they analyze looks. Some examples include odd transactions—lots of profits never show up in cash and/or suspicious-looking affiliated deals with third parties. “Almost every company we look at exhibits one or more of those characteristics,” says Chanos. “So I think it’s very problematic for Western investors to make money in the share market in China. Not only because I think the macro’s bad, I think the micro’s bad, too. You’re basically being fleeced as the Western investor in many of these companies.” Chanos points to examples of companies that suddenly stop trading, or corporate headquarters that don’t exist when Westerners fly out for a visit. “If you can borrow the stocks and get short them, it’s basically a field day for the short-seller over there because many companies look like they are fraudulent.”

Part of the problem in understanding China, Chanos says, is the prevailing myths. One is that the country’s balance sheet is healthy in that it doesn’t show much debt. That’s because the state-owned enterprises and local governments use special off-balance-sheet financing vehicles, with borrowing that has been growing very quickly, he says. “We estimated that China’s total debt reached about 180 percent of GDP in late 2011. If we assume that China will grow total credit this year between 30 percent to 40 percent of GDP, and half of that debt will go bad, that is 15 percent to 20 percent. Say the recoveries on that are 50 percent. That means that China, on an after write-off basis, may not be growing at all. It may have to simply write off some of this stuff in the future so its 9 percent growth may be zero.”

Back to Business School Basics

When Chanos is not busy looking into China, one of his other targets is the for-profit education sector, what he deems “a national shame.” Chanos predicts the industry will face continuing pressure over the next few years with dramatic cutbacks in federal loan guarantee despite the Republicans’ rear-guard battle to support the industry. “I think it’s just a national scandal that all these kids are getting degrees from these ‘universities’ and they are no more employable than if they had a high school diploma and they’re leaving with $20,000, $30,000, or more in debt they can’t repay,” says Chanos. “And then the burden is left on the taxpayer to repay.”

These days, Chanos has been spending some time inside the classroom himself. Teaching his first class as Visiting Lecturer at Yale’s School of Management titled “Financial Fraud throughout History: A Forensic Approach” over a series of eight lectures, he ventures up to New Haven every Monday afternoon to impart his financial wisdom to a room of about 50 graduating seniors.

Chanos spends half of the three-hour class giving a lecture; his students prepare case studies on fraudulent scenarios between 1992 and 2005 for the other half. At the final class in early May, the last student presentation is on Harken Energy Corporation and its limited partnership, Harken Andarko Partners.

A tall female student with glasses stands and begins loading her presentation at the front of the classroom. After a few slides, she gets to the meat of the first transgression. “A single capital transaction accounted for 50 percent of its operating profit in 1994. Disclosed or not, this is a clear financial misrepresentation of the company finances and tantamount to fraud,” she declares.

“Harvard’s asset management entity, Harvard Management Company, extended a loan, increased stock purchases, etcetera, to support Harken’s share price,” she continued. “Harvard sold out its interest while the price was solid and made a profit—about $20 million or a 3 percent annual return for a period when it held Harken stock.”

Chanos interrupts. “So what do you think was potentially fraudulent about any of these activities by Harvard?”

The student mumbled an answer that Chanos dismissed, and the student continued.

“The SEC probed Harken board chairman Alan Quasha’s ownership interests, but did not have any issues to charge him with.”

Chanos interjected, now addressing the class. “Remember one of our points, class. Even a transaction that looks immaterial to an entity may be material to one person in that entity. What was the key here? What was the connection? Why? Material circumstances. Always remember, what is immaterial to one entity can be very material to a key person.”

Chanos continues. “Why did Harvard keep throwing money at this company? How unusual is it for a company with a $150 million market capitalization to have involvement with such investors as Soros and Harvard. A company this small normally wouldn’t be on their radarscope. It appeared like the asset manager was doing everything to salvage the investment.”

A great case study for all of the cynical sleuths in training.

Chapter 9

The Derivatives Pioneer

Boaz Weinstein

Saba Capital Management

Our fund is looking for asymmetric investments, ones where we can make a lot more than we can lose.

—Boaz Weinstein, May 2011 interview

“Nothing in life is so exhilarating as to be shot at without result.” So said Winston Churchill, speaking of his experiences in the Battle of Omdurman, in Sudan, where as a 24-year-old lieutenant in the 21st Lancers, he participated in what came to be recognized as the last meaningful charge of the British cavalry.

Boaz Weinstein might be able to relate to this sentiment. Though he wasn’t exactly shot at during the financial crisis of 2008, he was at the vortex of the conflict. Then 35 years old and the youngest managing director in the history of Deutsche Bank, Weinstein helped manage the bank’s affairs at that perilous time, when banks were suffering significant losses. Weinstein was also running a proprietary trading group within Deutsche called Saba, which itself was hit with losses of $1.8 billion, or 18 percent, on capital of $10 billion, a sudden turn of events after 10 profitable years. Moreover, Weinstein had long championed credit default swaps (CDSs), the still poorly understood instruments that were widely blamed for accelerating the collapse.

Yet after all the shooting on the financial battlefield subsided, Weinstein emerged none the worse for wear. In the first eight weeks of 2009, Saba recovered a third of what it had lost. In February 2009, with the aftershocks of the crisis still rumbling, Weinstein acted on a long-standing agreement with the bank that allowed him to start his own hedge fund, not only with the bank’s blessing, but with 12 key members of his team, along with trading systems, analytics, and other intellectual property that the group had developed. Weinstein launched credit-focused Saba Capital Management with $140 million, and within two years it had $3.3 billion in assets, earning recognition from
Absolute Return-Alpha
magazine as the fastest growing fund in the industry, and winning Weinstein the rank of seventeenth in
Fortune
magazine’s “40 Under 40” list for 2010 and nineteenth for 2011. (The fund now has more than $5 billion in assets.)

Growing up, Weinstein amazed those around him with a precocious aptitude in two interrelated pursuits: numbers and games of strategy. The young math whiz memorized the stats on the back of his baseball cards, was a devotee of
Wall Street Week with Louis Rukeyser
, and earned the title of National Master in chess at age 16. (Also highly adept at blackjack and poker, he was invited by Warren Buffett in 2005 to play in a poker tournament, and won a Maserati.)

Weinstein, for one, downplays the significance. “People make a lot of the connections between chess and investing and say things like, ‘Oh, you must be able to see many moves ahead,’ as if skill at chess can directly translate to markets in a way that non—chess players cannot access. I think that’s overstated. That said, there certainly are some related concepts, such as the ability to quickly recognize patterns, and the discipline of being hyperrational in evaluating the strength of your position. And as it happens, I got a summer job in trading at Goldman Sachs because there was a senior partner who was very interested in chess. So it certainly helped me get my start.”