David Einhorn is not afraid to call a bluff when he sees it. The President of Greenlight Capital has built a reputation within hedge fund circles as a fiercely independent, critical-thinking manager with a knack for making bearish bets on established, generally well-respected companies. No stranger to the public eye, previously publicized campaigns against the likes of Allied Capital and Lehman Brothers have aided his fund to post outsized returns for more than a decade, helping his fund grow from a lowly $1 million in assets under management in 1996 to its roughly $5 billion size of today. One of his current fixations, the debt rating agencies, offers investors an additional glimpse into his investing philosophy.
During a speech at this spring’s Ira W. Sohn Investment Research Conference, “The Curse of the Triple A,” Einhorn made a compelling claim against the debt rating agencies. Much of these firms’ success ties itself to the enormous fees they reaped during the earlier stages of this decade, rating structured debt products on behalf of institutional clients. As the housing market ballooned, in particular, Wall Street licked its fingers in anticipation of the arrival of new tranches of mortgages which would be quickly packaged and resold to investors. By law, many financial institutions are required to invest in assets based upon the underlying investment’s rating. Hence, the likes of Moody’s, Standard and Poor’s, A.M. Best, and Fitch’s labeled the vast majority of subprime loans as AAA or investment grade, thus fueling more demand for these presumably low risk, “safe” products that banks and money managers clamored for.
However, the recent failures of several of these products, representing billions of dollars, suggests that the agencies may have misjudged or even ignored the risk of default. As Einhorn has stated, many of these investors “…thought they were buying safety, but instead bought disaster.” Under regulation FD, the ratings agencies are allowed to receive confidential information from underwriters that is not made available to other market players. Hence, the investor should logically expect that these assigned ratings truly reflect the underlying product’s risk characteristics. Yet, the widening discrepancy between these products’ losses and their lofty risk-based ratings has led many on Wall Street to question the validity of the debt rating process.
Just last week, a US District Court Judge in New York dismissed claims by Moody’s and McGraw-Hill Cos. (Standard & Poor’s parent company) that investors cannot sue them over ratings. The ratings firms had claimed that their ratings are protected under free speech laws. Einhorn clearly believes that the decision will open up the possibility for investors to file class-action suits, under the premise that the ratings firms hid the existence of risk. Einhorn referred to the decision as “Landmark,” and went on to compare it to when tobacco victims were finally permitted to sue cigarette manufacturers. If found liable, these suits could, in fact, threaten their survival.
However, Einhorn still faces his share of skeptics. While the ruling opens up the possibility of future lawsuits, investors must be able to prove that the firms deliberately misled investors, eventually causing them losses. With little concrete evidence, this could be difficult to prove in court. In fact, in addition to Berkshire Hathaway, the likes of Morgan Stanley, Vanguard, and T. Rowe Price still hold considerable stakes in Moody’s. As a result, while Einhorn’s efforts may have contributed to Moody’s share price falling more than 35% over the past year, a slew of investors still view the firm’s discounted shares as a value opportunity.
Nonetheless, Einhorn stands by his claim. Readers may recall that Einhorn feuded with lender Allied Capital earlier this decade, even outlining his criticisms of the firm in a book, Fooling Some of the People All of the Time. Despite dodging an SEC investigation by Elliot Spitzer concerning market manipulation, Einhorn stuck to his guns, accusing the firm of fraudulent behavior and crooked accounting. The SEC eventually found Allied guilty of breaking several securities laws. That battle, which lasted six years, reflects his innate ability to persevere. Indeed, that stick-to-itiveness has helped to produce annual investor returns of over 20% since the fund’s inception.
In 2006, Einhorn placed 18th out of nearly 9,000 competitors in the World Series of Poker Tournament in Las Vegas. After bowing out to the eventual tourney winner, he pocketed a cool $660,000 in prize money (which he in turn gave to charity). Admittedly only a part-time player, Einhorn displayed little hesitation when rubbing elbows with some of the most elite players in the world. Similarly, his short positions in Moody’s and McGraw-Hill Cos. represent his latest challenge, an opportunity to prove his mettle against several of Wall Street’s titans. In his first quarter letter to investors, he included a quote from the late President John F. Kennedy, “A nation that is afraid to let its people judge the truth and falsehood in an open market is a nation that is afraid of its people.” For Einhorn, to ‘judge the truth’ involves discrediting an entire industry, exposing the status quo for its alleged wrongdoings. His current plight represents one of the most engaging investments of his relatively short career. Yet, if his past serves as any indication, don’t expect Einhorn to “fold” any time soon.
