Review of Fooling Some of the People All of the Time, A Long Short Story by David Einhorn

Allied Capital was a "business development company" - sort of like a bank except funded more with equity - that made "mezzanine" (that is, high loan to value) loans to corporations. It was mostly owned by retail investors who were hungry for the high dividend yield and couldn't really analyze the company much beyond that.

Poor David Einhorn shorted Allied Capital in 2002 and spent years talking it down and trying to get regulators to investigate its admittedly suspicious sounding accounting for loan impairments.

However, at the same time that Einhorn was shorting Allied, he had a significant long position in New Century Financial. Here was the rationale that he gave in a speech [pdf] at the Value Investing Congress on November 10, 2006:

"We have a company in our portfolio, New Century Financial (NEW), that turned a wonderful non-capital intensive business, the origination and sale of mortgages, and reinvested the cash flows into a mediocre capital intensive business of holding mortgage loans. Worse, they went into the capital markets to raise additional capital to focus on the capital intensive opportunity. I thought this was such a bad idea that I joined the Board with the goal of unwinding this decision and to free the valuable service business from the investment business. It is too soon to discuss my progress."

He was right that the company made a mistake by expanding into the business of owning/holding mortgage loans. However, it is also clear from his comment (and the fact that he owned a big stake in the company) that he completely missed what was going on in the mortgage market; both in the New Century portfolio and in the entire U.S. market. He did not resign from the board until March 2007.

Allied Capital did poorly in the financial crisis, but it lasted until 2010 when it was taken under at $5 per share. Much better performance than New Century which of course went to zero. This old Bloomberg article says that Einhorn's fund lost $140 million on New Century.

Note that the book came out in May 2008, which means he had probably been working on it in 2006 and 2007. Working on a book is very time consuming. It's also backward looking, which is why there are not very many great investment books. What if he had done real estate field research instead of working on this book? Greenlight lost 20 percent in 2008 [annual letter PDF]. 

I haven't read the new version of Fooling Some of the People All of the Time, A Long Short (and Now Complete) Story, Updated with New Epilogue, but the conclusion I draw from the original version is that life is too short to chase after the fraudulent stock shorts. Actually, the more crooked management, the harder it is to make money. Frauds can go on for years and years and years. As long as a fraud can attract investors fooled by some kind of batesian mimicry - in this case a high dividend yield - it can persist.

But if a company is unprofitable and it owes more money than it can repay, the creditors can be the catalyst for the short.

3/5

Why Einhorn Owned New Century Financial

Fascinating; I had forgotten that he was on the other (losing) side of this trade from me.

"We have a company in our portfolio, New Century Financial (NEW), that turned a wonderful non-capital intensive business, the origination and sale of mortgages, and reinvested the cash flows into a mediocre capital intensive business of holding mortgage loans. Worse, they went into the capital markets to raise additional capital to focus on the capital intensive opportunity. I thought this was such a bad idea that I joined the Board with the goal of unwinding this decision and to free the valuable service business from the investment business. It is too soon to discuss my progress."

That was from David Einhorn’s Speech [pdf] at the Value Investing Congress, Friday, November 10, 2006. He was right that the company made a mistake by expanding into the business of owning/holding mortgage loans.

However, it is also clear from his comment (and the fact that he owned a big stake in the company) that he completely missed what was going on in the mortgage market; both in the New Century portfolio and in the entire U.S. market. He did not resign from the board until March 2007.

I've said before, I think that Manhattan-based investors were more likely to miss what was going on in the rest of the country. See my previous posts about this:

• Key WSJ Article: "Laffer and Moore: A 50-State Tax Lesson for the President"
• Paper: "Perils of the Periphery: Social Network Position and Hedge Fund Performance"
• Oliver Stone Inadvertently Sheds Light on New York Groupthink
• Review of Diary of a Very Bad Year: Confessions of an Anonymous Hedge Fund Manager

Laszlo Birinyi, The Guy Who Says the S&P 500 Could Surge to 2,854 by 2013

Oh boy. I just looked into the background and track record of Laszlo Birinyi, The Guy Who Says the S&P 500 Could Surge to 2,854 by 2013.

I am overjoyed and delirious with excitement. Here is a choice selection from his Forbes column, February 12, 2007,

If you are venturesome, also remain with New Century (30, NEW), a subprime mortgage lender. The stock is down 32% since last April when I recommended it. But the company has raised its dividend for each of the last eight quarters, and the stock yields 25%. Don't put your retirement funds here or take a large position, but at four times trailing earnings, it's cheap. And there has to be a bottom somewhere.

Shorting New Century was my first Credit Bubble trade, although by the time I started the blog, the New Century short was over and I was using it to illustrate that Downey Financial was worse.

Here's another great pearl of wisdom, this time from January 2008,

The bearish arguments for 2008 aren't any more valid. Many bears expect a recession, which they assume is poison for market performance. Not quite. In the 11 recessions since World War II the market has averaged a 3% gain, despite the inclusion in that data set of the 23% decline in 1974. During 6 of those downturns the S&P went up. If 2008 is a recession year, it is not automatically fated to be bad for stocks.

What, me worry?

S.E.C. Accuses 3 New Century Financial (NEW) Ex-Officers of Fraud

Credit Bubble Stocks started out with a New Century Financial short. Now, three years later, the S.E.C. is accusing three former officers of fraud. Among other fine examples is this gem:

New Century allegedly misrepresented its LTV ratios, reporting that a 100% LTV 80/20 loan had an LTV of only 84%.

New Century was run Sopranos-style.

New Century Financial Common Stock is a Zero

NEW CENTURY FINANCIAL CORP filed this Form 8-K on 12/14/07:

"Based on a preliminary review of the claims against the Company received by the claim bar date, the Company currently believes that there will be no recovery in respect of the Company’s outstanding common stock under the Debtors’ plan of liquidation."

You've come a long way, baby!

Incentive Incompatibility at Mortgage Brokers

From a recent Washington Post:

"Maggie Hardiman cringed as she heard the salesmen knocking the sides of desks with a baseball bat as they walked through her office. Bang! Bang!

'You cut my [expletive] deal!' she recalls one man yelling at her. 'You can't do that.' Bang! The bat whacked the top of her desk. As an appraiser for a company called New Century Financial, Hardiman was supposed to weed out bad mortgage applications. Most of the mortgage applications Hardiman reviewed had problems, she said.

But 'you didn't want to turn away a loan because all hell would break loose,' she recounted in interviews. When she did, her bosses often overruled her and found another appraiser to sign off on it.

'There was instant notification to everyone as soon as you rejected a loan. And you dreaded doing it because you paid for it. Two guys would come with a bat, and they were all [ticked] off because you cut their deals.'

This sounds like something out of The Sopranos, except it was happening at the nation's third largest subprime lender, which wrote tens of billions in loans.

It's really not that surprising. This story could have come from a book about S&L Crisis I.

DSL vs NEW Comparison

Most of the NEW stats are 2005 data; DSL stats are from the previous filing as reported on this blog.

NEW stock price vs Markit 2006 BBB- ABX index

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