Over the next several weeks, names were removed from the credit basket as Greenlight closed out some short positions and focused its capital on a handful of firms, Lehman still among them.
As these banks began reporting their quarterly results in September, Einhorn paid close attention and became especially concerned by some of the things he heard in Lehman’s September 18 conference call on its third-quarter earnings.
For one, like others on Wall Street at the time, the Lehman executive on the call, Chris O’Meara, the chief financial officer, seemed overly optimistic. “It is early, and we don’t give guidance on future periods, but as I mentioned, I think the worst of this credit correction is behind us,” O’Meara announced to the analysts.
More important, Einhorn thought Lehman was not being forthcoming about a dubious accounting maneuver that had enabled it to record revenue when the value of its own debt fell, arguing that theoretically it could buy that debt back at a lower price and pocket the difference. Other Wall Street firms had also adopted the practice, but Lehman seemed cagier about it than the others, unwilling to put a precise number on the gain.
“This is crazy accounting. I don’t know why they put it in,” Einhorn told his staff. “It means that the day before you go bankrupt is the most profitable day in the history of your company, because you’ll say all the debt was worthless. You get to call it revenue. And literally they pay bonuses off this, which drives me nuts.”
Six months later, Einhorn had listened intently to Lehman’s earnings call on March 18, 2008, and was baffled to hear Erin Callan offering an equally confident prognosis. It was, in fact, the emergence of Callan as Lehman’s chief defender that had galvanized his thinking. How could a tax lawyer, who had not worked in the finance department and who had been chief financial officer for only six months, understand these complicated assessments? On what basis could she be so certain that they were valuing the firm’s assets properly?
He had suspected that Callan might be in over her head—or the firm was exaggerating its figures—ever since he had had the opportunity to speak directly to her and some of her colleagues back in November 2007. Lehman, having heard that Einhorn was critical of the firm, set up a conference call with him and made some of its top people available to him in hopes of assuaging his concerns.
But something about the call unnerved him. He had repeatedly asked how often the firm marked—or revalued—certain illiquid assets, like real estate. As a concept, mark-to-market is simple to understand, but it is a burden to deal with on a daily basis. In the past, most banks had rarely if ever bothered putting a dollar amount on illiquid investments, such as real estate or mortgages, that they planned to keep. Most banks valued their illiquid investments simply at the price they paid for them, rather than venture to estimate what they might be worth on any given day. If they later sold them for more than they paid for them, they made a profit; if they sold them for less, they recorded a loss. But in 2007 that straightforward equation changed when a new accounting rule, FAS 157, was enacted. Now if a bank owned an illiquid asset—the property on which its headquarters was located, for example—it had to account for that asset in the same way as it would a stock. If the market went up for those assets in general, it would have to record that new value in its books and “write it up,” as the traders put it. And if it fell? In that case, it was supposed to “write it down.” Of course, no one ever wanted to write down the value of his assets. While it may have been an interesting theoretical exercise—the gains and losses are not actually “realized” until the asset is sold—mark-to-market had a practical impact: A firm that had a huge write-down has less value.
What Einhorn now wanted to know was whether Lehman reassessed the value of its illiquid assets—including some $9 billion in mortgages—every day, every week, or every quarter.
To him it was a crucial question, because as values of virtually all assets continued to fall, he wanted to understand how vigilant the firm was being in reflecting those declines on its balance sheet. O’Meara suggested the firm marked the assets daily, but when the controller was brought onto the call, he indicated that the firm marked those assets on only a quarterly basis. Callan had been on the phone for the entire conversation and must have heard the contradictory answers but never stepped in to acknowledge the inconsistency. Einhorn himself didn’t remark on the discrepancy, but he counted it as one more point against the firm.
By late April, he had already begun speaking his mind publicly about the problems he saw at Lehman, suggesting during a presentation to investors that “from a balance sheet and business mix perspective, Lehman is not that materially different from Bear Stearns.”
That comment had gone largely unnoticed in the market, but it did raise the ire of Lehman. Einhorn set up another call with Lehman, and again, Callan tried to answer his questions and to turn his view of the company around. But despite her outward affability, he felt she was obfuscating.
Now, as he began preparing for his major upcoming speech in late May 2008, it was that conversation with Callan that confirmed for him that he needed to make Lehman the focus of his presentation. He decided to follow up with Callan one last time, sending her an e-mail to inform her that he planned to cite their earlier conversation in his talk at the Ira W. Sohn Investment Research Conference.
She responded immediately, skipping the niceties: “I can only feel that you set me up, and you will now cherry-pick what you like out of the conversation to suit your thesis,” she wrote back.
Einhorn was accustomed to companies turning hostile—anyone who wanted to be loved in the financial industry had no business selling shares short. He fired a tough e-mail right back: “I completely reject the notion that I have been disingenuous with you in any way. You had no reason to expect that our discussion was confidential in any way.” And then he finished writing his speech.
Einhorn stood in the wings of the Frederick P. Rose Hall in the Time Warner Center on May 21, waiting his turn to speak.
He had been scheduled to take the stage at 4:05 p.m., just after the markets closed—timing that had been carefully planned by the organizers of the conference. Given his stature within the industry and what he was about to say—and considering the firepower of the investors in the audience—he could easily rattle the markets, especially Lehman’s shares.
As investor events go—and there are many—this was one that genuinely mattered. The hedge fund industry is famously reclusive, but today the key players in the field were in attendance, the auditorium packed with industry titans such as Carl Icahn, Bill Miller, and Bill Ackman. By some estimates, the guests in the audience that day had more than $500 billion under management.
From the stage’s corner, Einhorn watched as his warm-up act, Richard S. Pzena, a successful value investor, was apparently finishing his speech, having run over his time allotment as he offered his big investment idea to the audience.
“Buy stock in Citigroup,” he instructed, suggesting that, at $21.06 a share, its closing price that afternoon, it was a screaming buy. “This is classic value. There is lots of stress,” he said. “When we come out of this, the upside is huge!”
If an investor had actually heeded that advice, he would have lost an enormous amount of money. But the audience applauded politely as it waited for the main event.
Beyond speaking about Lehman, Einhorn viewed his appearance today as an opportunity to promote his new book, Fooling Some of the People All of the Time, which stemmed from an earlier speech he had delivered at this very conference in 2002—a speech that had landed him in trouble with the feds. In it he had raised questions about the accounting methods used by a company called Allied Capital, a Washington-based private-equity firm that specialized in midsize companies. On the day after he criticized the firm, shares of Allied plunged nearly 11 percent, and Einhorn, at age thirty-three, immediately became an investing hero—and a villain to those he bet against.