Chanos on the Financial Crisis (and How It Made Me Think Differently)

Everyone has their favorite demon for the financial crisis, whether it’s mortgage originators, rating agencies, banks, the Fed, hedge funds or as some would have it, angry gods.

Then there’s some favorite policies, like mark-to-market accounting, that people like to point to as accuse of exacerbating the crisis and making it worse than it actually is.

I went to a panel discussion at NYU’s School of Professional and Continuing Studies – “Back to the Future: How NOT to Repeat Yesterday’s Mistakes in Tomorrow’s Markets” – with Jim Chanos, the hedge fund manager famous for shorting Enron before the fall. The event made me think twice about the role of hedge funds and mark-to-market accounting in this crisis.

Chanos was flanked by Ed Grebeck, a structured finance expert famous for warning investors not to put their money into collateralized debt obligations (CDOs) before the crisis (“Why Should Institutional Investors Invest in CDOs, at All?” – published in Euromoney in April 2006).

Grebeck made the point that mortgage-linked CDOs were crafted such that “your structured finance model is my equity risk”. That is, the depth of the CDO modeller’s research into historical housing prices and default rates was essentially what determined how risky of an investment it was for the buyer. As a result – all tranches, from the AAA-rated slices all the way down to the BBB mezzanine portions and the unrated equity portion – should have carried an equity risk premium. And the senior-most AAA portions certainly didn’t deserve risk equivalency with treasuries.

So they were, in effect, ticking time bombs of massively under-priced, illiquid securities that were loaded with irreconcilable conflicts of interest and didn’t give investors enough information about how they were pieced together.

Now, in hindsight, it is easy to see that. But what about 2004 through 2007, when these instruments were being mass-manufactured by investment banks?

All the biggest investment banks adopted FAS 157 – the financial directive that introduced mark-to-market accounting – in late 2006 or early 2007. The accounting standard required them to split their assets into three buckets – level 1 (which have observable market prices, like stocks) and level 2 (observable market prices, but model inputs are based on them, like interest-rate swaps benchmarked over a 10 year treasury bond) and level 3 assets (no observable market prices, so carrying values are based solely on management estimates).

In the spring of 2007, short-sellers such as Chanos, always looking at the fine print to determine whether it’s worth taking a bet that the price of a security will fall in value, for the first time had “better granularity into the financial system”, as he put it, thanks to FAS 157. Stock prices for all the big investment banks began to tumble because, for the first time people realized just how much exposure they had to those level 2 and 3 assets – the stuff Grebeck was talking about – and how heavily over-leveraged investment banks had become, he said.

So when I asked Chanos whether FAS 157 has exacerbated the crisis – since its introduction, people have argued that mark-to-market accounting is difficult, inaccurate, exaggerates losses and distracts management – he disagreed wholeheartedly. More disclosure is better than less disclosure, he said. He also called the CDO boom-and-bust “one of the biggest heists in the history of capitalism” essentially enabled by a lack of transparency.

And, naturally, he doesn’t believe that short hedge funds such as his – Kynikos Associates (Kynikos is Greek for “cynic”) should be vilified for making use of that information in making investments.

“It’s always easier to blame some nameless, faceless ‘they’ than face what got us here,” Chanos said.

But it will likely take a while for governments to get on the same page. He recalled giving a presentation at the G7 meeting in the spring of 2007 just as FAS 157 was being implemented. He and another speaker gave “60 minutes of horrific presentations” about what they saw coming in the financial markets. When they were done, the first question from the German finance minister, Chanos recalled, was, “thank you very much – now, what do you think about hedge funds?” – as if it were all their fault.

Which takes us back to the blame game all over again. Sure, there’s plenty to go around and the list of causes and culprits is still being tallied. But I, for one, am convinced that more disclosure and short hedge funds making use of that disclosure should stay firmly off the list.