The spread of the subprime crisis provided opportunities to recoup those losses. The trigger for Greenlight was an unheralded item that came across the wire in late July: The largest bank in France, BNP Paribas, had frozen its depositors out of their money-market accounts, an event that caused barely a ripple of coverage in the United States. But at the Greenlight office, an alarm went off. “I was thinking to myself that these people are workers in France, they’ve got a money-market account that they’re earning no money on. Their only goal is to have that money available to them whenever they want it; that’s what a money-market account is. You can’t freeze the money market. But when they did that, I was already studying the collateralized-debt obligations and all that other stuff because our short on bond insurer MBIA was beginning to work. The stock was going down. There was pressure building.”
The news convinced Einhorn that a much larger crisis was imminent, and on a Friday afternoon, he called together his analysts and they developed a plan for the weekend—to come up with as comprehensive a list as possible of financial firms with exposure to subprime loans. “We did something we’d never done before. We left on Friday, and by Sunday night, we had a list of 25 financial firms that we wanted to short. Research-wise, we did a lot less work than we usually do when we take a position. There wasn’t time.”
Over the next three days, Greenlight shorted all 25 stocks. “It was what we called the ‘credit basket,’ ” says Einhorn. “A big macro call. One percent of this, one percent of that. No large positions. We were looking for the firms that we thought had the most exposure. Over the next two or three weeks, we kept working on it, closing some shorts, concentrating our positions on the firms that we felt were the most vulnerable. Goldman, Morgan Stanley, Merrill Lynch, UBS, Bear Stearns, Lehman, Citigroup—we got them all. They started announcing earnings. We started listening to conference calls, tracking the earnings.”
The earnings conference call is a routine exercise on Wall Street. Typically, firms release their quarterly earnings a few days in advance and then answer the specific queries of analysts during the call. Like many investors, Einhorn finds them a useful check of a firm’s truthfulness, and when he listened to the Lehman call in September, he didn’t like what he heard. “They sounded less honest than the other firms.”
Was that merely a gut feeling? I asked.
“It wasn’t a gut feeling. It’s an experience. It’s when people ask reasonable questions clearly and they get bogus answers back.”
Among other things, Lehman was taking advantage of a new accounting mechanism that allowed it to book revenue based on the declining value of its own debts. In other words, because of the increasingly risky state of Lehman, loans that other firms had made to Lehman had dropped in value, and under the new accounting, Lehman could count this as a gain.
Lehman is not the only firm that employs this trick, but in Einhorn’s view, it was the least transparent about it. “Morgan Stanley announced their quarter and they did the same thing, although they were incredibly explicit about it. ‘We’re fair-valuing our liabilities, it creates a gain for us, here’s the amount of our gain.’ Lehman wouldn’t even tell you the amount of the gain. This is crazy accounting. I don’t know why they put it in. 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.” Einhorn almost sounded like he might be getting mad. But he kept his tone at the level of intense bemusement.
In sifting out the worst companies in the basket, Einhorn understood where he could make the most money. “The world just broke apart. On the one side, you had Goldman, which obviously had it right, and Lehman, which said they were like Goldman. And then there was everybody else, who either had it wrong or massively wrong. As you looked, you could see where Goldman had it right, and you couldn’t really see it for Lehman, except they kept repeating it, louder and louder, and the media is going off, story after story about how Lehman got it right, how Lehman’s hedged. It just didn’t make any sense.”
The credit basket went from 25 firms to six. The process wasn’t perfect. Greenlight covered its short on Citigroup just before the stock took a major hit. But before long, the basket was down to two, Lehman and Bear Stearns. And though Bear was the one to go down, Einhorn believes Lehman barely escaped the same fate. “Other than the charismatic value of the leadership and maybe the popularity of the company,” he says, “Lehman’s exposures are worse than Bear’s on an apples-to-apples basis.”