by Matt Taibbi
As a velocity trader, Graber constantly bought and sold the same stocks.… He talked about the stock he traded with intense passion, passing around made-up gossip, false speculation, and occasionally real news—anything to stir up action. One of Graber’s abilities was to “paint the tape,” the illegal practice of trading with the sole purpose of moving the price of a stock. The agribusiness giant Archer Daniels Midland was one of the stocks Graber fooled with relentlessly. To paint the tape on ADM, Graber and Israel would call eight different brokers and put in buy orders simultaneously to run up the price—at a time when Graber was holding lots of the stock ready to sell into a rising market. It was a racket the Securities and Exchange Commission was hopelessly ill-equipped to stop.
“The SEC questioned Freddy all the time,” Phil Ratner recalled. “But they couldn’t catch him. He traded so much that it was impossible to say he’d traded on inside information.”
Israel ended up abandoning that velocity trading method and actually got in real trouble only when he tried to earn his money honestly, with a half-baked computer investing program that tried to automate a Moneyball approach to stock picking. When the losses mounted from his failed attempts at an honest system, Israel resorted to outright accounting fraud to hide his financial condition from investors.
Just as Sam Israel once had, many of the other big shots in the hedge fund revolution that gripped the Street in the early 1990s operated using some form of high-velocity trading system—not necessarily an illegal system, like the one Fred Graber taught Israel, but one based on speed and volume nonetheless. The result was a generation of traders who exemplified an ethos completely opposite that preached by Buffett, Graham, and, well, Prem Watsa: people who didn’t invest in companies for the long haul but instead invested in stock positions and sometimes held those positions for just a few seconds.
These people did not think of themselves as part owners of companies. They boarded this or that ship only for a few minutes, raped and robbed as much as possible from the hold, and then took off back out into the open ocean.
If there’s any one person in the global business community who represents the total polar opposite of Warren Buffett–style value investing, it’s Stevie Cohen.*2 (Well, it might also be Warren Buffett, but that’s another story for another day.) In the late 1970s, Cohen was a young arbitrage trader working for a middling firm called Gruntal & Co., where he quickly rose to a job most young men would be happy with, managing six traders and a $75 million fund.
But in 1992 Cohen broke off and founded SAC Capital, a secretive hedge fund whose awesomely rapid rise in that decade roughly paralleled the rapid growth of Watsa’s Fairfax up north. But it wasn’t long before the compensation numbers Cohen was putting up made Watsa look like a McDonald’s franchisee by comparison.
Within ten years of branching off on his own, Cohen was personally earning $350 million a year. A few years after that, Cohen had nearly tripled his compensation and was earning a billion a year. Less than a dozen years after founding SAC, Cohen was one of the top forty richest people in America, and he made a major statement to the rest of America’s elite by building an obscene 35,000-square-foot mansion in the capital of Rich America, Greenwich, Connecticut.
The mansion shocked even the Greenwich crowd with its sprawling grounds and its Versailles-like architecture, complete with an often-visible Zamboni machine tending to a 6,000-square-foot skating rink. A Vanity Fair writer said Cohen’s home “resembles Buckingham Palace.… One billionaire, whose name I’ve promised not to reveal here, said his jaw dropped the first time he visited.” A physical transformation followed, as the no-longer-young fund manager adopted a severe, shaven-headed Lex Luthor look that perfectly fit his garishly enormous financial empire and supervillainish estate.
Where did the money come from? SAC had quickly become one of the world’s largest hedge funds through its mysterious, impossible-sounding performance record. In the first fifteen years of its existence, SAC claimed an incredible 43 percent annual return for its clients. Somehow Cohen was beating the average growth of the stock market by four, five, or six times over, every single year for more than a decade.
For such incredible performance, Cohen’s clients paid a premium that went beyond enviable into being outright suspicious. The standard fee for a hedge fund manager is a formula known on Wall Street as “two and twenty.” If you give a hedge fund manager $10 million, he gets a 2 percent management fee for the ten mil, plus 20 percent of any profits he makes for you.
But Cohen, incredibly, charged his clients 50 percent for the profits he earned them, which is a little like paying five thousand dollars to get a one-hour massage from a Swedish coed. If you’re paying that much, you’re probably getting more than a massage. And with Cohen, what you paid for was guaranteed impossible profits.
“Some people in this business are dirty, definitely,” says one hedge fund manager, who incidentally would end up being short Fairfax for a time. “Look at Cohen. It’s a little like juicers in baseball—when a guy hits that many home runs every single year, and never has a down year, you just know.”
That no one can post 40 percent returns for fifteen years without cheating is blatantly obvious to everyone on Wall Street, but instead of sounding the general alarm, the almost universal reaction of the world financial media has been to celebrate the genius of such miracle investors with worshipful profiles. (At least until Cohen was finally nailed by regulators many years after the Fairfax episode.) Early in his career, Cohen got to explain his “system” over and over again to starry-eyed reporters, and what they heard was the exact opposite of the Buffett/Graham value investing concept.
Cohen claimed to be making money based on minute-to-minute calculations made as he was monitoring trading flow, or “watching the tape.” This was eerily similar to the “painting the tape” process that Fred Graber taught Sam Israel.
When he felt stock prices were wrong, as The Wall Street Journal explained, “Mr. Cohen would pounce, and then he would bail as soon as they ticked in the right direction.” His huge profits, he said, were derived from the fact that his bets were so enormous and the volume of his trading so obscene. By the mid-2000s, SAC’s trading all by itself accounted for as much as 2 percent of all trading activity on any given day on the New York Stock Exchange.
SAC grew so big so fast that, like a Bill Parcells or a Bill Belichick, Cohen quickly saw his coaching tree start to bloom. A number of former SAC traders branched off and created their own funds. Adam Sender was a sort of mini-Cohen who split off from his mentor in 1998 to form his own fund, Exis Capital Management. Like Cohen, Sender quickly began turning in impossible-sounding results. (He claimed a 53 percent return after fees in 2006.) And like Cohen, Sender couldn’t wait to show the world how rich he was. Within a decade or so after founding Exis, he had a personal collection of more than one thousand works of modern art that were collectively valued at over $100 million.
Cohen and Sender were part of a new class of hedge fund conquerors who used their instant millions and billions to buy places in the pop-culture limelight, usually by patronizing modern artists. Cohen shocked the art world in 2005 when he gave $12 million—the highest sum ever paid to a living artist for a single piece of work—to the awesomely pretentious Englishman Damien Hirst for his The Physical Impossibility of Death in the Mind of Someone Living. This preposterous sculpture was a fourteen-foot pickled shark suspended in a formaldehydelike solution. The notion that Cohen had paid $12 million for a kind of schlock monument to his own self-image as a financial killing machine is a long-standing joke on Wall Street, right down to the fact that the dead animal started to rot almost immediately: shortly after purchase, Cohen had to hire the artist to refurbish the creature.
Another in the curator club was Dan Loeb, the billionaire head of a fund called Third Point, who by the early 2000s had become famous not just for being a dick but for being a very particular kind of dick. Loeb’s favorite activity was to invest h
eavily in a big company (he at one point owned more than 5 percent of Yahoo!) and then write blisteringly insulting public letters to management, berating them for not making him enough money. When he spotted the CEO of one company courtside at the U.S. Open, he publicly attacked him for “hobnobbing and snacking on shrimp cocktail” when he should have been out making Loeb money. He launched a similar assault on the head of Star Gas Partners, Irik Sevin, urging him to step aside and “do what you do best: retreat to your waterfront mansion in the Hamptons where you can play tennis and hobnob with your fellow socialites.” Loeb loves the word “hobnob.”
That Loeb himself had been at the U.S. Open final, and also has a $15 million estate in East Hampton far bigger than Sevin’s, is beside the point. Loeb’s letters set him up as an inspiration to day traders and “outside investors” everywhere, a self-proclaimed populist hero who made his living publicly beating the hell out of America’s decadent CEO class.*3 His act is a kind of living tribute to the legendary scene in Wall Street when Gekko-Douglas undresses the executives from Teldar Paper at a shareholder meeting, urging investors to defy the fat-cat “bureaucrats with their steak lunches, their hunting and fishing trips” who paid themselves big salaries but lacked the balls to buy stock in their own firms. Like Gekko, Loeb pitches himself as the guy who does have the balls, who puts his money where his mouth is. Known as the “Angry Investor,” he’s made a public career as a kind of investors’ ombudsman.
Lastly, there’s Jim Chanos, another billionaire who was Buffett’s (or the mythical Buffett’s) opposite for another reason: he almost exclusively bet against companies, not on them. Known as “the Catastrophe Capitalist” and elevated to fame on Wall Street for having helped uncover the Enron disaster (he had a huge short on against Enron, and his research is said to have essentially exposed the fraud), Chanos could move markets just by signaling that he was betting against this or that company.
Humorously, and appropriately, Chanos named his hedge fund Kynikos, which is Greek for “cynic.” He described his campaigns against target companies as “jihads” and became well known for his withering, devastating criticisms of just about anybody who fell within his field of view. He sneered, for instance, at traders who blindly rode the tech boom while he was doing real work, seeking out bad companies like Enron. “The marginal people on the trading desks, there’s no skill set,” he chirped. “The next stop [for them] is driving a cab.”
On one hand, Chanos represented everything that was good about short sellers. In an investment community policed by weakling regulators and a mostly blind press, it’s often left to short sellers to spot and correct even the most blatant corruption, which Chanos apparently did in the Enron case.
But the high-roller shorts like Chanos almost by necessity have to be psychologically a little unhinged. An investor who bets on companies to succeed, a so-called long investor, always at the very least knows the worst-case scenario when he invests in a company. If you buy a share of IBM for $10, the most you can lose is that ten bucks. But a short’s losses can be infinite. Every time you put a big short on, you risk your entire neck.
“You have to have titanium balls” is how one trader explains it. The reason has to do with the mechanics of the profession. When you short a stock, you first borrow shares in the company, then sell them off immediately for cash. Then, after the stock’s value has dropped, you go out and buy the same amount of shares in the open market and return them to the original source.
So say you borrow a share of IBM at 10. You sell it immediately for that ten bucks, then wait for something bad to happen (IBM forced to announce a product recall, say). The stock drops to 9. You can then go out and buy a share of IBM on the open market, return that share to your original source, and pocket a one-dollar profit.
But what if IBM goes up? What if there is no product recall, and the next product IBM comes out with puts the iPad out of business? What if the stock goes past 10—to 15, 20, 40, 50 dollars?
You still eventually have to return the stock. The higher the stock climbs, the more money you owe. And there’s no zero down there to stop the bleeding. You could pick wrong, bet against Google or Microsoft in its infancy, and end up beyond broke, hurtling down a bottomless financial pit.
Another factor is that short sellers have to pay fees to borrow stocks before they can short them, which means that if you’re shorting IBM at 10, you probably need it to drop below 9, maybe to 8 or even 7, to actually make a profit. It depends on how hard the stock is to borrow, how high those borrowing fees are. (This issue would come into play in a big way in the Fairfax case.) So if you’re putting a big short on, you usually need to see a serious drop to make a buck, not just a tick or two in the right direction.
This is why the big short sellers tend to be wired differently from other Wall Street players. These men (and they’re mostly men) live for the thrill of the chase and the high of conquest when the target of their short finally rolls over and dies.
Chanos perfectly embodies that spirit. “I’ll always understand the Schadenfreude aspect to short-selling,” he said early in his career. “I get that no one will always like it.”
By the early 2000s, just those four men—Loeb, Chanos, Cohen, and Sender—collectively managed tens of billions of dollars and exerted enormous influence on the daily trading flow of the New York Stock Exchange.
And here’s what we know. Sometime in 2002 this collection of high-profile, belligerent, letter-writing, art-collecting millionaires and billionaires, along with hotshots from a few other prominent hedge funds, began talking to one another about a new stock they might want to target: Fairfax Financial Holdings.
An important thing to understand about short sellers is that they can play not just a legitimate role in finance but an urgently necessary one, being as they are the world’s best-funded researchers of corruption and inefficiency in the markets, far surpassing the press and federal regulators. When they’re right, and they often are, they provide a valuable service.
Jim Chanos was famous for being right. His biggest claim to fame, of course, is Enron. But the short that actually made his career involved an insurance company. The firm was called Baldwin-United, and back in the Reagan years, it looked like one of the hottest companies in the world. The Ohio-based company used to make pianos but had switched to insurance and was making a killing selling a product called single premium deferred annuities, or SPDAs. By 1981, the firm had $24 billion in assets and was being lauded in Fortune magazine.
Within a year, though, the company went into bankruptcy—the largest bankruptcy of all time at that point. The firm went bust largely because a little-known trader at a Chicago-based firm called Gilford Securities, Jim Chanos, had exposed the company’s financials as a sham. In an eerie preview of Enron, Baldwin had been using accounting tricks to book five and six years of income at a time, and Chanos, who was less than a year removed from graduating from Yale, didn’t like the way the financials looked. “I’ve never seen financials that looked so cloudy,” he said. When the company went bust, Chanos became a star, and the model for his victory was interesting: while places like The Washington Post and The Wall Street Journal were skeptical of his analysis, Forbes magazine believed Chanos’s analysis and published an aggressive story against the firm. It was enough to bring the company down. The media were an essential weapon in the short campaign.
Years later Chanos would repeat this same technique, again to apparent social good, by attacking Enron’s financials with the aid of Bethany McLean of Fortune magazine.
Now it was a few years after the Enron story, and Chanos, as he had in 1982 with Baldwin, got a tip about another insurance company with supposedly dicey financials.
Fairfax in many ways was similar to Baldwin. It was roughly the same size, in the $20-billion-to-$30-billion-in-assets range. When Chanos first heard of Baldwin in the early 1980s, it had just swallowed another huge company called MGIC. In 2002 Fairfax was still digesting its Crum & Forster and Odyss
eyRe acquisitions. And Chanos didn’t like the look of the relationships among Fairfax’s many subsidiaries. He was sure self-dealing was going on, just as there had been with Enron.
Chanos was the first of the really big hedge fund magnates to make a big short bet against Fairfax, in mid-2002. And the fact that it was Chanos targeting another insurance company swayed some other funds. “Jim knew about insurance,” says Marc Cohodes, the former head of Copper River Partners, a hedge fund that would eventually short Fairfax. “He had made his name with the Baldwin thing. It carried a lot of weight.”
The billionaire that summer evangelized his decision to short Fairfax all over town. Many were more than willing to bet down the stock. For all its positive press in Canada, Fairfax didn’t have the greatest reputation in New York. “A third-rate insurer with crappy underwriting standards” is how one analyst put it. “Plus they were Canadian, and run by an Indian. In retrospect, that probably played into it, too. There were a lot of reasons to pile on.”
By the end of 2002, nearly a dozen major hedge funds—including SAC, Kynikos, and Loeb’s Third Point—had taken short positions against Fairfax and were trading information with one another about the stock. That’s when the analysts came in.
The key player was Gwynn, the Morgan Keegan analyst. Fairfax was the first company he would ever cover as an analyst for Morgan Keegan. This was his first task after coming to the bank from the Trinity hedge fund, which, in an amazing coincidence, was one of the funds that would put a huge short on against Fairfax.
So the former hedge fund employee Gwynn joined a major investment bank and immediately began preparing a research report on a Canadian company that operated in a business he knew very little about. The report wouldn’t be published until January 17, 2003, but well over a month before that, it mysteriously began circulating among the traders at many of these big hedge funds.