Chanos calls China syndrome

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China is in the midst of the biggest real estate bubble in human history—"Dubai in 2007 times 1,000." And Sino-Forest, the less-than-meets-the-eye Canadian forestry play in China? That fits a pattern: Promoters "find a different investment hype, a story, to get people excited. In the 1990s, it was the Internet, and now it's China. Unbridled growth."

Why should we believe this prophecy of imminent calamity in the market that we were all counting on to buoy us for decades to come? Well, Jim Chanos—who uttered both of those quotes—has a pretty good record in doomsaying. And in profiting from that doomsaying.

Chanos, 53, is the most renowned, or, if you prefer, notorious, short seller on Wall Street. He runs Kynikos Associates, the world's largest investment fund devoted exclusively to shorting. It manages about $6-billion (all currency in U.S. dollars except where noted).

Chanos's fattest, juiciest-looking target for the past several years has been China. Yes, China's GDP is still expanding by about 9 per cent annually, but embarrassing cracks are appearing in the official high-growth façade, particularly the evidence of boom-time overbuilding of condos, offices and infrastructure.

Chanos sees himself as a sort of watchdog. But others see short sellers as the undomesticated type of canine: jackals who wait for the stragglers of capitalism to show the slightest weakness, so they can attack in a pack and run them to death, profiting obscenely in the process.

It's a debate almost as old as financial markets, and it cranked up to high pitch in early August as stock indexes around the world plunged. Shorts are a convenient scapegoat during a crisis, and France, Italy, Spain and Belgium quickly imposed temporary bans on short selling.

But the financial mainstream, both the big players and the rule makers, no longer enjoys a reputation for omniscience and infallibility. Is it now the smart thing, even the right thing, to run with the wolves?

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As Chanos tells it, his career is one of those that had the benefit of an early epiphany. In 1980, the Milwaukee native, freshly armed with a degree from Yale in economics and political science, landed a job as a junior analyst at the Chicago office of the brokerage firm Blyth Eastman Paine Webber.

At the time, the firm was trying to convince McDonald's, the most important company in the city, to issue bonds at 12 per cent to fuel its expansion. A veteran partner quietly suggested to Chanos that the fast food giant's earnings per share would actually grow a lot more if it bought back some of its own shares instead of issuing a supersized portion of expensive debt.

Chanos ran the numbers. The veteran was right. McDonald's would be better off with a buyback, although that would also mean lower fees for Blyth Eastman. Chanos presented his findings to the firm's banking partner. "Who authorized this analysis?" the partner asked, then told him to shelve it.

"That's when I knew I was not going to be a banker," Chanos says. "They're not interested in truth or what's best for the client, but in making the sale with the least amount of work."

Fortunately for Chanos, another long-time partner, Bob Holmes, left the firm and started his own outfit, Gilford Securities. Chanos followed him. In early 1982, the pair started probing Baldwin-United Corp., a venerable manufacturer of keyboard instruments that, during the conglomerate mania of the 1970s, had mutated into a $9-billion insurance giant.

Baldwin-United was issuing annuities that offered fat annual returns of up to 14.5 per cent. Wall Street investment dealers were selling hundreds of millions of dollars worth of them. But when Chanos looked at Baldwin-United's accounting, he couldn't make head nor tail of it. "I now call it the Rule of Three," he says. "If you read a company's financial statements three times, and you still can't figure out how they make their money, that's usually for a reason."

Chanos concluded that Baldwin-United wasn't earning enough on its investments to support the annuities. To conceal the gap, he deduced, the company was making overly optimistic projections about the proceeds from the annuities years into the future and then booking the current value of those estimates as revenue.

In August, 1982, Gilford issued Chanos's report, along with a "sell" recommendation. It was no bombshell. In fact, Baldwin-United's share price climbed from about $20 to almost $50 in November.

Then, as has often happened since, Chanos got a critical assist from a journalist. Forbes reporter Dick Stern flew to Chicago, and Chanos spent three days walking him through the numbers.

A few days before Stern's story appeared, news reports warned that it would be critical. Baldwin-United's share price dropped $9 in two days—and kept going. The following year, the company set a new record for the biggest bankruptcy in U.S. history.

"I actually thought the story was pretty innocuous, but it gave credibility to a 24-year-old analyst," says Chanos. It also made him think he might have a future in shorting. "That's when the light went on with me. We started getting calls from clients asking, 'What else does Chanos not like?'" In 1985, he and a partner, James Levitas, launched Kynikos with $16 million—$1 million of it their own money, the remainder from a single client. (The name of the company comes from the Greek word for "cynic.")

Reporters kept calling, too. James Grant first met Chanos at a dinner in 1984, a year after Grant had left Barron's to found Grant's Interest Rate Observer. The two hit it off and have been friends ever since. They shared a nose for financial excess and chicanery, which they chased through both its 1980s incarnation (Drexel Burnham Lambert, Michael Milken) and the commercial real estate bubble that followed.

But Chanos also learned early on that the media can turn on you. A September, 1985, Wall Street Journal article accused him and several other prominent short sellers of underhanded tactics such as spreading rumours about companies. And he's been getting hit with the same rap ever since: Chanos is an opportunist who quietly spoon-feeds reporters to cast a cloud over target companies. "I think every good investor is an opportunist," says Grant. Over all, he says, Chanos is "a crusader for truth, justice and The American Way."

Chanos makes no apologies. "We do not call journalists. They call here all the time." When they do, he'll explain his research. "We live by the rules," he adds. It's a crime to "knowingly pass on information that you know to be false." In any case, he sees some hypocrisy in the name-calling. It's fine for money managers and brokers who are long on a stock to explain why, but if a short dumps on a stock, "Oh my God, it's pitchforks and torches." In the final analysis, "The market is the ultimate arbiter."

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You'd think it would have been easy for short sellers to hit the jackpot during the tech bubble of the late 1990s. The stock market valuations of many dot-com start-ups were absurd—hundreds of times earnings per share in some cases. If there were earnings.

The trouble was that the sustained bull market that began in the early 1990s was very punishing for shorts, and particularly so for Chanos's long-term approach to shorting. He's no rapid-fire electronic trader who holds positions for milliseconds during market plunges. His usual strategy is to have his analysts comb through the financial statements of a potential target company. If they can develop a detailed thesis of why the stock is overvalued, Chanos will then take a hefty short position and wait for the market to catch up with him—sometimes for years.

But if stock markets as a whole keep climbing, the rising tide tends to lift all shares. "The general direction of the market shouldn't matter, but it does," says hedge fund manager Bill Fleckenstein, president of Seattle-based Fleckenstein Capital. Kynikos's assets under management plunged from about $600 million in 1990 to about $150 million in 1995, and the company needed an investment from publishing heir Dirk Ziff to keep going.

Even as many fabulously overvalued dot-com companies began to blow up toward the end of the decade, Chanos struggled to hang on to his clients. Then as now, those clients were mostly pension funds, endowment funds and other institutions. Many of them were afraid of getting out of a bubble too early and falling behind rivals. "In the world of, say, pension investing in 1999, if you're not in technology, you're running significant career risk," Chanos says.

The mechanics of shorting were problematic in the tech bubble, too. Shorts need to borrow stock, and the hot young companies that gave the bubble its particular effervescence often hadn't issued a lot of it.

Fortunately for short sellers, the bubble burst in 2000 and dragged the rest of the market down with it. The Standard and Poor's 500 index declined by almost half from 2000 to 2002. The hangover from a decade of greed also exposed several blockbuster accounting scandals. Chanos was a prominent and outspoken short in two of the biggest: Enron and Tyco.

Both calls played to his strengths—ferreting out elaborate accounting irregularities and guiding inquiring reporters through his findings.

Houston-based Enron enjoyed a gold-plated reputation—the energy giant was a stock market darling throughout the 1990s, and was named "America's Most Innovative Company" by Fortune for six years in a row, 1996 to 2001.

But when Chanos started poring over Enron's financial statements and regulatory filings in 2000, he saw a lot of related-party transactions with so-called special-purpose entities that Enron had set up, but that weren't on its balance sheet. When he factored in the losses shovelled into those entities, he figured that Enron really was earning hardly any return on its invested capital.

His main journalistic ally this time was Bethany McLean, a Fortune reporter. After Enron collapsed in 2001, she and a co-writer scored a $1.4-million book deal for The Smartest Guys in the Room, which served as the basis for an Oscar-nominated documentary.

Thanks to Enron, Chanos was back on a roll, and couldn't resist the opportunity to gloat. Testifying before the House of Representatives committee on energy and commerce in 2002, he said, "I can't think of one major financial fraud in the United States in the last 10 years that was uncovered by a major brokerage house analyst or an outside accounting firm. Almost every such fraud ultimately was unmasked by short sellers and/or financial journalists."

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As Chanos peers at you through thick glasses and delivers a torrent of numbers, you're reminded of the whiz in your high-school physics class who actually knew the equations. No wonder reporters love this guy as a source.

Yet Chanos is no nerd: He co-owns Manhattan's rugged Edge Gym. As for the statement in a 2008 New York profile that he can bench-press 300 pounds, he demurs. The actual number is 335. (His shoulders are formidable, although he might want to do more cardio to reduce a slight paunch.) The man is clearly happy in his skin—in person, he's more relaxed and laughs more than in his TV appearances on CNBC or, needless to say, while testifying in congressional hearings.

He's an intriguing mix of Establishment and Outsider. In 2008, he bought a 14-room triplex penthouse in a former Gilded Age mansion on Manhattan's Upper East Side that had been listed for $24.8 million. The father of four grown children, he's president of the board of trustees of the elite Browning School and a trustee of the New York Historical Society.

Divorced in 2006, Chanos likes going to dance clubs in New York and the Hamptons, where he has a summer house. In 2008, his name hit the tabloids when reporters discovered that his house sitter was none other than Ashley Dupre, the escort in the scandal that had brought down New York governor Eliot Spitzer that February. "I'm a divorced single man," is all that Chanos will say about his after-hours activities, albeit with a bit of a smile. What he's told friends is that the association with Dupre was innocuous. Like a lot of young women, she approached him in a club. He didn't sleep with her, didn't know she was an escort and was as surprised as anyone else when the scandal broke.

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Chanos isn't always right, and he can get carried away by his own numbers. His bravado has earned him a spot in a $6-billion lawsuit filed by Toronto-based insurer Fairfax Financial Holdings against about a dozen U.S. money managers and analysts. The lawsuit argues that this supposed cabal of short sellers mounted "a massive, illegal and continuing stock market manipulation scheme," dating back to the early part of the last decade, with the objective of driving down Fairfax's share price. Chanos, loudly and publicly critical of Fairfax for years, was not among the original defendants, but Fairfax added Kynikos to the suit in 2007.

Neither Chanos nor Fairfax will comment on the case. The various parties have filed literally millions of pages of court documents, and lawyers say the dispute likely won't go to trial until next year at the earliest. The documents show that some defendants certainly communicated with one another, but whether that amounted to an illegal conspiracy is another question.

Kynikos's submissions say it first shorted Fairfax in March, 2002, at $175 (Canadian). The company's share price declined to a low of $70 (Canadian) the following year. Fairfax chairman and CEO Prem Watsa has a formidable investment track record, but Chanos argued that the company's underlying property and casualty insurance business—which is an Everest of complex accounting—wasn't profitable. In 2005, Chanos told a value-investing newsletter that he typically makes a call as to whether "something is a zero or just meaningfully overvalued. In this case, we think this is a zero." Since then, however, Fairfax's share price has climbed back up past $400 (Canadian).

Chanos's history on big, sector-wide calls isn't perfect, either. At a 2005 investment conference, he delivered a widely publicized presentation about traditional media/entertainment giants, titled "Twilight of the Gatekeepers." Among the companies he singled out: Time Warner, Viacom, News Corp. and Disney. Six years later, share prices of all four have held up, more or less.

But Chanos was certainly right on the money on the U.S. subprime mortgage crisis. In April, 2007, he and hedge fund manager Paul Singer were asked by Bob Steel, an old Wall Street friend who was then undersecretary of the U.S. Treasury, to deliver an hour-long briefing to the G7 finance ministers' meeting in Washington. Chanos and Singer explained that the major American banks and brokerage firms were highly vulnerable to a real estate bust because many were leveraged 30-to-1 or more, and were holding large amounts of dubious mortgage-backed securities and derivatives.

The banking and stock market meltdowns of 2008 resulted in a hugely profitable year for Chanos, but also a frustrating one. The first major domino to fall on Wall Street was the investment bank Bear Stearns, which collapsed in March. As the end neared, Bear Stearns CEO Alan Schwartz lashed out at short sellers. For Chanos, the experience crossed into the bizarre. He wasn't short Bear Stearns, and the day before the collapse, Schwartz asked him to go on television to say so. Chanos refused. "I was stunned to get that phone call," he says. "Here they were trying to co-opt a short seller to tell the market everything was fine. Talk about misdirection."

Chanos says he spent much of the summer of 2008 doing what a long-term short seller should be doing: buying. That meant closing off roughly one-quarter of Kynikos's short positions—ones in U.S. home builders and financial sector stocks. Yet he also railed against short-selling restrictions imposed by regulators. In July, the SEC banned so-called naked shorting of 19 major banks and brokerage firms, including Lehman Brothers and Merrill Lynch. Chanos doesn't naked-short (the issuing of a sell order for shares you haven't borrowed yet or have no likelihood of securing soon). But he says the regulator's ban backfired—it screamed to the market that the firms were weak, effectively putting bull's eyes on their backs.

In September, after Lehman collapsed, regulators banned shorting altogether on 799 American financial companies. Chanos argues this move made the ensuing global hemorrhaging much worse than it should have been. The crisis of confidence meant that banks and other institutions wouldn't deal with one another to temporarily lay off risk. And investors wouldn't buy their stock. "Beware of the law of unintended consequences when you start fiddling with the market just because you don't like where prices are," he says.

This past August, however, Chanos was buoyed when the United Kingdom's Financial Standards Authority and the U.S. Securities and Exchange Commission declined to follow suit after European countries banned short selling. Shorts, at least the long-termers among them, argue that they actually help stabilize markets during massive sell-offs—they have to buy to cover their sale positions. "The FSA and SEC now do seem to consider evidence before they implement policy," Chanos says drily.

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So what's the evidence on China? Sitting in front of a whiteboard that takes up a whole wall in Kynikos's boardroom in midtown Manhattan, Chanos argues that not only are many Chinese companies, including banks, hugely overvalued, but so are Western companies that have been swept up into the bubble—building contractors and resource producers and the like. And there's more. Chanos and other shorts say that many of the hottest Chinese investment plays may be out-and-out bogus, particularly so-called reverse takeover stocks—companies that do most or all of their business in China, but which have secured listings in North America.

In June, Sino-Forest Corp. , a company listed on the Toronto Stock Exchange that owns and manages timberlands in China, garnered worldwide publicity when its share price plunged by almost 90 per cent after a report by a mysterious young U.S. short-seller, Carson Block, alleged that it is a massive fraud—a charge that company executives strenuously deny. Chanos wasn't short Sino-Forest, but he says it fits the pattern.

Chanos says he and his analysts first began digging deeply into China's economic statistics in the summer of 2009, after seeing that commodity producers were relying heavily on Chinese demand. In one favourite anecdote, Chanos says that one of his analysts reported a Chinese government forecast that the country would build 2.8 billion square metres of Class A office space over the following couple of years. "I said, 'You're off by a factor of 10.' And he said, 'I thought the same thing, and I'm not.'" It helps to convert the number to square feet, says Chanos. "That's basically a five-foot by five-foot office cubicle for every man, woman and child in China."

Or there's this one: Chanos says the value of China's housing stock relative to GDP is about 325%, comparable only to Japan in 1989 and Ireland in 2007—that is, just before their real estate bubbles burst. Then there are the news stories about empty new high-rises, shopping malls and stadiums. Chanos has plenty of slides of these empty buildings in his presentations.

As in the U.S. and European real estate busts, Chanos says that China's property bubble is infecting its banking system. The country has already had to cleanse and recapitalize its banks twice—in 1999 and 2003. Basically, it took non-performing loans off the banks' books and put them into specially created asset management companies, which then issued long-term bonds for them. "And guess who bought the bonds?" says Chanos. "The banks."

Many China bulls say that Chanos's numbers and anecdotes don't add up to disaster. A notable one is Mark Mobius, executive chairman of Templeton Emerging Markets Group, who oversees more than $50 billion in emerging-markets mutual funds. "Of course there are 'see-through buildings' that have been recently built and are empty," says Mobius.

But there are several fundamental differences between China's real estate boom and the property debacles in the United States and Europe, Mobius argues. First, the surge in commercial and residential demand in China is mostly real, not just a bidding-up of asset prices. "If it's a bubble, why are so many people still living in substandard housing in China?" he asks. And he doesn't buy that there's the same toxic spillover to the financial system, either—China doesn't have the credit default swaps and other ersatz real estate-linked securities that triggered the market collapses in the West in 2008. "The subprime crisis was a derivatives crisis," Mobius says.

Yes, Beijing has had to recapitalize its banks twice, but to Mobius that shows strength, not weakness. Chinese leaders dealt with problems, rather than letting them fester. "The government will bail out the banks at a moment's notice," he says.

He and Chanos could both be right. History shows that many emerging economies and stock markets have grown exponentially over the past two centuries. But there have been plenty of frauds, bubbles and crashes for the cynics to feed on along the way.

CHINA: THE SHORT STORY

Say you agree with Jim Chanos's thesis on China, and you want to know how you too can short the country. If, and only if, you feel you could bear the risk (shorting is not for the average investor), the most obvious targets this past spring were so-called Chinese reverse-takeover stocks in North America. Many Chinese companies obtain stock market listings here by buying dormant shell companies, thereby getting around the more onerous regulatory hurdles for new issues.

Short seller Carson Block's scathing report on Toronto-listed Sino-Forest Corp. in June alleged that there were more "China frauds" among this class of stocks. Is every Chinese stock listed in North America bogus? Just some? Just one? Whether Block's allegations were justified or not, they triggered a panicked sell-off across the sector. There are 17 Chinese issuers with stocks listed on the Toronto Stock Exchange, 38 on the TSX Venture Exchange and reportedly more than 350 in the United States: Many of them got sideswiped by the Sino-Forest scandal.

But Chanos says that targets among those stocks are limited. "The problem is that they're extremely difficult to borrow because they have very limited public floats," he says. Instead, Chanos has identified targets such as Poly (Hong Kong) Investments Ltd., a subsidiary of a large mainland developer. But there aren't many similar large Chinese companies that foreigners can short directly. He's also set his sights on big global commodity producers that sell into China, such as Brazilian mining giant Vale Inc. (which owns Inco). But China is only a portion of its business.

Shorting what looks like a sure loser is often harder than buying what looks like a sure winner.

Chinese stocks listed on the Toronto Stock Exchange