The Crusading Hedge-Fund Manager

By Justin Fox

Last October, I stood in the back of a packed Manhattan ballroom listening to hedge-fund manager David Einhorn explain to an audience what had gone wrong with Wall Street. Packaging home loans into securities was a "mediocre idea," he said. Repackaging those securities into yet other securities was a downright bad one. Credit ratings were a joke. Investment banks--he mentioned Bear Stearns and Lehman Bros. by name--took too many risks and disclosed too little.

To be honest, I didn't think much of the speech at the time. One could hear similar critiques every day from finance professors, regulators and even some Wall Street executives. Yet there turned out to be a crucial difference: Einhorn was actually doing something about it, betting that the gig would soon be up at Bear and Lehman by selling their shares short.

It is a bet that he has now largely won. With Bear Stearns, which the Federal Reserve forced into a fire sale to JPMorgan Chase, he cashed his checks quietly. But in the case of Lehman Bros., Einhorn engaged in a riveting public campaign to goad the firm into confessing its shortcomings. In mid-June, it more or less did. Einhorn, 39--a soft-spoken, baby-faced hedge-fund manager previously best known for winning $659,730 at the 2006 World Series of Poker--had briefly made himself the most important crusader for financial morality on Wall Street. Which may say less about him than about our society's general inability to do anything about financial excess before it's too late.

This happens to be a favorite theme of Einhorn's. "The authorities are good at cleaning up fraud after the money's gone," he writes in his new book, Fooling Some of the People All of the Time. But they "really don't know what to do about fraud when they discover it in progress." Einhorn's Greenlight Capital manages $6 billion, most of it invested in stocks that Einhorn actually likes. But Greenlight also makes money short-selling the stocks he doesn't like. Six years ago, Einhorn stood up at a charity event and recommended shorting Allied Capital, a finance company that he was convinced was understating its loan losses. The company vehemently disagreed, igniting a long war that is the main subject of his book. But as Einhorn recounts in a tone of aggrieved righteousness in its pages, his greatest disappointment was with the financial media and the Securities and Exchange Commission (SEC), which instead of joining him in his crusade grilled him for conspiring to drive Allied's stock price down.

Last summer the bet against Allied finally started to pay off (the company's stock is down 50% over the past year), and Einhorn began shorting Bear and Lehman--the smallest and least diversified of Wall Street's big firms. These companies once made all their money off commissions and fees, but the bulk of their profits in recent years has come from making bets. At Lehman Bros., trading and investing on the firm's own account contributed about 60% of its $6 billion in pretax profits last year. Key to these profits is leverage, a.k.a. debt. But with high leverage comes high risk. If your investments go sour or nobody will lend to you, your business can evaporate in a matter of days. That happened to hedge fund Carlyle Capital in early March. Then lenders and customers cut off Bear Stearns.

After Lehman weathered the Bear scare, Einhorn began to speak out. He said in April that the firm needed to cut its borrowing dramatically. Then in early May he began pointing out apparent gaps in its first-quarter earnings report. His comments, he later told me, amounted to saying, "Gee, there's a naked emperor."

For weeks, Lehman battled Einhorn's assertions. Some of the Wall Street analysts who follow the firm dismissed him as a half-informed dabbler. Then Lehman disclosed that it had lost $2.8 billion in the second quarter. It raised $6 billion by selling new shares, addressing Einhorn's concerns about overindebtedness. It removed its chief financial officer and chief operating officer. Chief executive Richard Fuld got on the company public-address system and declared, "Einhorn didn't lose us $2.8 billion. We lost it."

It's possible that some of this would have happened without Einhorn's badgering. But nobody else--not the SEC, not the Fed, not the analysts, not investors, not Lehman's board--was putting public pressure on the firm's executives to come clean. Some may have feared inciting a panic like the one at Bear Stearns. I asked Einhorn whether he worried about that. No, he said. "If you're running a financial firm, you need to run it in such a way that you can survive a civil discussion."

So far, Lehman has survived, although its stock price is down 70% from a year ago. Perhaps it's time for a few more such civil discussions about how Wall Street does business.

Extra Money? To read Justin Fox's daily take on business and the economy, go to time.com/curiouscapitalist