by Matt Taibbi
We know this because traders for Chanos and Cohen and others sent one another reams of emails and texts blithely bragging about their access to this nonpublic information. For instance, on December 21, 2002, an analyst for Chanos sent a note to a trader at another hedge fund about a new report on FFH, Fairfax Holdings:
Last night John Gwynn at Morgan Keegan faxed over to me an outline detailing the issues at FFH, basically those he will be publishing on. He has been a huge help and even offered to talk to me from his home today. We can look at these and talk to him next week.… On the major issue of reserve deficiencies … the entire company deficiency is shown to be $2.6 BN without tail, and $5.0 BN with tail.
Nearly a month before the analyst report came out, then, someone at the Kynikos fund knew the entire substance of the Morgan Keegan research and was sharing it with another hedge fund.
As it happens, this sort of behavior—bank analysts sharing their research with hedge fund clients—was so common at the time that it ultimately became the centerpiece of the so-called Global Settlement arranged by Eliot Spitzer and the SEC with big Wall Street banks like Goldman Sachs, Lehman Brothers, Bear Stearns, and Piper Jaffray.
There’s nothing unethical about a private company doing research, and there’s nothing unethical about a bank researching a firm and selling that research to clients. But a major bank releasing a major report on a publicly listed company can have a material impact on the movement of a stock, and here’s where we get into unethical and/or illegal territory. Tipping off a hedge fund that your analyst is going to give a “buy” rating to a stock weeks before that research is made public can be enormously valuable to the hedge fund, for the obvious reason that the fund now has a pretty good idea of a concrete date and time when the stock is going to tick upward. If the release of the research will have a material impact on the value of the stock, it becomes illegal and improper to trade on knowledge of such a report ahead of time.
What Spitzer’s investigation uncovered was that banks in the 1990s and early 2000s were routinely trading such valuable inside information in return for promises that the funds would choose their companies to do their investment banking work. It was straight quid pro quo: information for business. For instance, when asked in a questionnaire what his three most important goals were for the year 2000, a Goldman analyst replied, “1. Get more investment banking revenue. 2. Get more investment banking revenue. 3. Get more investment banking revenue.”
The way the game evolved, big hedge fund clients had access to investment banking research far ahead of everyone else, creating a two-tiered investment environment. There was one market for insiders, and one for everyone else. As the former hedge fund manager Marc Cohodes explains, “Joe Sixpack has zero chance to succeed here.”
Morgan Keegan in this case tried blatantly to secure the investment banking business of funds like Kynikos by handing out Gwynn’s research report like Halloween candy to anyone and everyone capable of throwing it banking business.
Ten days before Gwynn’s report came out, for instance, a Morgan Keegan salesman named Bill Hinckley berated an SAC Capital trader for not putting a bigger bet down against Fairfax. “Did you short that FFH on the listing?” he asked. When the SAC trader hemmed and hawed, Hinckley got impatient:
DAMN IT. DRINK FROM THE WATER, YOU HORSE.
The day before the report came out, Chanos himself was informed about Gwynn’s research. One of his analysts briefed him:
Just got off the phone with Gwynn at Morgan Keegan—his piece that rips FFH is supposed to be published tomorrow.
By mid-January 2003, employees at nearly a dozen major hedge funds, many of which were already trading Fairfax stock or were about to, had either directly seen the unpublished Morgan Keegan report or had learned the substance of it. The email record detailing these communications between the hedge funds and the bank analysts during this time is surreal.
In the email record, both bankers and traders talked openly about the info-for-biz quid pro quo.
For instance, one of Dan Loeb’s traders at Third Point, a certain Jeff Hires, sent an email to a Morgan Keegan rep named John Fox congratulating him on Gwynn’s “damn good report.”
“Kudos to your analyst,” Hires told Fox in a cheery email.
Fox, in response, cravenly asked Hires for a handout:
Thank you, Jeff. Please try to keep Morgan Keegan in mind for commission payments to our analyst. A small 50,000 share trade goes a long way. We go out of our way to hire individuals of the caliber of our John Gwynn. Looking forward to working with you. Thank you.
In any case, virtually all the hedge funds that saw the Gwynn report acted on it, deciding to place short bets against Fairfax. Chanos’s fund, Kynikos, had actually started to pull its bets against Fairfax, but when it saw the Gwynn report, it doubled down and put about $5 million down on a short against the Canadians, about half of that on the day before the report came out.
And it wasn’t just Heiman or some other minor Kynikos operative doing an end run. The billionaire Chanos himself was intimately involved in these trades. In fact, on January 16, 2003, the day before the Gwynn report came out, “Catastrophe Capitalist” Chanos and “Angry Investor” Loeb—two of the great icons of the hedge fund era—had an instant-message text conversation about Fairfax, in which Loeb asked Chanos if he should short the firm. Temporarily at least, the pair showed a little discretion:
LOEB: should short one more?
CHANOS: CAN’T COMMENT.
LOEB: understood.
Days later, after the report came out and Chanos had made a bundle on the damage done to Fairfax’s stock, he and Loeb had another exchange:
LOEB: Just read the Morgan Keegan report which is one of the best and most extraordinarily good pieces of work I’ve ever read.
CHANOS: I KNOW. THAT’S WHY I COULDN’T TALK TO YOU LAST WEEK.
Again, this is one of the richest men in America, and one of the most respected figures on Wall Street, blithely admitting, in writing, that he’d read a crucial piece of insider information about a stock he was trading before its publication. Neither Chanos nor Loeb responded to requests for comment about any of this.
All these communications seem to account for the remarkable surge in trading activity that Watsa noticed in the days preceding the publication of the Morgan Keegan report. Subsequent analysis revealed that trading in the stock was at levels fourteen times higher than usual. When the Morgan Keegan report finally came out, the impact was predictably devastating: Fairfax’s stock plummeted 25 percent in a single day.
Within a short period of time, in fact, the Canadian listing plummeted 32 percent, to an eight-year low. At Morgan Keegan, the news that Fairfax was in a death spiral was met with celebration. An internal bank memorandum circulated at the end of January said it all: “Gwynn—tremendous call on FFH sent the stock down 18 points!”
To recap quickly: in the summer of 2002, Jim Chanos, an investing legend who had made his bones disentangling bad accounting at an insurance holding company in the 1980s, decided there was something wrong at Fairfax and decided to wager against the firm. Chanos evangelized his belief in Fairfax’s shortcomings, and other hedge funds also bet against Fairfax at the end of 2002. One of those funds, Trinity, seems to have played a role in getting an analyst hired at an investment bank. That analyst then came up with a negative research report on Fairfax that was passed around to other hedge funds and to journalists before it became public. The report came out, and like clockwork, the stock price of Fairfax plummeted.
The hedge funds may have genuinely believed that Fairfax was a corrupt and/or incompetently run company, and some of the hedge fund employees and their supporters will insist to this day that the initial bet against Fairfax was righteous. But the record suggests that their collective belief that enough bad press and negative market momentum would crater the firm was even stronger than their belief in Fairfax’s actual problems.
And indeed, Fairfax’s fate seem
ed to have been sealed when the Morgan Keegan report sent the stock down 32 percent. Under normal circumstances, this might have been enough to kill a company, particularly a financial company like Fairfax, whose business is entirely dependent upon public confidence. As Fairfax’s lawyers would later repeatedly point out, Chanos himself once openly explained this dynamic. “With a financial services company like Fairfax, it can all be self-fulfilling,” he said in a 2005 interview. “If the market finally decides the glass isn’t half full any more, the trouble starts … you can see the stock go into a waterfall.”
That was probably what was supposed to happen with Gwynn’s report, but it didn’t, because Gwynn screwed up and overplayed his hand. Almost immediately after issuing his report, questions began to surface about the accuracy of his $5 billion calculation. Moreover, in early February 2003, Fairfax issued a positive financial report, causing the market to start to doubt the rumors of Fairfax being the next Enron. As a result, the stock price began to tick menacingly upward: in one day, it went up ten dollars a share.
The hedge funds pressured Gwynn and Morgan Keegan to continue dumping on the Canadians.
For instance, on February 10, 2003, a day after Fairfax released its positive financial report and the stock ticked upward, Jeff Hires, Dan Loeb’s trader at Third Point, reached out to John Fox at Morgan Keegan:
Where’s the new report on FFH????
Fox stalled, telling Hires a full day later that the report was in the “editor’s process” and wouldn’t be out until the next day, February 12. At that, Hires sharply shot back:
Just make sure it’s really negative.
On that same day, February 11, Morgan Keegan salesman Bill Hinckley urged a hedge fund manager named Eduardo Tomacelli to place another bet against Fairfax, telling him that the second report was coming out the following day and would be devastating.
WE SAY FFH RESULTS WERE WORSE THAN EXPECTED.… PUT THE SHORT BACK ON.… YOU NEED TO TALK TO JOHN GWYNN AND SLAP THAT DOG.
And slap the dog they did. Ultimately, over the course of three years John Gwynn would issue an incredible sixty-four reports about Fairfax, every single one negative to one degree or another. It’s unclear exactly what his motivation was. Though some of the discovery shows the bank cravenly trying to extract business from hedge funds that seemed to relish Gwynn’s conclusions, the bank also would eventually fire Gwynn (years later, it is true) for leaking information to those same funds. “Gwynn was discharged from Morgan Keegan for violation of a firm policy relating to his apparent advance disclosure of his pending research coverage of Fairfax Financial Holdings,” a Morgan Keegan spokeswoman would say a full five years later, amid the chaos of September 2008.
Although negative press and analyst reports and high volumes of carefully timed short selling can definitely exert downward pressure on a stock, and can even “waterfall” a company into collapse, a firm with a solid enough foundation can stick it out for a good long time.
But the shorts didn’t have time. The game these major hedge funds were playing was a high-stakes, high-risk totaler Krieg where there’s no room for patience, compromise, or pyrrhic victories. When you bet $50 million, $100 million, $200 million against a certain type of company, inflicting minor damage—like moving its stock down a few percentage points here and there—is not sufficient. You have to sink the boat, or else you yourself will be drowned.
Why? Because shorting a stock becomes more and more expensive the longer the short bet is on. Remember, in order to bet against a company, you have to borrow shares of that stock. But so many people may be clamoring to short a certain stock that the number of shares available for borrowing may not be sufficient to meet the demand. In that case (and it can happen for other reasons as well), a stock becomes “hard to borrow,” and the cost to borrow a single share for any length of time can become exorbitant.
Short sellers talk about the price of “the borrow” when they figure their costs. And in the case of Fairfax, the borrow was through the roof. Between 2003 and 2006, the cost to borrow Fairfax stock skyrocketed, to the point where a short seller had to pay a surcharge of 30 percent or more just to borrow a share. Years later, when all this got aired out in court, Andy Heller—the chief operating officer of Adam Sender’s Exis Capital—explained in a deposition why hedge funds like his needed Fairfax not just to wobble but to fall over completely. “Fairfax had an enormously expensive borrow,” he said:
HELLER: If Fairfax didn’t go out of business in three years, the trade was a loser.
Q: Automatically?
HELLER: Automatically. If I’m paying 35 percent a year to borrow the security, just do the math.
The short sellers had done a pretty fair job of battering Fairfax with the crude, old-school trade-ahead-of-negative-research scheme. But when Fairfax didn’t collapse after the first Morgan Keegan reports and the accompanying negative press from journalists like Peter Eavis, the shorts flipped out. In a text conversation, Loeb and a then–SAC trader named Jeff Perry reacted to a positive financial report released by Fairfax. In Loeb’s mind, the good news coming from Fairfax meant they were both going to take it up the ass—literally.
LOEB: This is surreal
PERRY: WHAT?
LOEB: bend over and get your bungus grease. FFH
Moments later Loeb had a text conversation with Jeff Hires, one of his own cohorts at Third Point. At this crucial moment, Loeb realizes that the first blow wasn’t enough and suggests that the shorts might need to look elsewhere for ways to drive Fairfax’s stock downward.
LOEB: Holy shit … look at the FFH indication.
HIRES: Indeed
LOEB: This is insane.
HIRES: ugh
LOEB: We need to speak to the ratings agencies today … they could provide the downside catalyst.
Thus began the second stage of the attack on Fairfax, the search for an elusive “downside catalyst”—some outside force that would drive the stock down.
The usual weaponry wasn’t working. They needed to think outside the box. They had to find some other way to bring Fairfax Financial Holdings all the way down.
A quick aside. Stories like this at first blush seem to have little relevance outside Lower Manhattan. Had Fairfax gone out of business, sure, thousands of jobs would have been lost, many in the metro New York area. (Morristown, New Jersey, alone would have lost thousands.) But for the most part, insider trading is a crime of fractional violence.
You steal from uninformed investors all over the world, a few pennies or dollars at a time. The damage fans out evenly across a vast geography, and it’s hard to see. It’s because of this that lots of Wall Street people genuinely think of insider trading and naked short selling as victimless crimes. People get hurt, sure, but the victims are mostly sophisticated investors who should know better, and it’s not like you’re hitting them in the head with a brick or anything. It’s not a real crime. At least it doesn’t look like one.
That may once have been true. But in the Fairfax case, the principals in this “victimless” scheme started to mimic the gangster aesthetic.
Like most privileged, overeducated Americans who try it, they would suck at being real tough guys. They tried, however, and here’s the crazy thing: in a city where police in some neighborhoods define crime as standing on the sidewalk the wrong way, these idiots took their stock-trading act-like-a-thug life, screwed it up a hundred different ways, and not only couldn’t get arrested, they couldn’t even get police of any kind to notice.
On November 9, 2005, Barry Parker, pastor at St. Paul’s Anglican church in Toronto, received a curious FedEx package at his office. Having for over a decade headed this, one of the largest Anglican churches in North America, he knew a thing or two about famous churches, and he immediately sensed something odd about the return address, 460 Madison Avenue in New York.
“I remember thinking the address looked familiar,” he recalls today. “When I looked it up later, I realized the package was ‘sent’ f
rom St. Patrick’s Catholic Cathedral.”
Parker opened the package. Inside, there was a letter addressed to him. It read:
Dear Father,
The attached documents are being sent to you out of my concern for the Church’s finances. I am extremely sensitive to this as a result of losing a dear friend, Father Richard Bourgeois, an enlightened Benedictine Priest formally of the Collegio D’Anselmo, which as you may know is the Cardinal College of the Vatican.
On September 4, 1999 the fugitive Marty Frankel, who perpetrated a massive fraud on the Catholic Church, was arrested at the Hotel Prem in Germany. Interestingly, a review of your most recent “Talk in the Pews” shows Mr. Watsa as the Chairman of the investment committee of the church. More interesting are the similarities in facial features between Mr. Marty Frankel and Mr. Prem Watsa. While these coincidences are surprising, they do not compare to the similarities between the massive money-laundering schemes perpetrated by Marty Frankel and the massively convoluted paper shuffle created by Mr. Watsa through his public vehicle Fairfax Financial Holdings Ltd.…
The pattern of activities of Mr. Prem are too similar to the course of conduct of Marty Frankel to be overlooked by a person such as yourself, who is responsible ultimately for the funds of the congregation. Be aware, Father, be skeptical and ask Mr. Watsa to make confession.
God Bless,
P. Fate
Along with the bizarre letter was a thirty-page article about the real-world insurance scam artist Marty Frankel, a corporate huckster who had bilked some $200 million out of a variety of marks, including the Catholic Church. The article was complete with lurid descriptions of Frankel’s obsessions with sadomasochism and group sex, as well as descriptions of a brothel apparently being run out of Frankel’s home.
The brazenness of sending such material to one of Canada’s most high-profile religious figures, coupled with the breathless, faux-Nabokovian fictional flourishes in “P. Fate’s” letter (in ham-fistedly telling of losing his “dear” friend, the Catholic priest “Father Richard Bourgeois,” is the author not so subtly calling Parker a bourgeois dick?), suggested that whoever sent the package had taken fiendish pleasure in the entire enterprise, and that was unsettling in itself.
