Jim Chanos | Founder of Kynikos Associates | Enron, Beyond Meat, and the "Golden Age of Fraud"

My complete pleasure. Thank you for having me.

Well, first of all, don't get into the dry cleaning business, which was a pretty brutal business. And not the least of which was it was also, I found out much later, a pretty dangerous business given the chemicals you had to work with. But it just taught me self-reliance from my father and his brothers. They were in the family business after World War II and really were in it for the better part of 30 or 40 years. So I saw a lot about persistence and reliance and learned about that. But also very early on, my father taught me that one needed to supplement one's income down through the years by investing their savings. And he was an early proponent of the stock market and got me interested in the stock market as a young boy. I started reading books and he started talking to me about it. He was an investor in the 60s and beyond. So it was interesting to sort of learn from him before I actually got to Wall Street.

I had a fascination, and I had a trading account when I was in college. And so even though the stock market was a very brutal place to be in the 70s, people forget the Dow peaked in 1966 and when it bottomed out in 1982 in real terms it was down as much as it was after the great crash of 1929, dropped about 80, 90% in real terms. So it was a brutal time and I point out to people today and to my students today that not only were prices down dramatically in real terms from the mid-60s to the early 80s, but employment in Wall Street dropped by 75%. So people that were working on Wall Street by and large lost their jobs. And that's nothing that we've seen in any bear markets since the 1970s.

And it just goes to show you that there's no certainties in finance. And there's a whole generation of people on Wall Street who left and were quite literally driving cabs in New York and elsewhere by 1979, 1980 when I got onto Wall Street. And when I started interviewing, most of my peers who went into finance went into commercial banking. That was sort of the glamorous job in the late 70s as you were recycling petrodollars. And all the big New York banks, I believe the London banks had training programs to basically teach you finance and teach you lending practices and credit. When I started interviewing at investment banks, people thought I was crazy. The fellow that hired me ultimately in Chicago wondered why I was interested in working on Wall Street. And in fact, I worked in a steel mill for my last two summers in between university years. And in my last year in 1979, working three months in a steel mill, I earned more than I did in my first full year working on Wall Street. That's how low the pay was and just how out of favor Wall Street was in 1980 when I got there. So it turned out to be really good timing for anyone that was joining finance and particularly Wall Street or the City in the early 80s, but we didn't know it at the time.

Well, again, I liked having traded stocks in the late 70s and there were places to make money, particularly the energy area. I was just fascinated by the whole concept of the stock market and the idea of matching wits with other investors and setting prices. To me that seemed a lot more interesting than just lending money to people and hoping they pay you back if you were a banker. So the concept of markets intrigued me. And the first job I got was in investment banking. So I learned kind of the hard way on how to set up models and spreadsheets and all those things way back then, but I spent my lunch hours down visiting the head of the retail brokerage arm of the firm I worked for, Blyth Eastman PaineWebber, and just spent lunchtime talking stocks with the head of the office, who ultimately then ended up hiring me when he spun out of PaineWebber and formed his own brokerage firm, Guilford Securities, and I joined him as an analyst in 1982. But I just found that much more interesting than cranking out deal books to convince McDonald's to issue debt at 11% back in 1981.

No. No. No, that was totally by coincidence. And really because the first major company I looked at while I was at Guilford Securities turned out to be an enormous fraud and so I had no predisposition to being a short seller prior to that. It just happened to be interesting that this company that I couldn't figure out at first was destined to become the largest bankruptcy in US history when it happened in 1983. So again, I had no predisposition but after the collapse of that company, which we had put a sell on, I began to think that maybe there was a market niche to be exploited as a young analyst if I was willing to say sell as well as buy. So it was completely serendipitous and coincidental.

Well, like working in a dry cleaner, it taught me I didn't want to do that. But I also, it was an interesting time because it was the peak of labor and I mentioned, you know, that I made more money in 3 months working in a factory in 1979 than I did working on Wall Street in 1980. And what I didn't know, I know now, is that it was sort of the peak of labor both globally and in the US. And I didn't know then, but I do know now that the election of Margaret Thatcher in 1979 in the UK and Ronald Reagan in the US a year later, 1980, would begin to shift the pendulum back from labor to capital and that labor was going to be treated less well and capital was going to be treated more favorably. And that's of course one of the things that set off this giant bull market that we probably arguably are still in. It was a major shift from the viewpoints of both governments and voters who could care less about capital in the 1970s or even the 1960s but cared a lot about it going forward 1980s and beyond. And you had cuts in tax rates, you had breaking of unions in both the UK and the US. And it was really a sea change in political economy. Again, didn't know it at the time, but I always kind of look back and think, you know, the fact that I was making so much money working two shifts and weekends and nights in a steel mill that was working three shifts a day putting out tubular steel for the oil industry, you know, was an interesting sign of the times.

I just had a wonderful set of professors there that I really liked. My real love was history and I probably should have gotten a double major in history because I took enough courses, but I was too lazy to write a second paper, a senior thesis. I kind of regret that now. But history and political economy are linked, too. And as you probably know from your studies, but I was fascinated by the interplay of politics with finance and economics and Yale was one of the few US institutions that had that combined major and I was attracted to it but again it was also the quality of my professors that really also helped.

As I said, I had a trading account. And like anybody with limited capital, I was attracted to the options market where I learned some brutal lessons very early on about market efficiency and leverage. And so I think it's always good to lose money early in your career and figure out why you did before it becomes a lot more costly later on. And I learned quite a bit those first few years. And then the first few years that I was on Wall Street, I kept trading and again learned some humbling lessons on market efficiency and pricing, which I think stood me well for later on.

I mean, you know, I'm not a macro guy. My career has really settled on being a securities analyst and a portfolio manager. So the macro meant less and less to me. I think macro, however, still plays an important part in all markets. You can't ignore it. You can't ignore the big forces that move markets, the big themes that move markets. So all of those things come from the macro world and then how you implement it comes down to much more the micro security analysis world that I live in. But you can't ignore it. And I think you have to be mindful of these major waves that entice investors. We're in one right now with AI. Certainly there was one in the 80s with the leveraged buyout boom and the S&Ls as well as the advent of the PC and then in the 90s of course with the internet and the telecom buildout and then the credit bubble before the global financial crisis and now we're in another tech boom, the AI boom. And so you have to be mindful of both opportunities and risks that those kinds of big macro trends can give you and invest accordingly.

Yeah, I mean it really was, again, I was attracted to the stock market, not corporate finance. And I realized that pretty early on doing corporate finance that I just didn't want to be, you know, advising people on deals ultimately. And that I'd rather be in the capital markets directly. So it wasn't a tough choice when I was offered the job to join this smaller brokerage house to do research. It really, even though it was risky, I didn't have a lot of responsibilities at the time. And it's one of the things I advise my students when they ask me career advice. I often say, look, you know, you can take more risks when you're young than when you're old. And if you do have the opportunity to reach for the brass ring as a way to determine it at a young age and if it doesn't work and you fail, nobody cares, right? You dust yourself off and move on and go back and do what you were originally doing or do something else. But no one cares if you fail in your 20s. It's much harder to fail in your 40s and 50s, and much harder to come back from that. So I've always told my students that, you know, every once in a while you're going to be faced with hardship and bad luck in your career. And everybody knows that, right? But the flip side of that is every once in a while occasionally you're going to be blessed with good luck or an unusual opportunity to the upside. And you have to understand that when it crosses your path as well as what you do when hardship crosses your path and to take risks that are judicious and smart and you can take more of those when you're younger rather than older.

Well, it was the old Baldwin Piano Company that had transformed itself into a financial services conglomerate and its main business was selling annuities via Wall Street firms to investors and retirees and then using the proceeds of those annuities to go out and make positions. And I think that people didn't understand the accounting at the company, which was interestingly a precursor of what we're going to see later with Enron and other companies, is they were allowed to take all of the future expected profits from selling an annuity in year one by making certain assumptions. And I learned at a very early age that dishonest management can abuse that accounting. And Baldwin did. But it was a high-flying stock. It was Merrill Lynch's favorite stock in 1982 when we took a look at it. It was growing very rapidly and it had a very charismatic CEO, a guy by the name of Morley Thompson, who got his start, and this always kind of blows my mind, he got his start selling pianos door-to-door in America. Now imagine trying to sell someone something door-to-door that you don't have. And he was very good at it and he rose up through the ranks and became the CEO and convinced Wall Street that two plus two equals five for a number of years until it all came kind of tumbling down in December of '82.

I got a lot of pushback. The New York partner of the firm wanted me fired. My boss in Chicago stood up for me, for which I'm eternally grateful. And I mean, just every insurance analyst and financial service analyst pretty much had a buy on the company and ridiculed me because I was a young analyst. I wasn't an insurance analyst. I had to learn insurance accounting from scratch, which I think at the end of the day was an advantage because I was just asking questions when numbers didn't make sense. But we took a lot of heat for it and the company threatened to sue us. And again, it was an unpleasant period when the stock doubled on me right off the bat. It was also a good lesson. But what was maybe the most interesting aspect of the whole story as the stock was going up in the fall of '82, there were documents that were publicly available that we got our hands on from the Arkansas Insurance Department where they were domiciled that indicated that regulators and consultants hired by the regulators were basically claiming the company was insolvent, the insurance companies were insolvent, which was our case. So we had an evidentiary trail that was public that basically backed up everything we were saying and yet the stock still doubled. So it was a very good lesson about public markets, that public markets are pretty efficient, and I believe they're pretty efficient, but every once in a while on that way to efficiency, they're pretty inefficient. And Baldwin was a great case of a giant insolvent insurance company whose stock, you know, continued to go up even after people like me had pointed out the insolvency.

Yeah, it fell apart very quickly in the last month of '82. I had gotten visited by a couple of reporters at Forbes magazine right around our Thanksgiving Day holiday in November and they were going to spend a few hours with me. They ended up spending three days with me as I kind of walked them through the whole story. And I had, you know, back then in my office this crazy board with, you know, yarn and rubber bands and marker lines drawing all these lines between the subsidiaries and what was going on and how they were moving money around. And they ended up writing a story in early December that raised some questions and the stock began to drop. And then a day or two after the story in Forbes came out, Merrill Lynch's analyst, who was the number one bull on the company, she came out and reiterated her buy and said, 'We can find no affiliated paper in the Baldwin subsidiaries.' Now, even Baldwin themselves admitted to billions and billions of dollars of other Baldwin holding company paper that were in their insurance company as investments. And it was a sort of light bulb moment over my head where I realized Merrill Lynch, not only recommending the stock but selling billions of the annuities, had never looked, had never really kind of done a deep dive into the insurance company's subsidiaries themselves. And that's when I knew that, you know, we were going to be right and probably make a lot of money. And then I got a call right around Christmas, I think it was even possibly on Christmas Eve, from my boss. I was visiting my parents in Wisconsin and he said, 'I'm going to give you a great Christmas present. The state of Arkansas has moved in and seized Baldwin's insurance subsidiaries for being insolvent.' And that was that. I mean, that was the end of the game. The stock collapsed and filed bankruptcy shortly thereafter. So when it happened, it happened fast and that was another sort of lesson as a young investor, young analyst, that you can be right, it can go against you. But on the short side, when things do happen, they happen pretty quickly. And fear is a stronger emotion than greed. And when it became very apparent to Wall Street investors that in fact the bears were right, the collapse happened just in a matter of weeks.

[laughter] I was fired, basically. I was there for two years, had a great time and worked with a great team and did sell-side research in New York. And in September of '85, there was a front page article in the Wall Street Journal about how evil short sellers were conspiring to bring down these great companies. And there were, I think, 10 companies mentioned in the story and eight or nine of them went broke or were indicted for fraud subsequently, you know, within a couple of years later. But I was the featured short seller in the piece and my bosses in Germany apparently woke up and weren't exactly pleased with that. So I was informed that same day that my contract would not be renewed at year end. And so I called all my clients that day to tell them I would be leaving shortly. And one of them said, 'That's great news.' And I didn't really see what the great news about being fired was. And they said, 'Oh, we can set you up in business.' And they did. And they became my first investor in what would be Kynikos Associates, which I started October 1 that year. And they asked for a two-year exclusive, which I was happy to give them. And again, just better to be lucky than smart. The two-year exclusive ended on September 30, 1987, three weeks before the crash of '87. And I was able to take in a lot of new capital on October 1 of 1987. So again, sometimes you get lucky in these things, but I was fortunate that I had a pair of clients that believed in me and were willing to back me when I left Deutsche Bank.

I think it helped. You know, I've always joked I'm in the insurance business and that a good short portfolio enables you to be more long. You know, it's really a hedge and you can sell stocks and raise cash. You can also short stocks and use the proceeds to buy stocks, which was the classic long-short hedge fund construct. So the idea always was to me that a good fundamental short portfolio allowed you to take more risks on the long side. And that's been our ethos since we started. I never wanted to take money from clients who thought the market was going down. I think that's pretty unpredictable. And I'd much rather be someone's hedge for a diversified portfolio than someone's bet that the world is coming to an end. And that was always our idea in constructing a portfolio of fundamental ideas, that we were in effect an insurance policy that paid premiums over time and that's what happened.

It was actually my partner at the time, his wife, who came up with the idea. And it means in ancient Greek, it means like a dog, literally. But the Cynics were a group of philosophers who lived outside of Athens and basically railed against demagogues in Athens and elsewhere. And they became known in English as the cynics and it was not a pejorative in Greek as it may seem in the English language. Being a cynic was a good thing. It meant you were thinking for yourself and you didn't just accept what people told you. And I thought that had a pretty good carryover to the way financial markets work and the way you ought to think in financial markets. You should be skeptical. You should be questioning of what people tell you because there's a lot of money involved. And as I've learned over, you know, almost 50 years now, there are a lot of people who are willing to tell you things that aren't necessarily true to separate you from your money.

Yeah. Well, again, we were fortunate because we did really, really well our first five years. And so it was kind of, others have really dubbed it the golden age of short selling because the market was going up but stocks that had question marks or sort of black clouds over them did not and or went down. And so it was a really, it was one of those rare times where you could actually make money, a reasonable amount of money on your pure short positions in a bull market. We haven't really seen much of that since the late 80s. By and large, in strong bull markets, you hope your shorts go up less than the market, thus creating alpha. But in the late 80s, you actually made absolute dollars in years in which the market was going up 20 and 30% a year. So the alphas were just off the charts. And again, that was just the cycle that we were in, happened to be a period of time that I was lucky to be doing what I was doing and raising money doing what we were doing. That all changed in the early 90s and short sellers got a pretty good lesson about how markets can revert and it was a very difficult period for us from '91 to '95. But again, I think that it was a market niche. Some hedge funds had short portfolios obviously, but it was not an institutional business. We had money from either other hedge funds like George Soros who backed us or wealthy individuals but you really didn't have pension funds or tax-exempt institutions putting a lot of money either in short sellers or in hedge funds. That didn't occur until really the early 2000s.

So that came across our desk. A friend of ours in Dallas, Texas, a hedge fund, gave me a call one day in September of 2000 and said, 'Have you seen this story in the Texas Wall Street Journal?' Now, back then, the Wall Street Journal had regional editions and wasn't really readily available online. So I said, 'Well, I don't get the Texas Wall Street Journal, so I have no idea what you're talking about.' He said, 'I'll fax it to you.' So he faxed me this story by a writer by the name of John Heilbrunn, who later went to work for me and is now back himself at the Journal, about how these energy merchant banks like Enron had gotten SEC approval to use what was erroneously called mark-to-market accounting. What it really was was mark-to-model accounting and enabled them to do energy deals much like Baldwin's annuities that we talked about a little while ago and book the entire expected profits from the deal at the time the deal was signed as opposed to waiting for the deal to play out and booking profits and losses, you know, along the way. And I immediately said, 'This is, you know, I've seen this movie before, right?' And so that was the impetus to break open a file on Enron, which was the largest of the energy merchant banks, but all of them got this treatment. And as soon as I started looking at the 1999 10-K and the June 10-Q, I immediately had questions. I mean, there was lots of red flags right away in terms of their footnotes and how they say they made their money and the balance sheet itself. And one of the things that struck us was just how low the returns on capital at the business were. I mean, again, this was a high-flying firm. It was a market darling. Everybody loved it. It had sailed through the first selloff of the dot-com era unscathed and people were very excited about the idea of trading energy derivatives and Enron was the leader in that. But we calculated that they had a 6% pre-tax return on their capital. And my partner at the time, Doug Mallette, said, 'You know, why are people paying five or six times book for an energy hedge fund earning 6%?' Which was a great way to look at it. But then on top of that there were the disclosures of these funds in the footnotes that were trading with the parent where a senior executive of Enron was the general partner of the fund and that just screams conflict of interest, right? And so there were lots of things that fell into place in the Enron story. But we were tipped off by a fellow hedge fund manager in Texas to look at this Wall Street Journal story and that's what got us interested.