Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New David Einhorn (best classic books of all time .TXT) 📖

quarter of 2008, Allied lost $0.25 per share due to unrealized depreciation in many investments, including $39 million at BLX. The loss was surprisingly small considering that the deterioration of the credit markets had taken a particularly large toll on Allied’s portfolio, which was littered with structured finance products. Allied’s subsidiary Callidus was a large player in the structured products market, and Allied had invested its own capital in the riskiest junior bonds and equity pieces of Callidus’s collateralized loan obligations (CLOs). According to Morgan Stanley’s credit research team, the value of junior pieces of CLOs created during the credit bubble (2005 to 2007) had fallen to between 35 percent and 55 percent of their original value. Allied took a small write-down, and marked its $317 million portfolio of CLOs at 90 cents on the dollar.

Meanwhile, management claimed that Allied’s opportunities were improving. Piper Jaffray analyst Robert Napoli supported that view and raised his earnings estimates, saying that Allied “is poised to capitalize on the wider spreads and a strong pipeline.” He concluded, “We also view the dividend as rock solid for the next few years.”

This view proved optimistic. On June 10, 2008, after the shareholders’ final rejection of its plan to sell discounted shares, Allied’s stock price fell below $16, reflecting a discount to stated net asset value for the first time. In an attempt to rebuild market confidence, Allied hosted an analyst day, but it proved to be a nonevent, adding nothing new to the story. As Friedman, Billings & Ramsey analyst John Stilmar observed, “The CEO remained emphatic about future ability to pay the dividend, but management was collectively vague about the future roadmap related to NOI [net operating income] coverage of the dividend.” In July 2008, Allied tried to hold things together by announcing both the third- and fourth-quarter distributions of $0.65 per share. Nonetheless, the share price continued to decline, falling below $13 by the time Allied announced its second-quarter results in August 2008.

The second quarter produced another, larger loss, this time of $0.59 per share. On the quarterly conference call, Walton misleadingly suggested a modicum of self-sacrifice, stating, “As part of this reduction, I will—I anticipate that I will receive no bonus in 2008.” (Ultimately, Allied paid Walton $5.1 million for presiding over a 90 percent shareholder loss in 2008.)

As for BLX, Allied capitulated. In one fell swoop it wrote off all but $9,000 of its $327 million investment. Five years after I’d first written to the SEC that BLX was probably worthless, Allied’s financial statements finally concurred. But there was still the matter of Allied guaranteeing hundreds of millions of dollars of BLX’s debts—a topic the analysts repeatedly raised on the conference call. Management assured everyone that this liability had been taken into account in the June 30, 2008, valuation, and that Allied did not need to take a write-down for it. In time, this too would prove false.

On September 26, 2008, the Department of Justice notified BLX that it was the defendant in a False Claims Act suit.

Four days later, BLX filed for bankruptcy.

The bankruptcy had two immediate effects: First, Allied announced that it would pay $320 million to BLX’s existing creditors to meet its guarantee obligations. Second, BLX was required to file publicly its near-term cash flow forecast with the bankruptcy court.

For years, Allied had touted BLX as being an income-generating machine, with Walton going so far as to call it a “cash cow.” According to BLX’s earlier financial statements, its balance sheet was full of “residual” assets that should throw off cash over time if the loans performed anywhere near management projections. Allied had used these wildly optimistic projections of future cash flows to inflate BLX’s reported earnings, and to justify huge management bonuses. And though I expected the near-term forecast to reflect numbers more in line with reality, even I was surprised to discover that BLX generated no cash flow at all. None. The bankruptcy documents showed that BLX’s cash flow barely covered the cost of collecting the money. At that point, it was clear that BLX would almost certainly wind up being a complete loss to Allied, including the full amount of all its guarantees. The alleged cash cow was all moo and no milk.

Allied, however, didn’t see it that way. Allied argued that the bankruptcy did not require it to exit the investment in BLX and swallow the realized loss. In fact, BLX’s bankruptcy was of such apparent unimportance, Allied wouldn’t even need to reduce the tax distribution. As analyst Robert Dodd at Morgan Keegan observed, “In actuality, there is no defined time line in which Allied must sell and realize the loss of BLX’s assets; as a result, the bankruptcy and liquidation process could take years to complete.”

However, Greg Mason at Stifel Nicolaus noticed a possible problem:

We estimate that if ALD had to take unrealized losses of $320 million on Ciena [BLX] and continued to pay out its spillover dividend out of book value, it would violate the BDC 1:1 debt:equity requirement in 2Q09. We are not assuming any additional writedowns in ALD’s portfolio, which may be too optimistic given the current dislocations in the credit markets and the potential for further economic deterioration. As a result, even if ALD does not realize its loss in Ciena [BLX], we think there is a very good chance that in 1Q09 ALD will cut its dividend in line with its operating income of $1.33 or $0.33 per quarter, down from the current rate of $2.60 or $0.65 per quarter.

He even acknowledged Fooling Some of the People in his report: “As many may recall this is the investment that David Einhorn @ Greenlight Capital has criticized since 2002 and published a book on the topic this past spring.” Allied’s share price, which was $12.55 before the BLX bankruptcy announcement, plummeted to $4.96 by October 10, 2008, nine trading days later.

A month later, Allied announced a $1.78 per share loss for the third quarter. Net asset value fell to $13.51