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) 📖

This was not true. While investment-grade bonds often have skimpy covenant packages, it is standard for high-yield bonds to have exactly these types of covenants and restrictions—that’s teeth. People with hands-on experience in bankruptcies and financial restructurings know the absurdity of Walton’s in-the-game-vs.-watching-the-game analogy and Roll’s clueless parroting of it.

Rather than argue, I moved to a more dramatic example. I asked her to compare the risk in Allied’s portfolio to non-investment-grade commercial bank loans, which would have better asset protection, seniority, and even tighter covenants than the loans Allied made. Though these loans were plainly safer than Allied’s subordinated loans, industry figures indicated they recently suffered much greater losses than 1 percent per year.

Roll replied that banks aren’t structured to work out problem credits. Their regulators pressure them to dispose of non-performing assets, so they can’t be as patient. As a result, they would have to “take haircuts on getting out of an investment that we wouldn’t be willing to take because we have staying power,” Roll concluded.

It was now clear to me what was going on. The company had a qualitative method of valuation, where write-downs occurred only when they determined money would be permanently lost. They could hold the investments as long as they wanted to, for years perhaps, hoping that they would eventually get their money back and avoid a loss. As a result, they reported a loss rate superior not just to high-yield bonds, but also to much safer senior bank loans. This made no sense.

I pictured Allied management sitting in a room saying, “Do you think we’ll eventually get our money back?”

“I think so. This business could turn up.”

“All right, then we don’t need to take a write-down.”

I knew this had nothing to do with fair-value accounting.

We continued the conversation, covering specific problem investments. One of them, Cooper Natural Resources, had performed “sideways,” a euphemism for performing badly, but not yet bankrupt. The senior lenders asked Allied to convert its debt instrument into equity. Allied did that, but did not reduce the value. Roll admitted that Cooper performed below plan and the balance sheet needed to be restructured to appease the senior lender.

“Why wouldn’t that lead to some, even modest, mark-down in value?” I asked.

“Because sometimes in these cases, you haven’t really moved any further down the balance sheet,” she said. “You just recharacterize it in a different security—and if you look at the long-term projections of the company, then we were still in the money . . . so, when you look at the value of the company, you have to look at where they are today. But you also have to look in the future, and we didn’t see that we had any permanent impairment from this transaction.”

Time would reveal the suspect nature of this treatment. Eventually, in September 2003, Allied began to write-down the equity piece of Cooper Natural Resources. Allied valued the equity piece at zero in March 2004 and recognized a realized loss in 2006 (see Table 5.1).

Table 5.1 Allied’s Investment in Cooper Natural Resources

We asked about several additional investments that we suspected were troubled, including Galaxy American Communications, a rural cable provider, and three publicly traded bankrupt companies: Startec Global Communications Corporation, NETtel Communications, and the Loewen Group. We were following the Loewen Group bankruptcy because we had shorted its stock. It appeared that Allied carried its bond investment above the trading price. We asked Roll how they marked the bonds.

“What we were doing is, because there were really no trades going on in this bond once the bankruptcy hit, any trade that was made was a privately negotiated sale,” she said. “And given the status of the company, you were, if you wanted to sell versus hanging in in bankruptcy, we would just have to take probably more of a haircut than you otherwise would have. So what we were doing is, we were looking at trades, and you couldn’t really say they were market trades, as one data point. But we were on the secured [sic] creditors’ committee for a long time, so we were actually using the data we were getting from the secured [sic] creditors’ committee to value the company, on the underlying assets in the company and where they thought they would be in the emergence from bankruptcy.”

Roll’s story that the bonds did not trade was—not to put too fine a point on it—a lie. These were registered, publicly traded bonds. We received pricing sheets from dealers daily, quoting Loewen bonds at relatively narrow bid-ask spreads. There was an active market for Loewen debt, and the quotes were reliable. Greenlight itself had reviewed the possibility of buying Loewen debt several times during the bankruptcy. Her comment that a sale would cause more of a haircut was simply an admission that Allied carried the investment above market. Allied determined the value itself, based on its view that there was no objective market measuring the value. In fact, there was a market. Allied just didn’t like the price.

The conversation then turned to the limited facts disclosed about Allied’s controlled companies: BLX and Hillman. Finally, I observed that at the end of 2001, Allied’s auditor, Arthur Andersen, removed a sentence from Allied’s opinion letter that appeared in previous years. The auditors no longer opined, “We have reviewed the procedures used by the Board of Directors in arriving at its estimated value of such investments and have inspected the underlying documentation, and in the circumstances we believe the procedures are reasonable and the documentation appropriate.” Andersen had removed the same confirmation with Sirrom years before.

I questioned whether this removal indicated that the auditors conducted a lesser level of review or inspection, or perhaps didn’t agree with the values or procedures. Roll explained that the Audit Guide changed in 2001, which caused Andersen to change the standard language in