Book review: Fooling some of the people all the time

Tait Simpson reveals what caused the credit crunch

There are two ways to get your head around the financial crisis of the last year. The first is to read any number of books that attempt to explain, in a top down manner, all the factors that led to last autumn's crash, when it seemed as if banks were disappearing daily. The other approach, that of hedge fund manager David Einhorn in his terrific book Fooling Some of the People All of the Time: A Long Short Story, is to take a bottom up look. He tells the story of one company, Allied Capital, and how its obfuscation of company performance typified much of the poor corporate behaviour of the last decade that led directly to the financial crisis. The approach taken by Einhorn makes his book both fun to read and easy to comprehend - a great combination written by a finance professional at the top of his game.

At a 2002 charity event where investment gurus gave speeches on their best investment ideas, Einhorn, then a 34 year-old founder of hedge fund Greenlight Capital, advocated selling short the shares of mid-cap financial Allied Capital, who make loans to small American businesses such as gas stations and auto dealers. Einhorn believed the company was creating bad, or even fictional, loans, guaranteeing them by virtue of a legal loophole found in the US' Small Business Administration statute. So persuasive was his speech that shares of Allied Capital opened down 20 per cent the following day.

Instead of addressing the claims against the company made by Einhorn, Allied Capital used every tool in the corporate tool box, even tapping his phone, in an effort to discredit his allegations. What followed was a five year battle between Einhorn, who provides compelling evidence of abandoned gas stations that had been loaned thousands of pounds, and Allied Capital, who attacked Einhorn at every turn. At the same time, Allied Capital proceeded to raise a further half billion pounds through new share issuance, whilst not once receiving any downgrades from ratings agencies or investment banking analysts.

Einhorn chronicles his interaction with the company in amusing detail. He never seems to take the affair too seriously, resting confidently on his own independent research (partly formulated by a private investigator hired to visit all the recipients of the bad loans). Sadly for the reader, the book ends without a conclusion. Only after the book was finished, but prior to being available in stores, did shares in Allied Capital really collapse, dropping 90% and not recovering - yielding an impressive financial return, as well as vindication, for Einhorn.

Part of what makes the book difficult to put down, and therefore worth picking up, is that it is eminently readable. Mr. Einhorn, unlike the authors of most finance related books published this year, does not attempt to describe everything that is wrong with the world economy and the financial industry. The sheer simplicity of his argument offers a refreshing change for readers. His first chapter on how he got his start, how he raised his money, and his approach to investing provides straightforward inspiration for young financiers.

Another of the book's strengths is its ongoing description of the institutionalised bias against the practice of short selling. Short selling involves borrowing shares from an investment bank in order to bet that the price of the shares will fall. When the shares have fallen, you can return the shares at the newly lowered price and pocket the difference. It is a risky practice for two reasons. One: because your losses are unlimited (shares can only fall to zero but there is no limit to how high their value can go), and two: because stock prices over the long term do tend to rise, not fall. However, when done properly on sound analysis, it can yield great profits in a short period of time, as stock price crashes often tend to be sudden instances, occurring when the broader investment community learns that a company is having undeniable problems.

The New Statesman's 24th September 2009 edition was devoted to the 50 people it believes matter most in the world today. At number 15 was David Einhorn, two spots behind Bill Gates and ten ahead of Warren Buffett. The magazine, not one to pay much attention to the investing world, praised Einhorn as an activist investor who denounces fraudulent companies and has helped to usher in the movement towards more accountability and stricter regulation in the financial world. With a reputation for being able to successfully analyse both good and bad company performance (he was also one of the first to question the accounting practices and balance sheet of Lehman Brothers, long before the bank's crash in September 2008,) both investors and readers would be well advised to pay attention to Einhorn: And, at just 41 years old, we may well be paying attention to him for years to come.