There’s a new (little) big short ripe for plucking. And finance expert Janet Tavakoli, one of the most vociferous critics of the financial world, reveals just where it lies in her new book.
In an interview with ThinkAdvisor, Tavakoli discusses this potential investing opportunity and identifies another new big short, too.
Tavakoli, who has logged more than 30 years working in complex finance, is well known for calling out industry and government cover-ups and bold-faced names that she brands liars, phonies and crooks — plus, charging the fourth estate with negligence in reporting.
Founder-president of Structured Finance, a risk consulting firm in Chicago, Tavakoli is all about finding problems in advance and identifying opportunities therein. In “Risk: Your Global Guide” (Lyons McNamara), she writes about both reducing unintended portfolio risk and seeking rewards for taking calculated risks.
Indeed, with her meticulous due diligence and wary eye, Tavakoli has discovered big risks most others have missed. That has enabled her to predict the thrift-industry blowup, the demise of Enron and that excessive leverage and structured products’ misratings would lead to the worldwide financial crisis, which was precipitated by hidden “malicious mischief” that in fact “could be seen in the course of competent work,” she contends.
Last spring, in her book, “Decisions: Life and Death on Wall Street” (Lyons McNamara, April 2015) and in an interview with ThinkAdvisor that May, Tavakoli discussed weak balance sheets at Deutsche Bank. Some readers of the book sold the stock; some shorted it, she says. In June 2015, Deutsche Bank posted a record loss.
It’s not surprising that one of Tavakoli’s favorite quotations is a line from David Mamet‘s film “The Spanish Prisoner”: “Always do business as if the person you’re doing business with is trying to screw you because most likely they are – and if they’re not, you can be pleasantly surprised.”
In “Risk” and in our most recent interview, Tavakoli pinpoints more than 10 red flags for fraud. By scrubbing fraud from your portfolio, “you’ll outperform almost everyone,” she writes. You must anticipate fraud as a part of doing business and look for it by doing a fraud analysis when evaluating any company, bank, corporation, hedge fund, pension fund manager or creditor, she says.
Formerly a chemical engineer, before founding her company she held senior posts in investment banking, trading and structuring and marketing structured products at firms such as Merrill Lynch, Goldman Sachs, PaineWebber, Bear Stearns, Bank One and Westdeutsche Landesbank.
ThinkAdvisor recently caught up with Tavakoli, who has also just released an edition of “Twenty Years of Inside Life in Wall Street,” by William Worthington Fowler, published in 1880, which she has annotated. In our interview, the outspoken risk consultant discussed fraud, the Fed’s “blind eye” and what financial advisors must do to protect themselves, as well as the unique investment opportunities often inherent in market distortions — such as the current ones. Here are highlights:
THINKADVISOR: Why is it critical for financial advisors to perform a fraud analysis on whatever they’d like to invest in — or when doing any deal?
JANET TAVAKOLI: You need to protect yourself. The Fed and the [Securities and Exchange Commission] aren’t doing their jobs, and the banks are financing a bunch of bad guys. You’re cruising for a bruising if you don’t take fraud into account and do a fraud analysis. Fraud is the most important thing to evaluate. When there’s fraud, there’s permanent value destruction in investments.
No. But look at situations with a jaundiced eye. Do a fraud analysis thorough enough to uncover fraud if it exists — unless it’s extremely clever fraud. If you don’t look for fraud, you won’t find it. The problem is that fraud starts seeping into everything.
Why do a fraud analysis when you’re diversifying a portfolio?
It will help minimize the times you inadvertently diversify into fraud.
What are the red flags for fraud?
Bad character. Character is paramount [to investigate]. It must include looking into personal life, like drug use and [involvement in] prostitution, and background checks on fund managers.
What’s another big red flag?
Poor transparency. We have negative real [interest] rates, and yet financial institutions have goals to earn double-digit returns. How do you pull off that magic trick? If you aren’t fudging around the edges, you can’t. There has to be something else going on. If you’re getting subsidized, then it’s not your genius that’s giving you a double-digit return. You can’t spin straw into gold.
Other red flags?
Profits that appear out of thin air. Lots of borrowing or hidden leverage. Poor risk controls. Questions that aren’t answered coherently or if the manager patronizes you. Principals who are cult figures that dodge scrutiny. Banks gauging consumers in terms of credit cards or other loans in order to earn higher returns, so that as one bubble bursts, another is put in to take its place.
How, specifically, do you do a fraud analysis?
Start with the underlying securities. If you find fraud in them, you have to do a greater sampling because your burden of due diligence becomes greater.
Where do you start when performing a fraud analysis on a bank?
Look at the bank balance sheet and large loan exposures – oil sectors, sovereign debt. Look at the exposure to European banks and European debt – even if they [insist], “This is as good as Triple A because it’s part of the European Union.” They come up with narratives to distract people from the underlying value of the debt and say, “Oh, don’t worry about it!” In housing, during the financial crisis, it was: “Don’t worry! It’s collateralized!” Or “Don’t worry. It’s Merrill Lynch!”
So should advisors be skeptical, in general, of what banks say on analyst calls?
Absolutely. Instead of facts, often you get force of personality trying to tell you what the “facts” are – in the face of contradictory evidence. You have to keep brushing aside the veil and makeup that are put on problems. Bank analysts say they’re taking great safeguards in securitizations and that the ratings agencies are being more careful. You’ve got to be kidding me!
You write: “It’s fair game to profit from market distortions born of fraud”— unless you “actively participate in the rigging.” What if you do uncover fraud and want to use it to short the market?
Fraud is a good short. You’d look for things that are growing fast, where people say that even though it’s growing fast, there isn’t much risk here. But it’s hard to make money by shorting the market.
You write that there’s a shorting opportunity in auto loan fraud, where losses are climbing. This is an example of shorting par-valued fixed income securities that are being securitized — and, you say, they have the same issues as CDOs in the financial crisis.
Yes, subprime auto loans are good candidates for a big short. Another is federal student loans.
What’s going on with auto loans?
A lot of fraud has crept into the subprime market. The FTC’s “Operation: Ruse Control” has found documentation fraud and deception in advertising, in add-on fees, in marketing of title loans and rates that approached 30%. Some car title loans are being made when the individual has no credit score whatsoever.
How can all this happen?
It’s being done through the shadow banking system. The borrowers in the most trouble have auto loans that are two-and-a-half times their after-tax annual income, and the underlying collateral — their car – may not be in such great shape when it gets repossessed. It may even have been sold to them at an inflated price.
Who’s responsible for perpetrating this fraud?
The loans have been securitized and financed by banks, but the fraud isn’t just in the loans. It’s going all the way up the line because so many people had to overlook it in order to keep moving. Of course, that goes way up to the Fed, who’s turning a blind eye and enabling it – not to mention our regulators. So you want to eject these businesses from your portfolio until you can do further investigation. Just get rid of them.
What are the biggest red flags for fraud in the subprime auto loan market?
Wildly increased loans made to a cohort of people who are notoriously fast at defaulting, a surge in auto-loan growth – in the [fourth quarter] of 2015 they were at an all-time record of [almost] $1 trillion – and opacity in the shadow banking system.
So classic red flags for fraud. Anything else?
When you do background checks, you [often find] that the lenders giving out these loans have bad character. With the mortgage market, it was, “Don’t worry! It’s collateralized!” But you saw all sorts of problems, like zero collateral left in the homes. You’re finding the same thing now with autos. But bank analysts are saying, “Don’t worry! It’s collateralized!”
Is this situation tantamount to what ultimately brought the financial meltdown?
With the overall market, no. It’s a smaller portion of the market. If you start shorting car securities, it’s unlikely they’re going to go up very much because they’re fixed-income securities, although they can go up if interest rates die even further and if the fraud isn’t discovered. In shorting the market, you want to short something that has a lot of downside potential due to fraud and almost no upside.
Any other advice about shorting in general?
You always need an exit strategy up and down for when to cut your losses. In a short position, the return profile is skewed against you at the start because stocks can always go up more than they can go down. There are some short sellers who hang onto their shorts come hell or high water, which is pretty stupid.
Tell me more about the federal student loan market, which, you say, has red flags for fraud too.
Just how did it grow so fast in a mere seven years? In 2007, there was only [about $1 billion] in federal student loans. As of 2014, [more than $800 billion] was outstanding. Today, it’s probably up to $1.2 trillion. What happened? They pushed more unready students into the university system and encouraged them to take out loans, which, of course, lowered the unemployment rate. However, this is just a holding cell for the students, who may or may not get good jobs when they get out of college. But they certainly will be saddled with a lot of debt.
If you’re a portfolio manager, you’ve got to explain to clients [your negative position] when the rest of the world is telling you that everything is A-OK. Unfortunately, no one can tell you exactly when the truth will come out.
Why is it important to do a fraud analysis when you’re diversifying a portfolio?
It will help minimize the times you inadvertently diversify into a fraud. Like a fraud analysis, diversification is a way to protect yourself.
Is a Monte Carlo model effective in discovering fraud?
No. It does you almost no good. It won’t uncover it. And it will completely understate your probability of default and completely overstate your recovery in the event of default. And, of course, Monte Carlo models say nothing about character.
What are your major concerns about the financial industry right now?
We’ve seen massive fraud and massive denial about it – and we haven’t prosecuted people. The Fed is encouraging lack of transparency and has distorted and manipulated markets. We have a monetary policy that creates bubbles and things that cause bubbles. Distortion has inflated stock prices and suppressed interest rates.
In that environment, are portfolio managers using sound investing strategies?
They’re investing in risky things because everyone else is. They’re competing for perceived returns. I’ve heard fixed income managers say, “I have to invest in these because otherwise I’ll underperform my peers. But I know I’m sitting on a powder keg.” The game is: How long can I continue to sit on the powder keg – a bubble that seems to expand further – before my portfolio gets burned? Rather than prudent investing, they’re playing a game of brinkmanship.
You write that now, more than eight years after the financial crisis, the major banks are so badly managed that “they do not have basic paperwork and systems in order, much less obey the law.” That’s pretty dismaying.
It’s ridiculous that they haven’t pulled it together. Right after the crisis, the major bank in the U.S. [JPMorgan] was the poster child for worst practices in risk management.
Do you think that Jamie Dimon — chair-president-CEO of JPMorgan Chase, who was Bank One CEO during some of the time you worked there, before it was acquired by JP Morgan — should be forced to resign? You say he covered up and violated securities law at JPMorgan.
Yes, of course. That should have happened a while ago. The Fed could have walked into JPMorgan’s offices, thanked Mr. Dimon for his service and introduced the board to their new CEO. But the Fed hasn’t used any of its moral suasion in this issue and chose to act as if nothing happened. This tells you that our regulatory system does not work at all and that the Fed [has] completely failed.
I assure you that our whole financial system would not fall apart if we broke up the banks. We’d have a healthier and more efficient financial system because it would root out a lot of fraud, opacity and lying about the quality of the balance sheet. We need to go back to the Glass-Steagall [Act] model.
What are your thoughts on the U.S. presidential hopefuls’ positions concerning Wall Street?
Not enough questions have been asked of them about what the Fed is doing. Not enough has been put in the public domain about their positions. This is mystifying, given that it’s such a part of the economic narrative.
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