Steven Pearlstein on William Ackman and unfairness of short selling
Several weeks ago, I sat down with William Ackman, the hedge fund manager and "activist" investor who is the closest thing there is these days to a rock star on Wall Street.
While Ackman is relatively unknown in Washington, the mere mention of his name can stop conversation in corporate boardrooms and elicit awe from young fund managers dazzled by his moxie and envious of the $7 billion kitty and 24 percent annual returns commanded by his Pershing Square Capital Management.
Ackman combines the analytical prowess of a value investor, the brashness of a corporate raider and the steely determination of a short-seller. Over the past few years, his firm has profitably bought and sold significant chunks of Wendy's, McDonald's and Pizza Hut. Although he tried and failed to force major changes in corporate strategy at Target, he's now trying it again at J.C. Penney, which so far has resisted his entreaties. He successfully engineered the turnaround of General Growth Properties, which he rescued out of bankruptcy. Meanwhile, Fortune Brands, a sprawling conglomerate whose brands include Moen faucets, Jim Beam bourbon and Titleist golf clubs, is seriously considering his breakup strategy.
Ackman is best known, however, for his determined campaign to expose - and profit from - the financial weakness of MBIA, the once-sleepy municipal bond insurer that decided to use its AAA bond rating to cash in on the subprime bonanza. Like hedge fund manager John Paulson, who hit the jackpot betting against subprime loans, Ackman saw the deterioration in lending and underwriting standards that fueled the boom in collateralized-debt obligations (CDOs) and other exotic securities. Unlike Paulson, Ackman was not content to simply bet against the new instruments and wait to profit from the inevitable meltdown.
Instead, he published a lengthy, chart-filled analysis showing how little capital MBIA held compared with the risks it was taking by insuring CDOs, then launched what became a six-year crusade to convince skeptical investors, business journalists, rating agencies, regulators and prosecutors that he was right. All the while, he was amassing an enormous bet against MBIA on the burgeoning credit-default swap market, in effect buying insurance policies on millions of dollars of MBIA bonds he didn't own. When the credit bubble finally burst and MBIA was stripped of its AAA credit rating, Ackman and his investors cashed out with more than a billion dollars in profits.
The question that brought me to Ackman's airy, modern office in midtown Manhattan was this: Do "activist investors" still serve a useful social and economic purpose? Or are they just another breed of financial speculator, extracting ransoms from an overly complex financial system that has long since outgrown its original purpose of efficiently allocating capital to businesses that create real products and real economic value?
Let's start out by acknowledging that Ackman is charming, smart, hardworking and public-spirited - he donated his entire share of the MBIA profit, $140 million, to his personal foundation. Like many short sellers, he brings to markets valuable new information and insight that serve as a counterweight to the relentlessly positive spin peddled by corporate executives and Wall Street analysts. His MBIA analysis was prescient and proved to be spot on. His fund adds liquidity to markets, making it easier and cheaper for everyone to trade. He has helped revive the value and business prospects of at least some of his targets. And without taking on the risks of investing with lots of borrowed money, Ackman has generated impressive returns for investors that include pension funds and university endowments.
"I believe in what we do," Ackman told me, saying his sharp-elbowed brand of investing is good for the business sector and the capital markets.
That's true, up to a point. There's a big difference, however, between bringing vital new information to markets and scheming to turn a bet into a self-fulfilling prophecy by waging publicity campaigns against a company, filing complaints with regulators and warning analysts they could face lawsuits if they fail to cut another firm's credit rating. That's exactly what Ackman did with MBIA. Indeed, according to "Confidence Game," a new book by Christine S. Richard, Ackman even called top executives of Citigroup to try to dissuade them from participating in a bailout of another bond insurer that might have taken pressure off MBIA and alleviated investor anxiety at a crucial moment in the financial crisis. Not helpful.
The fallacy behind the traditional defense of short selling is that there is some rough equivalent between those who are betting that a company will succeed and those who are betting that it will fail. The Wall Street view starts from the assumption that financial markets are an end unto themselves. But if you start with the assumption that markets are meant to help companies create real value, then treating "longs" and "shorts" as economically equivalent looks pretty absurd.
A second fallacy is that all financial instruments have the same economic value. It's hard to find fault with Ackman's long-term investments in the stocks and bonds of companies he suspects are undervalued. But we now know there are serious dangers in allowing speculators to take out insurance on bonds they don't even own, as Ackman did in purchasing MBIA credit-default swaps. These enormous markets in "side bets" not only distort prices on the markets for the real things, but when investor sentiment turns, the side bets turbocharge the effect and can lead to a meltdown in the entire system.
A third fallacy behind Ackman's defense of his brand of activist investing is that more liquidity is always a good thing. As Lord Adair Turner, Britain's top financial regulator, has argued, beyond a certain point having additional liqudity in a market can artificially inflate the value of financial assets by lulling investors into a false sense that they can get out at the first sign that a bubble has burst. As everyone discovered in September 2008, liquidity can dry up the instant market sentiment turns and everyone runs for the exits at the same time.
The final fallacy underlying Ackman's defense is that the profits he generated for his investors represent a net gain for the economy. Again, that's arguably true for some of his long-term investments in underperforming companies. But the market for credit-default swaps is a zero-sum game, and every dollar Pershing Square earned from its gamble on MBIA was a dollar lost by some investor on the other side of the trade.
In truth, Bill Ackman is probably one of the good guys on Wall Street. What's also true is that what he and many others do adds far less value to the economy than he and others presume - and certainly less than would be indicated by their extraordinary compensation. Turner made that case eloquently in a speech earlier this year that made him few friends in London's financial district. Even more accessible versions can be found in an article by John Cassidy in last week's New Yorker and in a wonderful essay by Harvard economist Benjamin Friedman in the fall issue of Daedalus magazine.
This debate over the size and purpose of a financial system is a good one to have. Too bad we didn't have it last year, before the enactment of the financial regulatory reform law.
Once again I'll be writing my annual holiday column about extraordinary acts of philanthropy by local companies this year. If you know of a company or group of employees that went above and beyond in 2010 on behalf of a local charity or nonprofit, I'd love to know about it. Just send me an e-mail explaining briefly who did what for whom. Be sure to put the words "holiday column" in the subject line and include the name and phone number of someone I can call for more information. Deadline is Dec. 13.