Odd Lots - Jim Chanos on Crypto, Tech and the Golden Age of Fraud

Episode Date: November 23, 2022

Earlier this year we talked to the legendary short seller Jim Chanos, during which he warned of more pain ahead for speculative areas of tech. That call proved to be prescient by a number of measures. So where are things now? We spoke to Chanos again at the recent Berkeley Forum on Corporate Governance in San Francisco. We discussed frauds, crypto, and the pro-cyclical effects of stock-based compensation. Note: This episode was recorded on November 9th, 2022. We're publishing our usual Thursday episode one day early due to the Thanksgiving holiday in the US.See omnystudio.com/listener for privacy information.

Hello, I'm Michelle Hussein, and for more than 20 years, I was at the BBC. But all the time I was delivering the headlines, I wanted to go further than the news of the day. To spend more time with the people shaping our world. And that's what I'm doing here on this podcast. Speaking to people from Nigel Farage, to love you trying ever so hard, to be taught a lesson, to tech journalist Karaswisha. And the tech industry is running wild. You know, they've gotten what they wanted and they've seen a huge run-up in their stock prices.

This will be a place where every weekend you can count on one essential conversation to help make sense of the world. So please join me, listen and subscribe to the Michelle Hussein show from Bloomberg weekend, wherever you get your podcast. You certainly ask interesting questions. Hello and welcome to another episode of the Allot's podcast. I'm Tracy Alloway. And I'm Joel. Weizenthal? So, Joe, you know, one of the most famous maxims in markets has to be that, I think it's that Warren, it's Warren Buffett, isn't it? The quote about when the tide goes out, you get to see who's swimming naked. Yes. It's a cliche. We are in a big time tide goes out environment.

I mean, the number of CEOs of various companies who have written some version of like, I screwed up, this was all my fault, I misjudged, etc. Every day it feels like, Like there's another one, and it is true. When there is a bare market, when there's a downturn, you discover both frauds, and you discover insolvencies, and you discover unsustainable structures. It all comes out. Right. It is a popular saying for a reason, which is that it tends to be true.

What is kind of amazing me about this particular cycle is, I guess, just the speed at which all of this seems to be happening. So, you know, it was only a few months ago that we had Jim Chanos, the fame shortseller, on the podcast talking about how he thought that there was going to be more pain ahead for a lot of different froth spots in the market and how interest rates going up basically meant that a bunch of frauds were going to be exposed. Yeah. And so basically the market, particularly a lot of the tech stocks and a lot of the gig economy, sharing economy, the arc economy, all these things really have gotten hit pretty hard since we talked to Jim earlier in the summer. And it's still a mess. And so I guess part of the question is, well, what does it look like at the bottom? What have we learned? What are we seeing with the tide going out? And are we any closer to, you know, something that could resemble like a bottom for this market?

Right. And then also, I guess my question is, do frauds pick up in this environment or do they get exposed and more difficult to perpetrate? So we're going to be talking about all those things with Jim Chanos. This is an episode that we recorded live at the Berkeley Forum for Corporate Governance in San Francisco. Jim is, of course, the co-founder of Chanos and Co, which used to be called Kinnikos. Here's our conversation. Hi, Jim. Hi, Jim. Hi, Jim. Now, Jim, the last time we spoke to you, I think was in June of this year. Fast forward a few months, you are completely correct. Or froth was blown off the top of the frothiest stocks in the market.

I don't even have a question. I think I'm just going to ask you, like, tell us what's going to happen now. Look, we're getting a situation where the various parts of speculation are getting wrung out of this market one by one. We talked a little about them back in June. I think we've waited right in the middle of kind of our second crypto crisis over these past few days. On top of it, you've got the tech complex melting down. And a lot of this is just the byproduct, as we discussed, of perhaps the most speculative market that I've seen in my lifetime, 40 years on the street, which was 2021.

And one by one, whether it's crypto, whether it's NFTs, whether it's SPACs, the poster children for that speculative. are basically being taken out to the woodshed and disposed of. And the question will be, does it spread to something in the markets anyway that's much broader than that? And that remains to be seen. Again, kind of like Tracy. I don't even have a question exactly. But FtX, give us the Jim Chano's tape. Well, I mean, I think, Joe, you basically are probably better prepared than me to talk about that because the quintessential moment for me in the whole crypto saga was the interview that you and Matt Levine had with SPF, I think back in April. Whereas I pointed out, he kept saying the quiet parts out loud about how business models were in effect Ponzi schemes. And I think we're going to look back at that as a watershed moment because the crises in liquidity and the revelations on the stable coins,

all immediately followed that interview. And it was one of those moments, and kudos to you all, it was one of those moments in the markets that not only went viral on social media, but went viral amongst professionals and others. Have you seen this interview? Did you see what was said here? And it's very rare you get that aha moment like that crystallized,

but that was one of them. And the whole idea, and I've called it a predatory junkyard, as you know, the whole crypto structure, in my view, was designed to extract fees from really unsuspecting investors and investors that were kind of sold a bill of goods where the bill of goods kept changing. You know, we remember all the use cases for crypto as they kept changing over the past handful of years. It was going to be an alternative currency. It was going to be a store of value. It was going to be an inflation hedge. And at the end of the day, it was really just a speculative asset and speculative asset class. And with,

with an immense cost structure built around it. So the idea really was for the crypto community was how can we extract the most amount of fees from unsuspecting investors? And that's my view and I still hold to it. What happens now for crypto? Is there a recovery here or is this so bad? I mean, FTCS, Sam Bankman-Fried.

And I was there at that Oddlots interview as well and we were all sat in the room quite shocked by what SPF had just said. For those who haven't listened to it, we asked him to describe how yield farming works, and he basically says, well, you put money in a box and more money comes out of the box, and you worry about the use case later. All right. So fast forward to today. It's all falling apart.

Can crypto emerge from this and potentially find, you know, a new narrative to sell, a new potential use case? Yeah. I'll just add, the ultimate irony in the last couple of days is the crypto community talking and sort of begging and asking, where are the regulators? It's really truly the ultimate irony since the crypto ethos was about, you know, really being outside of the regulatory environment and being a separate and independent system. And now it's begging for the same sorts of things. And, you know, as I pointed out for a few years, the real problem. The problem with anti-fiat structures is exactly when you need fiat is the time when people are most afraid and when fear stalks the markets because governments through their various different means can not only enforce contracts and adjudicate fraud, but in effect can act as lenders of last resort and or established deposit insurance, which is exactly what everyone looks for when people worried about getting their money back.

And it's why alternative currency schemes, and by the way, crypto isn't the first. I mean, there have been all kinds of alternative currency schemes to fiat for centuries now. And they always flourish in full markets when people's sense of disbelief is suspended. And people begin to believe things that are too good to be true. And crypto and all the other ancillary aspects of crypto, whether it's NFTs or what have you, really were the latest iteration of that. The last time we talked to you said that as well. What's an example of an alternative currency that thrived in a bull market? What's a historical parallel to?

So, I mean, you had the various different banking systems that thrived in the early 19th century in the U.S. That's certainly probably one that economic historians would point to. And we can go back further. I mean, the various different currencies that the father of Fiat, John Law, who I teach in my fraud course, brought forth in the early 17. in France, but there have been a number of them. And the problem, again, is they rely on a system of trust, whereby the systems that Fiat has developed in the past 300 years have really been designed to engender trust. It's the offset, of course, to the downside of Fiat, which is debasement.

And so the crypto community pointed out the risks of debasement and all the other risks of sovereign governments getting involved in your currency, but they forgot the good parts. And that's, I think, the lesson that we have to learn. Do you worry about crypto drama, what's going on in that industry, having a contagion effect on either the rest of Silicon Valley or the wider market, given that there do seem to be these interlinkages between, for instance, crypto players and venture capital firms? Yeah, to me, this looks, This looks a lot more, as we discussed, this looks a lot more to me like the dot-com era on steroids rather than sort of a prelude to the global financial crisis.

Because of the nature of the banking system and payments, I don't think this is a contagion effect. I do think it's a pretty bad mark-to-market effect for equity type investors, much like the dot-com era, but I don't think it is contagion through the credit markets. I mean, I think I saw something this morning that, and it might even be lower now as we speak, but I think the crypto mark to market for all the coins out there is something now below $1 trillion, somewhere on $800 billion. And, you know, $800 billion is a lot of money, but I'll remind you that until about a week ago,

you know, Tesla's market cap was $800 billion. That's just one stock. So I think the contagion effects are probably going to be de minimis to the payments. credit system. San Francisco. On April 4th, 2020, around 2 in the morning,

a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political

firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering,

the Killing of Bob Lee, beginning April 16. I definitely want to get to like tech stocks and Tesla and all that in one second. But one last question. You know, it's this, as you pointed out, the crash happened. People say, where are the regulators? This is, again, I think a classic part of the cycle that the regulators seem to come in late. What does history say about how far they go? Would you expect to see, for example, criminal

charges, people in jail as a result of this dot com trading on steroids in crypto? Yeah. So one of the things, one of the things I teach is that not only are the regulators, archaeologists, not detectives, but that asset prices are both the staunchest defense attorney and the harshest prosecutor for financial fraud. That nobody's out looking to bring the bad guys in when everybody's making money. It's only when people start losing money that you begin to get a public outcry of, you know, throw the rascals in jail. You know, if we go back again to the dot-com era, people were losing money in dot com for a better part of a year, but it wasn't until the Enron and WorldCom scandals hit that the federal government really geared up its efforts to look at corporate

wrongdoing and bring on Sarbanes-Oxley. So this is going to be the same thing. I mean, people have lost a lot of money in crypto, a lot of new investors, a lot of young investors. So you're going to get a political outcry now to regulate this system and bring bad guys to justice. Now, I've also pointed out that it seems to me that there might be a reason why a lot of these crypto entrepreneurs live in places like the Bahamas in Dubai and not New York City. So, you know, it might be, and I think there are one or two actually that are technically fugitives from justice already. So it's going to be interesting to see what we see from a prosecutorial as opposed to a regulatory initiative against this and what kind of wrongdoing that gets exposed. if it turns out that there was actual misrepresentations or assets that were claimed to be there, were not there.

On the other hand, it just seems, I mean, people have been warning about this for now a few years. It's not like the warning signs weren't there for people to notice. Yeah, there's at least one crypto entrepreneur that has effectively purchased diplomatic immunity as well, preemptively. Nothing's happened to him yet, but he has it. Let's talk about frauds more generally. And you mentioned Enron, and you've obviously been a player throughout different boom and bust cycles. What generally happens to frauds in a downturn?

I'm assuming many of them get exposed. But there must also be incentive there to maybe start new ones and try to bury some of your problems as they get worse. Well, that is a problem in that as it becomes more and more difficult to meet expectations, often the frauds get exponentially worse as they go on. But what I would point out is that the fraud cycle follows the financial cycle with a lag. So typically fraud thrives in a bull market. And the longer the bull market and the longer the business expansion, typically the worse, the waves of fraud that are subsequently discovered. And then when markets turn down and people become a little bit more leery, since most frauds require new capital to keep going, they tend to get exposed after the

market's turned down and made off in December of 08's a good example. And of course, we mentioned Enron and WorldCom and Tyco and that class. In this cycle, I think it's going to be, I think crypto is probably going to be right up there. And that has started, clearly. But I think the fraud that's occurring is much more subtle. And I think it's going to be even harder to prosecute. And that's the abuse of metrics, self-described and self-generated metrics that now investors have just gotten so used to, which have really, in my opinion, you know, masked over business plans that probably will never be profitable. And the amount of adjusted, adjusted profitability and adjusted EBITDA. There was one of our shorts reported last night, and they said that they expected

to be profitable by the end of 2023 on an adjusted basis, adjusted for other operating costs. I have no idea what that means. But, you know, analysts dutifully this morning said they expect to be profitable at the end of 2023. And so the investors have gotten so used to, particularly Silicon Valley, describing profitability as they would like it and not as it really exists, you kind of wonder, will the SEC crack down on that? Will Congress crack down on that and get us back to kind of generally accepted accounting principles as opposed to accounting principles are whatever I want them to be? Well, as you say, the fraud cycle follows the financial cycle. And of course, one way that Silicon Valley companies in particular, all companies, but Silicon Valley in particular

flatters their financials, makes profitability look better, is, you know, substantial share-based compensation. And, you know, it's not really a cash expense, but of course still investors are paying it. What happens to this place, Silicon Valley, what happens to share-based compensation in an era in which shares go down? I imagine for employees, they're not as excited about getting stock as they might have been a year ago or two years ago as part of their comp. So talk to us about, like, that unfolds and like what the down cycle of an industry that's so driven by equity issuance to employees, what happens in a down cycle? Well, it was a big issue, Joe, in post the dot-com era.

Back then it was stock option accounting that became, that went under the microscope and ultimately had to be accounted for. And now, of course, in effect, it's taken out through the use of pro forma adjustments. But what people found out was that it had to be accounted. had just a tremendous pro-cyclical effect on things. That is, when your stock price was going up, you didn't have to issue as many shares for a given dollar level of compensation. And now that the stock is down, if your stock is down 80 or 90 percent, you have to just issue

massive amounts of stock. So you're issuing more stock as it goes down. You're diluting people. So it becomes pro-cyclical to the downside as well. the numbers are now becoming meaningful. The company I mentioned just a few minutes ago that reported last night is got run rate share-based comp of almost a half a billion dollars, and based on their current share count, that means that the shares outstanding are going to be going up something like 7 to 10 percent a year, just on the back of share-based comp. The other

problem is we've seen a number of companies beginning in the second quarter, companies like DoorDash and Salesforce.com and Zoom announced large share buyback programs to offset the dilution of the share-based comp. So you have the you have the silliness of the share-based comp being excluded from the adjusted profit figures and actually being a positive for operating cash flow in the cash flow statement, but yet now the substantial share buyback cost is below the line in the cash flow statement under financing. So it's skewed in. incentives in so many different ways, but it's getting worse. The amount of share-based comp for some of these companies is actually going up faster than revenues. So they're on the treadmill, if you will,

and I don't know how they're going to get off it. Why do you think investors have been willing to accept these types of pro forma adjustments in the past? Because I mean, this has been a known issue. I think we had someone from the SEC recently. I think it was an article in the Wall Street Journal. they were talking about this. We used to make fun of, you know, community-adjusted EBITDA and stuff like that. People knew that this was happening, and yet it didn't seem to have that much impact on either the company's share price or its ability to raise funding. Yeah, until it did, right? And again, that's my view on the pro-cyclicality of all these kinds of developments. They make things look much better than they are on the way up, and they really hit you pretty hard on the way down. And so it just increases the amount of volatility in given corporate assets. There's one other aspect I will mention that your audience might not appreciate. And we saw it in the dot-com bust, and that is if you have a lavish equity issuance culture and you have a compliant board that basically will agree to almost any management equity

issuance plan, then when you issue stock options and various different equity instruments to your management and your employees, if the boards rubber stamp things, well, they will rubber stamp repricing those equity awards if the stock goes lower or granting more if the stock goes lower to keep employees happy. And what that means is that boards are acquiescing, to not only call options, but they're granting put options to the employees and management. And that's a frightening alternative because, number one, the Black Shoals model is only picking up the cost

of the call options. And B, you don't really want a management team that has a bunch of puts in their stock as well as calls. And it's something that I don't think a lot of people pay enough attention to on the governance side that I think you're a, Your audience might appreciate. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast.

Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets, from corporate law to constitutional law, and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean. We do this every weekday, then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen.

On the East Coast, listen as you start your day. And on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. I have a really short question. Are you going to make us look at which companies reported earnings on November 8th and have a half a billion dollar share-based compensation run rate? Are you going to just tell us the name of the company?

It's a fintech company that's based out where you guys are right now. And let's say it's involved in a sector of fintech that a lot of people have questioned. buy now, pay later. I think that'll narrow it down. That should narrow it down. Well, okay, this kind of leads into a process question. But in an environment like this, do you find identifying potential shorts easier than during the bull market?

Identifying them wasn't the problem, Tracy. It was where the stocks went. That was the issue. You know, some of these business models, I mean, to us and others, have been questionable from the get-go, you know, take a look at ride-haling or food delivery, something we're all familiar with. These companies been around for 10 and 15 years. They haven't found a way to make profit. DoorDash to single out one company actually has higher losses per order now than a few years ago. And so they're not scaling. And that is for companies that are based on digitization,

and having a platform and using the internet, you had better scale. That's the whole concept. And so many business models are showing increasing losses as they age. And I just sort of wonder at what point do people just say, okay, enough. And I've been shocked that it went on as long as it did for a lot of these business models. So identifying them was not the issue. having other investors care about that is really the issue. So I've always found this point that you make to be very compelling, that it's like,

okay, if these riot hailing, sharing economy, whatever companies couldn't make money during the boom, during the good times, then when were they ever going to make money? The counter that we've heard, and we did an interview not long after the last time we talked to you with the VC Jason Calicandis, he's like, yes, that's a good point. On the flip side, investors were encouraging. all these companies to grow at any cost, and they were not being rewarded for profitability. They were rewarding for growth. And so it's not fair to say they can't make money because they just weren't incentivized to. There was no reason why they would have when the gains were all to growth.

When you look at these models, why can't, in your view, they turned the dial? Because that is the big question, right? Can they cut costs now? Can they sort of like finally, like, right size and make money. We've seen these big stock price declines, in many cases 90%. We see management going into cost-cutting, layoff profitability mode. Why don't you think that they can now turn the dials and get to positive cash flow? We'll see. And so far, they haven't. And so maybe they're not losing as much money, but if you look at the operating metrics, a lot of them are still inherently unprofitable at reasonably high up in the income statement, whether it's operating income or gross profits. But what we're really looking for as short sellers in looking at these business

models is for the companies that have stopped growing and are still losing money. Because if they've stopped growing and the losses are still considerable, then the whole idea, well, we were investing for growth. We're investing for future capacity. Investors didn't care as long as our top line was growing. structurally unprofitable as you slow down or stop growing, then you have a problem. And that's why the things like the DoorDash metric I mentioned to you, you know, losses per order become important to judge whether or not what your guest said is true or not. We've made it 25 minutes without actually mentioning Elon Musk, although we did mention Tesla. So I don't, again, this is one of those things.

I don't even have a question, but Tesla, Elon Musk, Twitter, Jim, Go. Look, you know, the Twitter saga is one for the ages, and I'm an interested observer like everybody else. We're focused on Tesla the car company, and I would just keep pointing out to people that Tesla the car company is not only the most profitable car company, which certainly we never thought it would be, but is also. So going away still with the stock down almost 60 percent is still the most expensive automobile OEM in the world by a lot. And I think we're looking at a company that's trading now right around 30 times gross profits.

Thirty times gross profits is there's software versus service stocks that would kill for that. And basically sells luxury cars, right? He sells 50 and 60 and $70,000 cars that have immense gross profit margins, 30%, where the rest of the industry is lucky to get 15 or 20%. We don't think that's sustainable. We think that number one, the luxury car market is much smaller than people think. And number two, even though the other OEMs have been slow on the uptake, they are coming. competition will increase and most cars will be EVs by the next five to 10 years. And it's a

tough business. It's a low return on capital business. It always has been. He got the sweet spot to his and his shareholders benefit and to the short sellers detriment. But now he's got to maintain it. And I think that's increasingly difficult because his investors are still looking for 40 to 50% growth for the next, you know, decade. And that means that pretty much he's going to be the entire car industry, you know, by the early 2030s. And we just don't think that's going to happen. Are you short Tesla right now? We are.

Because I wasn't sure because I, where you're so obviously the stock has come down a lot, it's gotten hammered over the for a while now. But you just, even at the current level is unsustainable. We are. And I would be remissed if I didn't point out that people have now lost. more money in Tesla than they've made. It's like crypto, I believe. Think about that. Yeah. Yeah, exactly.

And what do you think about Twitter? Does that distract from Musk's role at Tesla? Well, remember, he's also the CEO of a couple of other companies, not just Twitter and Tesla. So, you know, it's, I don't understand the valuation. I don't understand the price he paid. but it seems to do with what he wants. And I believe in private property and free enterprise. And, you know, I'm kind of scratching my head at some of the initiatives.

But we'll see how it plays out. I don't think it was worth $44 billion. I think he thinks it probably wasn't worth $44 billion. And it'll be interesting to see how that plays out. But I think it's probably going to take a disproportionate amount of his attention over the near term. So we just have about a minute and a half. So just like really simple, you know, like when you've seen the end sides of many bubbles

in your career, does it look like we're close to the bottom here? And also, what would be the signs that we are close to something that you would call a bottom? Again, market timing is not my forte, but if it was a bottom, it would be the most expensive bottom probably in modern financial history. I mean, most bare market bottoms have basically bottomed out somewhere between nine and 15 times the previous peaks of earnings. And because normally the earnings are depressed at the bottom of a bare market. But if we think that roughly, you know, earnings are peaking right now, and they may or may not be, but my guess is they're pretty close. Nine to 15 times would be 1800 to 3,3,3100 on the S&P. We're a long way away from that.

So I, you know, I saw that for the first time, FACSET was saying that S&P earning estimates are coming down for the fourth quarter are going to be down year over year. So we might be at peak earnings right now of $205 or $210. You know, we were, where were we the other day? 900. So we were at 19 and a half times that number. That's a pretty rich number to be a stock market bottom. All right. Well, Jim Chanos, it was lovely seeing you again. We look forward to maybe catching up with you in like another four months and we'll just ask you. We'll just say you were right again. Thanks, guys. I appreciate it. Well, that was our conversation with Jim Chanos at the Berkeley Forum on Corporate Governance. Tracy, it's always a pleasure to talk to Jim, of course.

You know, I thought it was actually interesting. Obviously, we're in the sort of like fraud exposure cycle, but the other sort of pro-cyclical element besides discovering all this bad activity is just what we see about financing and what he talked about with share-based compensation and this sort of compensation structure coming home to roost. Right. And also the idea that those sorts of share-based compensation schemes can be an amplifying force for stock prices on the way up, but also on the way down. Right, because, you know, when it comes to, you know, Silicon Valley, you know, and we think about leverage, we sometimes don't think of tech companies in that because they don't have any debt per se. But when you think about, like, how crucial share-based compensation was, and if you think about it in terms of almost borrowing from your own investors

in order to pay employees and so forth so that they'll keep working at the salaries it expects, It really is like a form of financial leverage. It's just not a credit leverage. Share-based capital is the lower tier two capital of Silicon Valley. I like this. That's good. That's my new catchphrase. Roll with it.

Roll with it. Yeah. All right. Shall we leave it there? Let's leave it there. Okay. This has been another episode of the Odd Thoughts podcast. I'm Tracy Alloway.

You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthal. You can follow me on Twitter at the stalwart. Follow our guest, Jim Cheneos. He's at Wall Street Cynic. Follow our producers, Carmen Rodriguez, at Carmen Armin and Dashill Bennett at Dashbot, and check out all of our podcasts under the handle at podcasts. And I wanted to let you know about a special event that we're holding four listeners,

my co-host Tracy Alloway and I, will be speaking with past guests, Josh Younger, as well as Columbia Law Professor Lev Menad in a special live episode of the Odd Lots podcast on November 29th. We're going to be holding it at Bloomberg, 8,000. HQ, and you're welcome to come, mingle, join. We're going to have cocktails, canopets, and other stuff on that day, along with the live recording. So if you're interested in attending a live episode of the Odd Lots podcast, as well as meeting me and Tracy, as well as meeting our guest, and as well as meeting other Odd Lots listeners, go find the RSVP. Both Tracy and I have tweeted about it.

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