David Einhorn Testing Reflexivity of Markets

Happy New Year and welcome back from the holidays! At certain times (especially in crashes or bubbles), perception could become the reality; here is a real life instance illustrating the Theory of Reflexivity, which was preached by George Soros.

In May of 2008, Greenlight founder David Einhorn gave a famous and compelling thesis on shorting Lehman based on the fact that there were accounting inconsistencies, implying that Lehman should have marked down the value of certain illiquid assets much more than they had reported in recent financial statements. You can find the transcript here:
David Einhorn - 2008 Ira Sohn Speech

Reflexivity

True, Einhorn made some insightful fundamental arguments against Lehman, but what is also interesting is the impact of such a news announcement. Banks are highly levered institutions which rely on liabilities (deposits, commercial paper, unsecured borrow) to fund assets (loans, investments). In a rising interest rate environment where the long-term rates > short-term rates, almost all banks to try earn the spread [long-term rates - short-term rates] by lending for long duration (long time periods) and borrowing for shorter time periods. However, the profit is not risk-free since these banks need to make sure they can roll their liabilities (once their borrow expires, they can go back to the market or to their counter parties to extend borrow for a new period). 

Unfortunately, once the market loses confidence in any bank, it's essentially game over due to a "run on the bank", which is what resulted at Lehman Brothers. As bearish news (such as Einhorn's speech) hit the market, the stock started to trade lower and counterparties / other banks demanded a higher interest rate from Lehman in order to lend Lehman capital. As counterparties became less willing to lend to Lehman, their credit rating fell, causing the market to focus on their lack of liquidity, which in turn crushed the stock further. Then as credit agencies starting downgrading Lehman, less and less counterparties wanted to lend the bank money until finally Lehman cannot find enough players to lend it money via deposits, commercial paper, unsecured financing, etc. This vicious feedback loop and resulting downward spiral of frail companies was termed as "reflexivity" by George Soros in his book The Alchemy of Finance.



Sometimes, the price action of stocks which are caught in this downward spiral lend credibility to the adage in volatility trading "buy vol when it's low, sell vol when it's high, buy vol when it's ridiculously high." At the height of the panic, variance swaps on Lehman Brothers common stock (LEH) traded at 200%. 

Einhorn Artificially Creates a Catalyst For His Own Trade

One important thing to note on the art of short selling is that you need a catalyst to drive the stock lower. For example, shorting stocks based solely on valuation (P/E and earnings quality) is risky because they can become even more ridiculously valued (see Nasdaq tech bubble in early 2000). So timing is everything. However, shorting an overvalued pharmaceutical name could be profitable right before an FDA announcement, etc. With Lehman, David Einhorn essentially created a catalyst to drive the stock lower by pointing out certain problems in the bank. Otherwise, Einhorn would still be correct on his fundamental analysis but might still lose money on his short due to bad timing. Today, we see many managers publicly talk up their book on CNBC to essentially monetize their influence on the market. The recent Herbalife (HLF) story is a very good example.