Tuesday, June 21, 2011

Paulson and the Chinese Fraud

Over the past three weeks, Sino Forest Corporation, a Chinese company which "manages" forest land in China and produces various wood products through subsidiaries has fallen from $20 to less than $2 a share. A research and investment firm, Muddy Waters Research, which specializes in "shorting" Chinese stocks (betting that the share price will fall rather than rise over time) published an extensive report detailing what they believe to be a pervasive fraud committed by the company's management.

Caught in the middle of this was John Paulson, a hedge fund manager famous for making $3-4 billion shorting the housing market in 2007-2008. His firm, Paulson & Co., reportedly lost more than $750M when they exited their investment in the debt and equity of Sino Forest Corp. yesterday. Though this should make liberals and tea partiers alike estatic (just rewards for fat cat bankers and all that), I think there are two lessons to be drawn from this incident.

First, China is far from a developed nation in terms of accounting and capital controls. If Muddy Waters Research is correct, the fairly obvious fraud has existed since the mid-1990s. Further, Western accounting firms are easily fooled by Chinese management. Ernst & Young, one of the "Big Four" accounting firms was the company's auditor, and several former partners served on the company board. This fraud was not Enron-esque, it was fairly simple and it speaks volumes that the company board's oversight failed. Makes you wonder if they all knew and that's why the company was never listed in the United States in order to avoid potential criminal charges for the Western board members.

Second, Paulson & Co. seems to have grown so large that it is unable to conduct proper due diligence on its investments. With $30 billion under management and 8 separate funds, the former smarter guys in the room may just be unable to find and validate enough investments to made an adequate return. You see this same effect in mutual funds where performance begins to lag as the size of the fund grows. Yet another reason why the vast majority of Americans should be using ETFs for their investments. They are cheap and remove the investor from the business of trying to find a good manager for their money.

Update: Paulson actually lost $468M

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