Sunday, November 2, 2008

The Mother of Short Squeezes

Last week, the German stock market was roiled due to a clever ploy by Porsche. They engineered the biggest short squeeze in history, and may have used it to purchase a majority stake in Volkswagen at a dramatic discount.

Short selling is a techique for exploiting the stock market to conjure money from nothing. If I believe a stock, say General Motors, is going to decline, I can borrow some GM shares and sell them. Some weeks or months later, I go onto the market and buy enough GM shares to pay back the person I borrowed from. If GM is selling at $10 today, but goes down to $9 when I buy shares to pay back, I get to keep the $1. My total investment = $0, my profit = $1 minus whatever pennies I paid to "rent" the stocks. Why would anyone lend out their stocks in this way? Because if my neighbour owns GM stock and does not plan to sell, then a few pennies per share for lending them out is gravy.

There are three problems with short selling. The first is that if the price goes up rather than down, you are out the difference. If GM goes from $10 to $15, I will lose $5 per share. Because a stock can go up to infinity, my potenital liability is also infinte. For this reason alone, lots of people stay away from short selling. The other problem is that an event can force reconciliation. For example, if a large portion of the target company is bought or sold, if the company has a major revenue event, if the company initiates a large stock buy-back or if a serious issue with the wider market causes stock regulators to change the rules. When an external event causes short sellers to all have to repay the borrowed shares at the same time, you get artificial demand for the stock and the price goes up. This is a short squeeze, and the short sellers lose their shirts because they have to buy no matter what the price.

The third thing wrong with short selling is that it is very unpopular. Short sellers are the scavengers of the financial world. The CEOs of companys targeted by short sellers hate them with a passion. The practice seems to embody everything that is wrong with financial markets. Profiting off the misery of others, making money out of thin air, complex games of music chairs where normal rules don't seem to apply. Short sellers trade in bad news and rumour, doing anything legal (and sometimes not legal) to poison a company's reputation. The only reason they are tolerated by regulators is that they perform an essential function. Short sellers help to keep the market honest and companies in line. Any bit of bad news a company holds back becomes a potential opportunity for short sellers. Nowhere are short sellers more disliked than Germany. Germany is all about making and selling things, they don't like speculators for historical and cultural reasons. They especially don't like foreign speculators in the form of hedge funds.

All of this sets up Porsche's power play. They already owned 42.6% of Volkswagen. How a tiny sport-car company was able to buy 42.6% of the world's third largest car company is another story. Last Sunday, Porsche dropped a bombshell. They announced that via complex derivatives deals, they had secretly aqcuired another 31.5% of the company. Porsche's total stake was now 74.1%. The government of Lower Saxony owns 20.1%, so the outstanding public shares dropped to just under 5.8%. Volkswagen had been a popular short among international hedge funds and short sellers. The total number of stocks shorted amounted to 13% of the total stock. That means some of the people who lent stocks to short sellers had secretly pledged them to Porsche via derivatives. When Porsche announced the news, all the short sellers had to liquidate their positions. Since 13% is a lot bigger than 5.8%, there were a lot more buyers than sellers. The price of Volkswaqen share went from €210 on Friday to €1,000 on Monday.  The biggest short squeeze in history.

Presumably, some of the people that held the outstanding 5.8% of the shares held on to them. So where did all the shares come from that were sold to liquidate the short's positions? Probably from Porsche. They sold shares into the short squeeze and then bought them back later when the bloodbath was over. Porsche should have paid about about €14.8 billion for the 31% stake. If they did sell into the short squeeze, they may have netted out at closer to €5 billion, with the short sellers inadvertently providing the rest. NOTE: Porsche's profit from the short squeeze is my speculation.

In North America or Britain, Porsche's secret accumulation would have been illegal. But it has been done before in Germany. Porsche's interest in buying more of VW is well known, and they have been uncharacteristically quiet about it for months. The short sellers knew, or should have known, that they were playing with fire. Although Porsche's actions are very close to the legal borderline, and possibly over, nobody in Berlin is in a mood to do anything about it. A senior German politican's reaction was to call the short-sellers "locusts". It seems that much of the German financial community was involved, at least passively, in a sting designed to hurt primarily foreign speculators and profit German industry.