A “short squeeze” sounds innocuous enough...(radian.org)
radian.org
A “short squeeze” sounds innocuous enough...
http://radian.org/notebook/porsche
"One of the most masterful hacks of the financial system in history."
52 comments
He really should have just resigned and tried to leave with a bit of real money to have a comfortable (you know, by normal-people standards) retirement. It's sad to see heinously rich people kill themselves over money.
Most of these super rich have built their reputations on being successful, and when the cornerstone of their reputation is suddenly crushed they are overcome really quickly. So it's not so much about the money as it is the self-esteem and reputation.
Ivan Krstić was the security lead for the One Laptop Per Child project. Here's his completely unrelated retelling of the downfall of Adolf Merckle, one of the world’s richest men, who committed suicide yesterday by throwing himself under a train. Merckle is actually ancillary to the story; it's really more about how Porsche perpetrated "one of the most masterful hacks of the financial system in history." It's fascinating!
The key phrase is "infinite squeeze" which is a condition where shorts are forced to buy at any price determined by owners,
http://www.economist.com/displaystory.cfm?story_id=12523898&...
...this is the worst possible condition of a financial market, in which a class of investors can literally dictate prices without limit (IIRC, German authorities stepped in at some point to prevent catastrophe).
http://www.economist.com/displaystory.cfm?story_id=12523898&...
...this is the worst possible condition of a financial market, in which a class of investors can literally dictate prices without limit (IIRC, German authorities stepped in at some point to prevent catastrophe).
And since (theoretically) there's no upper bound on the price of a stock, then (theoretically) there's no upper bound on the losses one can incur when engaging in short-selling practises either.
Porsche is an evil genius of Finance. Their predatory trading practises have become legendary. Some more links on this:
http://www.nuclearphynance.com/Show%20Post.aspx?PostIDKey=12...
http://ftalphaville.ft.com/blog/2008/10/27/17465/the-disrepu...
http://www.bloomberg.com/apps/news?pid=20601087&sid=aAe7...
Porsche is an evil genius of Finance. Their predatory trading practises have become legendary. Some more links on this:
http://www.nuclearphynance.com/Show%20Post.aspx?PostIDKey=12...
http://ftalphaville.ft.com/blog/2008/10/27/17465/the-disrepu...
http://www.bloomberg.com/apps/news?pid=20601087&sid=aAe7...
Amusing quote from the first link:
"Porsche exhibiting their excellent cornering ability"
"Porsche exhibiting their excellent cornering ability"
What happens in the case of an "infinite squeeze" where the party who owes stock to another cannot pay it back?
Is this a risk the lender has to deal with, that they may not ever see the stock they lent out again because the party they lent it to squandered it? Seems to me in the "short squeeze" situation the value of the stock cannot be infinite -- it is bound by the terms of the contract to which the shares were lent out.
Is this a risk the lender has to deal with, that they may not ever see the stock they lent out again because the party they lent it to squandered it? Seems to me in the "short squeeze" situation the value of the stock cannot be infinite -- it is bound by the terms of the contract to which the shares were lent out.
You will forfeit whatever you posted for collateral. For a retailer investor, that might mean a margin call causing you to liquidate what you held with your brokerage. There are safety requirements (imposed by the government and your brokerage) to make sure you cover the liability.
But when you're talking about billion dollar bets, you probably didn't fully secure it. Nope, you put your reputation up for collateral instead -- "You can trust us to say this billion dollar chunk of stock will be returned on time to the very minute because we have NEVER FAILED TO DO SO, EVER".
You really need that capital bit to be true because, if not, you'll never be permitted to do this again by your counterparties. If that happens, say goodbye to your hedge fund -- actually securing the size of bets you are making is murderously expensive.
Do you understand why this means you're willing to pay literally any price to satisfy the short according to schedule? If you don't, your firm is finished as a going concern.
This is the same reason why no fund family will allow their money market funds to break the buck. They'll invariably kick in their own money to keep it solvent because the alternative means ruin. (The Reserve, which broke the buck earlier in the financial crisis and was not able to kick in funds from other sources, is probably finished, even though the FDIC is now insuring money market funds.)
But when you're talking about billion dollar bets, you probably didn't fully secure it. Nope, you put your reputation up for collateral instead -- "You can trust us to say this billion dollar chunk of stock will be returned on time to the very minute because we have NEVER FAILED TO DO SO, EVER".
You really need that capital bit to be true because, if not, you'll never be permitted to do this again by your counterparties. If that happens, say goodbye to your hedge fund -- actually securing the size of bets you are making is murderously expensive.
Do you understand why this means you're willing to pay literally any price to satisfy the short according to schedule? If you don't, your firm is finished as a going concern.
This is the same reason why no fund family will allow their money market funds to break the buck. They'll invariably kick in their own money to keep it solvent because the alternative means ruin. (The Reserve, which broke the buck earlier in the financial crisis and was not able to kick in funds from other sources, is probably finished, even though the FDIC is now insuring money market funds.)
Very informative. It comes down to reputation.
Probably similar to a bankruptcy case though the ins and outs of securities regulations would likely muddy the waters considerably.
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It ends with a bit of a thud, but I had no idea Ivan Krstic was this good a writer. Really great pacing.
This is a brilliantly clear explanation.
While the explanation is clear, it should address the simple steps these hedge funds should have taken to protect themselves.
The hedge funds knew that VW was largely owned by big institutional investors. They knew Porsche was interested in owning VW. They may have had good reason to short VW, but if they were going to do that, why didn't they just buy some cheap, far out, short term call options that would have protected themselves from the divide-by-zero problem? The purchase would have been far smaller than their potential profits had they been right about VW declining like GM, Toyota, etc.
The hedge funds knew that VW was largely owned by big institutional investors. They knew Porsche was interested in owning VW. They may have had good reason to short VW, but if they were going to do that, why didn't they just buy some cheap, far out, short term call options that would have protected themselves from the divide-by-zero problem? The purchase would have been far smaller than their potential profits had they been right about VW declining like GM, Toyota, etc.
Perhaps the author should also made it clear that Porsche took advantage of poor securities laws in Germany rather than showed any 'financial genius'.
In US and UK there are explicit regulations forbidding secretly building a stake in a company. This 'hack' is illegal here just like insider trading is.
In US and UK there are explicit regulations forbidding secretly building a stake in a company. This 'hack' is illegal here just like insider trading is.
Indeed - and it should be illegal. The lack of transparency means that hedge funds will now think twice before investing in a company that's based in that jurisdiction.
Not before "investing". Before speculating on the shares of companies in the region. The investors are only the people who purchase the stock as sold from the company - and those people have nothing to lose by this affair.
I don't quite follow. Isn't buying shares de facto "investing" ?
(You may have a point on the shorting of shares, but that serves a purpose too; to devalue overpriced assets)
(You may have a point on the shorting of shares, but that serves a purpose too; to devalue overpriced assets)
I think he's making a distinction between "classical" investment and Wall Street-style investment (for lack of better terms). There's an ideal that an investor puts money into a business that he thinks has potential to succeed (e.g. VC funding), and reaps his rewards through the success of the business.
Then there are others who invest purely as stock price speculation, and is generally disinterested in the actual goings-on of the business beyond what is likely to impact short-term stock price.
Then there are others who invest purely as stock price speculation, and is generally disinterested in the actual goings-on of the business beyond what is likely to impact short-term stock price.
I see what you're saying, but I don't perceive a meaningful difference between those two classes beyond, perhaps, what's in the investor's head.
In both cases you're investing money in a company because you think the value of that company is likely to rise in the future. And in both cases the company benefits from that investment.
I agree that many investors are too focused on the short-term... but if they think they can make more money by selling a stock and reinvesting elsewhere rather than holding onto it for years, can you really blame them? The whole point of investing is to make a return on your principal.
In both cases you're investing money in a company because you think the value of that company is likely to rise in the future. And in both cases the company benefits from that investment.
I agree that many investors are too focused on the short-term... but if they think they can make more money by selling a stock and reinvesting elsewhere rather than holding onto it for years, can you really blame them? The whole point of investing is to make a return on your principal.
A company sells 1000 shares. All get sold. Any further rrselling of those shares aka the stock market does not benefit the company.
At least not directly. E.g. it's easier to sell more stock or sell a bond with a healthy stock price.
Viewed another way, the stock _is_ the company.
Viewed another way, the stock _is_ the company.
Why would the German government care about what happens to hedge funds who get screwed by speculating with stupid unhedged short bets in the secondary market? That has no relationship to actual investing in German companies.
I am not sure you understand how hedging works. You don't go short and long on the same stock to hedge. You generally take one position (long or short) on the stock you are speculating on, and you take the opposite position with stocks in its peer group to protect against swings in the industry. The basis of the hedge is that stock performance is correlated within sub-industry. With a short squeeze like the one of VW stock, this type of a hedge wouldn't have helped.
But that was not my main point for this reply.
The German regulators should care about financial transparency, because even hedge funds (and even naked speculators) provide an counter force to the natural tendency of the stock market to always go up. if shorting was not allowed, the market has a natural tendency to go upwards. everyone benefits from the market always going up -- the buyer, the seller, the company, etc. a buyer can always sell the stock for more later. no one would benefit from a price drop. however, the stock price growth may not have anything to do with reality of company's books. shorting stocks helps keep the stock at a reasonable price point because when the stock price rises unreasonably, plenty of people would like to gain from its pending downward spiral.
as an example, look at china. no shorting is allowed there. their stock market went up, up, up. the balance shorting provided was not not presence. when people realized how vastly over rated the stock market was, it got hit. hit hard. now, it is one of the hardest hit market out there.
shorting (and other financial maneuvers) only work with greater transparency of information.
note that the hedge funds did take a big gamble and paid the price. I do not feel sorry for them.
(Anyway, I am sure I didn't do a thorough job of explaining the benefits of shorting and transparency.)
But that was not my main point for this reply.
The German regulators should care about financial transparency, because even hedge funds (and even naked speculators) provide an counter force to the natural tendency of the stock market to always go up. if shorting was not allowed, the market has a natural tendency to go upwards. everyone benefits from the market always going up -- the buyer, the seller, the company, etc. a buyer can always sell the stock for more later. no one would benefit from a price drop. however, the stock price growth may not have anything to do with reality of company's books. shorting stocks helps keep the stock at a reasonable price point because when the stock price rises unreasonably, plenty of people would like to gain from its pending downward spiral.
as an example, look at china. no shorting is allowed there. their stock market went up, up, up. the balance shorting provided was not not presence. when people realized how vastly over rated the stock market was, it got hit. hit hard. now, it is one of the hardest hit market out there.
shorting (and other financial maneuvers) only work with greater transparency of information.
note that the hedge funds did take a big gamble and paid the price. I do not feel sorry for them.
(Anyway, I am sure I didn't do a thorough job of explaining the benefits of shorting and transparency.)
Transparency is all well and good. I am sure that is happily accepted oversight/regulation. So I wouldn't expect any arguments that hedge funds need way more oversight/regulation. On the issue of transparency, why not require hedge funds to disclose their short positions? This is all such a farce. To hell with them.
How can you ignore the possibility that having a derivatives market that is ten (10) times the size of the global GDP, might be an issue?
How can you ignore the possibility that having a derivatives market that is ten (10) times the size of the global GDP, might be an issue?
No, I understand exactly how it works. If you take a short position by borrowing a stock there is always a small but non-zero risk of completely blowing up due to something like this. It's playing financial Russian roulette. Making the market more transparent reduces the risk a little more, but it's still non-zero.
Any trader with common sense would have hedged the downside risk using other derivatives. For example, he could have purchased enough deep out-of-the-money call options to cover all the shares he borrowed.
No one is suggesting that shorting or speculation ought to be banned. However I remain unconvinced that requiring Porsche to immediately disclose their VW ownership stake in this case would have had any benefit for the German economy as a whole.
Any trader with common sense would have hedged the downside risk using other derivatives. For example, he could have purchased enough deep out-of-the-money call options to cover all the shares he borrowed.
No one is suggesting that shorting or speculation ought to be banned. However I remain unconvinced that requiring Porsche to immediately disclose their VW ownership stake in this case would have had any benefit for the German economy as a whole.
Not every trader could have just hedged out the risk of a blowup. that is becuase derivatives are a zero sum game. For every trader who purchased the out of the money call, someone sold it. Therefore that person is now responsible for unlimited downside.
Exactly. And if you can't hedge at a reasonable price then you shouldn't make the trade in the first place.
Also, if the call seller is covered then he only has a small downside.
Exactly. But let's take it a step further. Once the call seller covers himself (by buying stock in proportion to the delta of the option), he is essentially causing someone else to be short it as well. The unlimited downside is now passed to him. You can see how this just continues to propagate.
The point is that in any situation where shorting occurs, and therefore an excess amount of stock is floating, there is a non hedgeable unlimited downside risk that SOMEONE has to bear. Whether you pass it off in option or stock form is not relevant. Not everyone can hedge unlimited downside. Proper rules try to make sure these artificial squeezes do not happen, so as not to discourage short sellers (who are extremely, extremely important).
Now, that isn't to say that VW should be forced to reveal their position. It is not a trivial question what is the optimal way to stop this kind of thing. But it's important to discourage this activity where people deliberately accumulate shares to squeeze shorts. No economic value is created in this type of activity, just a transfer of wealth, whereas shorting serves a very important economic function.
The point is that in any situation where shorting occurs, and therefore an excess amount of stock is floating, there is a non hedgeable unlimited downside risk that SOMEONE has to bear. Whether you pass it off in option or stock form is not relevant. Not everyone can hedge unlimited downside. Proper rules try to make sure these artificial squeezes do not happen, so as not to discourage short sellers (who are extremely, extremely important).
Now, that isn't to say that VW should be forced to reveal their position. It is not a trivial question what is the optimal way to stop this kind of thing. But it's important to discourage this activity where people deliberately accumulate shares to squeeze shorts. No economic value is created in this type of activity, just a transfer of wealth, whereas shorting serves a very important economic function.
That's not usually how it works. Most covered calls are sold by investors who already own the stock and want to juice it for some extra return. They're not going out and buying more, so the unlimited downside simply doesn't exist.
I still fail to see the problem with discouraging short sellers from making stupid unhedged speculative bets.
I still fail to see the problem with discouraging short sellers from making stupid unhedged speculative bets.
Actually, what you said is not how it works at all. Most covered calls are in the end, handled by wall street dealers who hedge their deltas with short sales (trust me about this). Retail investors that do covered calls do own the stock, but the net effect is not what you described, it is significantly more complicated. (by the way, the transaction you describe is equivalent to selling a put)
Without closing out the short sales that were done, usually there is always unlimited downside to at least ONE player in this transaction. Why is this intuitive? Abstract for a second. Treat the short sale as a contract, which it is, where you agree that you have to buy some object back in the future in return for a FIXED dollar amount now. If you assume that object (a stock in this case) can go up to an arbitrarily high price, then you always have unlimited downside as long as this contract is in effect.
The point is even if you disallow these artificial short squeezes, you are STILL discouraging "stupid speculative bets", becuase the price can go up naturally (when the thesis of betting against the stock is economically wrong). These are the right times for it to happen, and in fact happens all the time without a volkswagen type squeeze. The point about short squeezes is that someone can make a "smart speculative bet" (which society as a whole needs people to do) but still get blown up for non economic reasons.
Without closing out the short sales that were done, usually there is always unlimited downside to at least ONE player in this transaction. Why is this intuitive? Abstract for a second. Treat the short sale as a contract, which it is, where you agree that you have to buy some object back in the future in return for a FIXED dollar amount now. If you assume that object (a stock in this case) can go up to an arbitrarily high price, then you always have unlimited downside as long as this contract is in effect.
The point is even if you disallow these artificial short squeezes, you are STILL discouraging "stupid speculative bets", becuase the price can go up naturally (when the thesis of betting against the stock is economically wrong). These are the right times for it to happen, and in fact happens all the time without a volkswagen type squeeze. The point about short squeezes is that someone can make a "smart speculative bet" (which society as a whole needs people to do) but still get blown up for non economic reasons.
Thanks for clarifying that. I didn't realize that Wall Street dealers would be stupid enough to take on what's effectively an infinite risk. I guess I shouldn't have been surprised given how many have blown themselves up lately.
But I think my original point remains valid. As long as short sellers buy sufficient options to hedge their positions, and those options are only sold by investors who actually own the stock, then no one is exposed to unlimited downside. And I fail to see how any trade that carries unlimited downside could ever be considered a "smart speculative bet" from any standpoint, regardless of whether it's economically right or wrong.
But I think my original point remains valid. As long as short sellers buy sufficient options to hedge their positions, and those options are only sold by investors who actually own the stock, then no one is exposed to unlimited downside. And I fail to see how any trade that carries unlimited downside could ever be considered a "smart speculative bet" from any standpoint, regardless of whether it's economically right or wrong.
Note that "hedge funds" is kind of a misnomer. A hedge fund is just like any other fund, except that it's less regulated and exclusively for rich people (the thinking being that rich people need less gov't regulation over their money because, well, they're rich).
They don't make money by literally "hedging their bets."
They don't make money by literally "hedging their bets."
> exclusively for rich people
No, it is not. The California Public Employees’ Retirement System (Calpers) alone had more than $10 billion invested in hedge funds in 2007.
So your average Joe should not wish evil to hedge fund managers, his retirement money is at stake.
No, it is not. The California Public Employees’ Retirement System (Calpers) alone had more than $10 billion invested in hedge funds in 2007.
So your average Joe should not wish evil to hedge fund managers, his retirement money is at stake.
Alternatively, perhaps CalPERS shouldn't be risking average Joe's retirement money by putting money into unregulated speculative investment pools. There's no reason to expect that hedge funds will deliver superior risk-adjusted returns compared to any other asset class. And there are some really horrible structural problems with most hedge funds which make them poor choices for pensions.
I did not mean to imply otherwise.
But yes, I should have been clear: rich people and rich organizations.
But yes, I should have been clear: rich people and rich organizations.
Other investors are no doubt very happy that Porsche did this. They reaped the same benefits as the company did.
Was it really that secret?
Question: how is it that nobody knew how much VW Porche owned?
Is there no way to see who owns a certain stock, or what stock a company owns?
Is there no way to see who owns a certain stock, or what stock a company owns?
I'm sure disclosure laws vary by country, but in the U.S. companies must provide this information to the SEC (via form 13-F and others).
On an unrelated note, I believe a better suited word in this case is "innocuous," not "inconspicuous."
On an unrelated note, I believe a better suited word in this case is "innocuous," not "inconspicuous."
You get different brokers to buy it on your behalf bit by bit, anonymously. From there it depends on the laws of the country you are operating within.
Companies often do this when selling stock too, so as to not draw attention to themselves or their positions.
Companies often do this when selling stock too, so as to not draw attention to themselves or their positions.
Except that, in the US and UK, that's illegal. In Germany, though, where this happened, it's not. That's not a good thing for Germany.
... and it's not a good thing for hedge funds playing with billions to apparently not know about the laws of the market they are investing in:-)
It's only illegal for companies though, right? If individuals do it they don't need to declare anything do they?
I've poked through FEC data (lots is available free online via FTP) and seen releases indicating when an individual owns mroe than 5% of a public company. I understand that to be the reporting threshold but could be wrong.
Remember, in the US legal system, companies are people. And the legal system is reluctant to create laws restricting only corporate behavior.
Remember, in the US legal system, companies are people. And the legal system is reluctant to create laws restricting only corporate behavior.
The regulatory loophole they exploited only exists with cash settled options [1] - IIRC the hole will be closed this spring with new legislation. Btw. another German Company (Schaeffler) used the same loophole last summer to secretely buy Continental (with much less success, it seems).
[1] Cash settlement - Cash-settled options do not
require the actual delivery of the underlier.
Instead, the corresponding cash value of the underlier
is netted against the strike amount and the difference
is paid to the owner of the option.Thanks. Every article I read mentioning the Porsche/VW affair simply said Germany didn't require large shareholders to disclosure their ownership, which surprised me. Now it makes a little more sense.
I figure one could buy deep in-the-money options and practically own the stocks, but nobody (except one's counterpart) would know.
I figure one could buy deep in-the-money options and practically own the stocks, but nobody (except one's counterpart) would know.
"On paper, Porsche made between €30-40 billion in the affair. Once all is said and done, the actual profit is closer to some €6-12 billion. To put those numbers in perspective, Porsche’s revenue for the whole year of 2006 was a bit over €7 billion."
Just shows how out of whack the whole economy is in that Porsche could make more money for their shareholders by playing financial games then actually manufacturing products.
Just shows how out of whack the whole economy is in that Porsche could make more money for their shareholders by playing financial games then actually manufacturing products.
It came at a risk, though.
So would normal profits from products though. They're in the automotive industry after all.
But that's their normal business risk.