

A “short squeeze” sounds innocuous enough... - jdnier
http://radian.org/notebook/porsche
"One of the most masterful hacks of the financial system in history."
======
jdnier
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!

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sh1mmer
This is a brilliantly clear explanation.

~~~
1gor
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.

~~~
swombat
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.

~~~
nradov
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.

~~~
jayp
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.)

~~~
nradov
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.

~~~
op12
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.

~~~
nradov
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.

~~~
op12
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.

~~~
nradov
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.

~~~
op12
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.

~~~
nradov
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.

~~~
op12
Effectively infinite risk? So you think a regulatory agency in the US will
allow prices of a stock, say, GE to reach an unbounded number and still
require settlement in derivative contracts to this? And I would not be as
quick as you are in calling a professional stupid for doing something that any
professor of finance would tell you is important for smooth functioning of
capital markets.

You seem to just not grasp the magnitude of what you assume people should do
in this crazy option proposal. It is not unusual for a stock to have a 25%
short interest. That means a quarter of the shares are sold short. So you are
saying a quarter of shareholders should sell calls to every short seller who
wants to hedge? What if most shareholders do not want to sell options, and not
give up the upside in doing so (indeed, there is a tradeoff in "juicing" your
return, you lose the upside). In fact, most do not, so this is entirely
impractical of course.

The whole point is with proper regulation that prevents the case of a squeeze
or errant prices that are not sound, you prevent the "unlimited" downside (if
a company ever becomes infinitely valuable, we will have other more
interesting issues to deal with). This happens all the time--exchanges can
cancel trades done at what are called "obvious error" prices. Regulation
effectively clips the tail, which is why dealers have no problem shorting
shares to ensure liquid markets.

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mynameishere
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&...](http://www.economist.com/displaystory.cfm?story_id=12523898&amp;fsrc=nwl)

...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).

~~~
sam_in_nyc
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.

~~~
patio11
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.)

~~~
sam_in_nyc
Very informative. It comes down to reputation.

------
Guatejon
"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.

~~~
eru
It came at a risk, though.

~~~
run4yourlives
So would normal profits from products though. They're in the automotive
industry after all.

~~~
eru
But that's their normal business risk.

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tptacek
It ends with a bit of a thud, but I had no idea Ivan Krstic was this good a
writer. Really great pacing.

------
nihilocrat
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.

~~~
gsmaverick
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.

------
sam_in_nyc
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?

~~~
jsrn
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.

<http://en.wikipedia.org/wiki/Exercise_(options)>

~~~
nandemo
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.

