The Wolfsburg Corner...

Molly Neal in the WSJ:

Heard on the Street - WSJ.com: Inverse relationships rarely get as extreme as Volkswagen's soaring share price and the plummeting reputation of Germany's financial-market authorities. The retort from the authorities and Porsche that nobody has broken any rules during the past week's maneuverings won't wash.... Porsche has built up its stake in VW using options it doesn't have to declare publicly.... A sudden decision to publicly declare a much larger stake than expected, sending VW's stock sky-rocketing, has distorted Germany's stock market -- VW is a component of the benchmark DAX 30 index -- in the middle of the world's severest financial crisis since the 1920s.

The repercussions may be more significant. Any major losses suffered by hedge funds which have scrambled to cover short positions in VW at ever more exorbitant prices could end up enfeebling counterparty banks, already hard hit by the credit crunch. Sniggering over the irony of hedge funds' calls for more, rather than less, regulation would then prove short lived. It's hard to square this with the orderly functioning of Germany's financial markets for which Deutsche Borse and Bafin, the watchdog, are responsible. Deutsche Borse's reweighting of the DAX index to limit VW's contribution to 10% is too little too late.

Porsche's move to sell back up to 5% of VW in an attempt to improve the stock's liquidity is a tacit admission it is partly, if indirectly, to blame for the short squeeze. VW's shares nearly halved in value Wednesday to 550 euros but are still trading at more than double Friday's closing price. Bafin remains missing in action.... The... challenge of protecting investors' interests through timely and judicious oversight of the stock market remains.

Porsche investors and Volkswagen investors have done absolutely fine. It's the short hedge funds--and the banks that provided the leverage underpinning their option positions--who are in trouble.

I have a hard time thinking about this: after all, as long as there is a free float for Volkswagen shares--as long as there are enough individuals long VW--why don't they show up today, willing to lend their shares out? Couldn't the government of Lower Saxony lend out its shares (for a healthy consideration) and so keep the short squeeze from punishing hedge funds "too much"? And how do we figure out what "too much" is?

Comments

[wcw]

Banks? No bank writes cash-settled calls on 0.5% of a company's float without hedging. These calls represented 50-75% of the float, depending on when written. That is why there is a corner: the banks bought VOW:GY, and as it rose, bought more to delta hedge.

In other words, there is no free float. Niedersachsen owns 20%. Porsche owns 44%. The banks own 30%, since those options are now effectively cash-settled futures and their delta is now 1. So the float is 6% -- against a onetime short position of 16% (though we're pretty sure that's gone down). Lending shares into this mess doesn't end the corner -- but Porsche's selling 5% does.

[Ken Houghton]

But only aleviates 50% of the problem, so the share price is probably "fair," leading us to the only possible, realistic conclusion:

VW is too small of a stock to be treated as if it were a liquid, market-based asset.

The implications of the above are left as an exercise to the reader.

[PQuincy]

As a non-economist and non-investment professional, I don't see why any sympathy or regulatory action at all is called for to defend hedge fund managers who made a large short bet without considering the size of the float and threats to it. Porsche may have used options to buy up VW shares in a quiet way, but for heavens' sakes, thinking about this sort of contingency is what hedge fund managers supposedly earn their oversized bonuses for, isn't it?

Indeed, you'd expect the hedge funds to be the ones who could calculate "If I buy options to shrink VW's float to less than the growing short interest, I could make a killing", right?

And hedge funds collect their capital from 'sophisticated investors' who know that they are effectively gambling on the intelligence and cleverness of the fund's managers, right?

Moral hazard vs. public stability is one thing, but in this case, screwing the hedge funds seems entirely appropriate.

[Cash]

PQuincy,

Ordinarily, you'd be right. But as the WSJ points out, these are no ordinary times. Schadenfreude over hedgies getting squeezed shouldn't cause us to overlook the shabby response by German banks, the regulators, and as Brad notes, the government of Lower Saxony.

Let Porsche take greater control over VW (or not). But not in a way and not at a time when financial markets are already so unsettled that their maneuvering risks further destabilization and quite possibly, requiring further intervention.

I'm uncertain whether, in light of the circumstances, Porsche might have been wiser to play its cards a bit less aggressively and still prevail, but the regulatory response by the German was poor.

For all Europe's griping about American cowboy capitalism, nothing like this could have taken place in US since Joe Kennedy ran the SEC.

[Cash]

PQuincy,

Ordinarily, you'd be right. But as the WSJ points out, these are no ordinary times. Schadenfreude over hedgies getting squeezed shouldn't cause us to overlook the shabby response by German banks, the regulators, and as Brad notes, the government of Lower Saxony.

Let Porsche take greater control over VW (or not). But not in a way and not at a time when financial markets are already so unsettled that their maneuvering risks further destabilization and quite possibly, requiring further intervention.

I'm uncertain whether, in light of the circumstances, Porsche might have been wiser to play its cards a bit less aggressively and still prevail, but the regulatory response by the German was poor.

For all Europe's griping about American cowboy capitalism, nothing like this could have taken place in US since Joe Kennedy ran the SEC.

[pickled_shark]

I have never been more proud of my german heritage than after this porsche/volkswagen incident, well maybe the rise of the german green party. Even the little retail investor who has opened a margin account has had it drilled into their head that short selling exposes one to unlimited losses. No one forced these funds take a short position, period. When hedge funds are required to publicly report short positions the same way they are required to publicly report long positions then we'll talk about protecting investors interests. Let'em liquidate their portfolio into the market. the investors who sold their VW stock for $1200 a share can use their newfound wealth to buy up those liquidated assets, and more than likely will pay a good chunk of it in taxes(taxes that help to bail out financial institutions) since they aren't fortunate enough to be an incorporated entity out of the caymans or bermuda. Hell one of the hedge funds taking a big hit ob this is greenlight who helped stomp lehman into bankruptcy and made a couple billion with no regard for what that would do the global markets. Why should anyone go out of their way to do them a favor and protect their gambling winnings?

[Uber]

Brad, could you please link to your old post about Daniel Drew and Chapters of Erie; it seems more similar to what Porsche did than the Daniel Drew episode you posted (this time Drew is like Porsche, profiting like crazy from his call options). It isn't hedge funds we should feel sorry for, but we should be very angry if Porsche and VW manipulated stock prices. That is illegal.
Also, everyone should look how the Panic of 1907 started: it was a short squeeze in which a trust co (equivalent today I'd a HF or i-bank) went bust. If Porsche's gain takes down a few German or European banks, will they still feel schadenfreude?

[PQuincy]

Fair enough: Schadenfreude is not a good grounds for economic policy, and (as a non-expert), it's possible that better market regulation of Porsche might have been appropriate.

But for heaven's sakes: hedge funds have existed because they can untransparently play this kind of game, as well as various kinds of arbitrage, with minimal regulation and scrutiny. As a small investor, I buy mutual funds, which -- guess what! -- are not allowed to play short positions, and which have to periodically announce their holdings. Hedge funds are allowed to short, and to play derivatives, and to do it largely in secret, exactly because their capital comes from people understood to be sophisticated (which, alas, turns out to be false), and because investments in them are understood to be at risk of large or complete loss, as well as large gain (true, true!).

So the important point here is not that I'm feeling Schadenfreude about certain hedge funds -- though I am -- but rather that this is an entirely predictable outcome, in general. Is the fact that a regular and predictable outcome happens in the middle of a fiscal crisis enough to change how we deal with the failing hedge funds? I don't know, but I'm skeptical. Does Germany need better regulation of corporations like Porsche: most likely.

How's that?