A “short squeeze” sounds innocuous enough...

by jdnier • 18 years ago

224 51 18 years ago

"One of the most masterful hacks of the financial system in history."

jdnier• 18 years ago

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!

mynameishere• 18 years ago

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).

Rod• 18 years ago

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...

sokoloff• 18 years ago

Amusing quote from the first link:

"Porsche exhibiting their excellent cornering ability"

sam_in_nyc3• 18 years ago

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.

newt0311• 18 years ago

Probably similar to a bankruptcy case though the ins and outs of securities regulations would likely muddy the waters considerably.

patio11• 18 years ago

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.)

tptacek• 18 years ago

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

sh1mmer• 18 years ago

This is a brilliantly clear explanation.

1gor2• 18 years ago

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.

swombat2• 18 years ago

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.

eru4• 18 years ago

Was it really that secret?

3pt14159• 18 years ago

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.

sam_in_nyc3• 18 years ago

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?

svjunkie• 18 years ago

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."

dabeeeenster2• 18 years ago

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.

swombat2• 18 years ago

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.

jsrn2• 18 years ago

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• 18 years ago

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.

nihilocrat• 18 years ago

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• 18 years ago

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.

Guatejon• 18 years ago

"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.

eru4• 18 years ago

It came at a risk, though.

run4yourlives2• 18 years ago

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

A “short squeeze” sounds innocuous enough...

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