The financial world is a dangerous place: the Porshe short squeeze edition

Porsche Type 64, image from Lothar Spurzem under CC-BY-SA.Below the fold is Ivan Krsti’s explanation of a short squeeze, a maneuvre which allowed Porshe to filch around 6-12 billion from hedge funds that were shorting VW stock that Porshe was buying.  

Adolf Merckle, one of the worlds richest men, committed suicide yesterday by throwing himself under a train, Bloomberg reports. Financial difficulties, and particularly great losses he suffered on Volkswagen stock, are being cited as the key reason he ended his life:

1 VEM was caught in a so-called short squeeze after betting Wolfsburg, Germany-based Volkswagens stock would fall. Merckle lost at least 500 million euros on the bets on VW stock, people familiar said on Nov. 18. VEM lost low three-digit million euros on VW stock, the company said in November.

A short squeeze sounds inconspicuous enough; you wouldnt tell it by Bloombergs language, but Merckles Volkswagen bet lost out to one of the most masterful hacks of the financial system in history.

For those of us who dont live and breathe finance, this is that story.



In 1931, Austro-Hungarian engineer Ferdinand Porsche started a German company in his own name. It offered car design consulting services, and was not a car manufacturer itself until it produced the Type 64 in 1939. But things got interesting for Porsche long before then.

In 1933, he was approached by none other than Adolf Hitler, who commissioned a car designed for the German masses. Porsche accepted, and the result was the iconic Beetle, manufactured under the Volkswagen (lit. peoples car) brand. Today, Porsches company is one of the worlds premier luxury car brands, while Volkswagen (VW) is itself the worlds third-largest auto maker after General Motors and Toyota.

Three years ago, Volkswagen found itself fearing a foreign takeover. Porsche, the company, decided to step in and start buying VW stock ostensibly to protect the landmark brand, widely fueling market expectations that it would eventually buy Volkswagen outright. Of course, this isnt quite what came to pass.

For three years, Porsche kept accumulating VW stock without telling anyone how much it owned. Every time it purchased more, the amount of free-floating VW stock would decrease, driving the stock price up slightly; your basic supply and demand at work. Eventually the share price became high enough that, to outside observers, it wouldnt have made any sense for Porsche to buy Volkswagen. It would simply have cost too much.

To explain what happened next, Im going to first tell you about a financial maneuver called shorting.



At any given point, only a certain amount of a publicly traded companys stock is floating freely in the market. The rest is held in various portfolios, funds, and investment vehicles. Now, everyones familiar with the basic idea behind the stock market: you buy stock when it costs little, and you sell it when it costs a lot, profiting on the difference.

But that assumes a companys value is going to increase. What if, instead of betting a company will go up, you want to make money betting the company will go down? You can by selling stock you dont own.

Say you borrow a certain amount of stock from someone who already owns it. You pay a fixed fee for borrowing the stock, and you sign a contract saying you will return exactly the same amount of stock you took after some amount of time. So, you might borrow a thousand shares of Apple stock from me (I dont actually own any, but play along), pay me $100 for the privilege, and sign an obligation to return my stock in 3 months. At the time, Apple stock is worth $10 per share.

After you borrow the stock, you immediately sell it. At $10 a share, you get $10,000. Two and a half months later, another rumor about Steve Jobs health sends AAPL crashing to only $6 per share for a few hours, so you buy a thousand shares, costing you $6,000. You give me back those shares. Because you successfully bet the company would go down in value, you earned $4,000 minus the borrowing fee. This is called short-selling or shorting the stock, and the downside is obvious: if your bet was wrong, you would have lost money buying back the shares that you have to return to your lender.



Now things get kinky.

When Volkswagens share price exceeded the point where it made sense for Porsche to buy the company, a number of hedge funds realized that Volkswagen shares have nowhere to go but down. With Porsche out of the picture, there was simply no reason for VW to keep going up, and the funds were willing to bet on it. So they shorted huge amounts of VW stock, borrowing it from existing owners and selling it into circulation, waiting for the price drop they considered inevitable.

Porsche anticipated exactly this situation and promptly bought up much of these borrowed VW shares that the funds were selling. Do you see where this is going? Analysts did. According to The Economist, Adam Jonas from Morgan Stanley warned clients not to play billionaires poker against Porsche. Porsche denied any foul play, saying it wasnt doing anything unusual.

But then, last October 26th, they stepped forward and bared their portfolio: through a combination of stock and options, they owned 75% of Volkswagen, which is almost all the companys circulating stock. (The remainder is tied up in funds that cannot easily release it.)

To put it mildly, the numbers scared the living hell out of the hedge funds: if they didnt immediately buy back the Volkswagen stock they were shorting, there might not be any left to buy later, and it isnt their stock  they have to return it to someone. If their only option is thus to buy the VW stock from Porsche, then the miracle of supply and demand will hit again, and Porsche can ask for whatever price it wants per VW share twenty times their value, a hundred times their value because theres no other place to buy. Theyre the only game in town.

And that, my friends, is called a short squeeze.



Porsches ownership disclosure sent the hedge funds on such a flurry of purchases for any Volkswagen stock still in circulation that the VW share price jumped from below 200 to over 1000 at one point on October 28th, making Volkswagen for a brief time the worlds most valuable company by market cap.

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, Porsches revenue for the whole year of 2006 was a bit over 7 billion.

Porsches move took three years of careful maneuvering. It was darkly brilliant, a wealth transfer ingeniously conceived like few weve ever seen. Betting the right way, Porsche roiled the financial markets and took the hedge funds for a fortune.

Betting the wrong way, Adolf Merckle took his life. 

  1. Merckle’s company[]
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15 years ago

I saw this story a few months ago. I was most impressed, especially since the whole thing directly advanced a key corporate objective to boot (ownership of the non-Bavarian government part of Volkswagen). The version I saw (almost identical factually but longer) included the fact that Porsche apparently regularly make a killing on fx trading as well.

Mind you in any civilised country (ie ones where English is the first language!) my understanding is that amount of accumulation with so little communication would be illegal.