From the desk of Jeroen Bakker,
Benelux Lead, Pierpoint Financial Consulting
You have not just landed on the latest Top Gear blog to help you decide what new car to buy; Volkswagen or Porsche… No this is the second episode in my series on (In)Famous Securities Lending Transactions. In this episode I want to take you back to 2008; Apple launches the App Store and the iPhone 3 took off, Spain wins the EUFA Cup, SpaceX Falcon is the first private space launch vehicle to reach orbit and Barack Obama becomes the first African-American to be elected president of the United States.
In finance, the world would never be the same again. 2008 would be the year of bailouts, nationalisations, bankruptcies, the end of investment banking and the freeze of the credit markets; in short, the Great Financial Crisis.
Amongst all this, the mother of all short squeezes occurred in Germany – Volkswagen preference shares, but before I give you the details of the transaction with securities lending data provided by FIS' Astec Analytics, I need to explain a few things that created the environment for this $30bn loss-making transaction.
Short squeeze
We are talking about the mother of all squeezes, or infinity squeeze, but what exactly is a 'short squeeze'? A short squeeze is a technical, financial situation whereby the price of a particular stock quickly increases, causing short holders having to cover their position or close their shorts. This, in turn, results in additional upward pressure on the stock price, etc., etc. This situation often occurs when there is a lack of supply and an excess of demand for the stock in question or in layman's terms too many buyers and not enough sellers.
‘Prefs’ vs 'Ords’
In Germany, many of the DAX companies have two classes of share: common (or ordinary) and preferred, a practice called dual-share classes. The main reason for this structure is to safeguard the companies from foreign (read non-German) hostile takeovers. There are of course, differences between the two types of share.
The main difference between preferred and common stock is that preferred stock gives no voting rights to shareholders while common stock does. Preferred shareholders have priority over a company's income, meaning they are paid dividends before common shareholders. As a result, the preference shares are trading higher (at a premium) compared to the common shares or ordinary shares. (I will use interchangeably commons, ordinaries and ords.) In the hedge fund world, two shares with a relationship to each other means an arbitrage opportunity, as both shares should both reflect the company's future in equal or similar measure. If one is out of sync, this would be the premium to be captured.(More details on this in my third episode on securities lending transactions.)
In February 2003 SAP, the German software group, converted its preference shares into common shares to create a clearer capital construction and thereby hoping to attract more foreign investors. Holders of ords sold the preference short and netted a decent profit when the two share classes converged. Event-driven funds thought they had found their next target in Volkswagen, where the preference shares traded at a discount compared to commons partly because of Porsche's takeover demand.
The history between Volkswagen and Porsche
There is a long and illustrious history between Volkswagen and Porsche that dates back to the founding of Porsche back in the early 1930s and reads like a novel or one of Netflix's latest successful series. In short, it forms the backdrop for a Volkswagen takeover by Porsche. More on the background can be found in the FT Alphaville article “The day Volkswagen briefly conquered the world”.
So back to 2008 and Volkswagen; during the run-up to the Great Financial Crisis. The auto sector as a whole and in particular Volkswagen were seen as a highly attractive short trade; who would be buying cars when the world was on fire? Volkswagen had some financial difficulties, and the writing was on the wall for a potential bankruptcy. This combined with the preference / ordinary share structure, it was surely a short play too good to be true.
Porsche had already tried to take over Volkswagen in 2007 but failed. However, Porsche was holding 35% of the free float in ordinary shares of Volkswagen, with the German state of Lower Saxony holding another 20.1%, which leaves close to 45% as freely traded stock.
Porsche, already known as financial experts as the majority of their annual income was not derived from making and selling cars but from their financial (derivative) structures on their Volkswagen holding, dropped the bomb on the financial markets during the weekend of 26 October 2008:
The press release made it clear that Porsche had 74.1% of the shares in Volkswagen, which combined with the 20% of the state of Lower Saxony left only 5.9% as free float. However since Volkswagen is part of the DAX30, all index-tracker funds are required to hold the position as well, and with those index trackers taking up another 5% of the free float, this left only 0.9% actually available to trade.
Porsche also indicated in the press release that “it became clear that there are far more short positions in the market than expected. The disclosure would give so called short sellers (meaning financial institutions which have betted or are still betting on a falling share price in Volkswagen) the opportunity to settle their relevant positions without rush and without facing major risks”. This was a direct message to the hedge funds which played the ordinary – preference shares arbitrage.
So with the weekend to simmer over the news that approximately 12% of shorts could only be covered by 1% of shares freely traded, the markets readied themselves for a game of musical chairs with only 1 seat for every 12 players.
You don’t need to be a rocket scientist to understand what happened when the markets opened on 27 October 2008.
Volkswagen skyrocketed from €200 before the press release to €471 the day after the press release and even intraday to €990 on the Tuesday.
Volkswagen's capital consisted of 294,920,207 common shares at the end of 2008.Assuming there were no significant movements in this number since 28 October when the stock price closed at €919.50, the company was valued at €271.2bn or close to $400bn which put them just behind Exxon as the biggest company in the world measured by market capitalisation, but only for a day.
Securities Lending
From a securities lending point of view, we can review the data and index the securities lending fee with a baseline fee on 1 September of 100. In the run-up to the weekend of 26 October when the press release came out there is definitely some increased interest in the stock that leads to a doubling in fee. However, the fee really kicks off on 27 October for a period of one week before subsequently dropping rapidly towards the end of November.
You can derive different reasons for this, most likely that the squeeze was so fast that the SBL fee didn’t have time to recalibrate in conjunction with the stock price. So, in other words, the short holders knew they had to cover their shorts and didn’t actually go into the SBL market to secure their borrowed position by paying an increased fee. Another reason could be that there just wasn’t any additional stock to borrow in the first place, with fees only doubling instead of going through the roof.
Conclusion
So why was this such a massive short squeeze? Who was wrong, and was there any indication of foul play?
One can say that the hedge funds should have read the market better and should have investigated the Volkswagen long position in more detail before putting on the short. Others might say that Porsche manipulated the market when they didn’t disclose their cash-settled option positions. The latter thought has been pursued by many hedge funds in court, but both the CEO and CFO were acquitted of market manipulation in 2016. In the same year, hedge funds had their civil lawsuit dismissed by Germany’s federal court of justice.
So, in the end, it was the short side of the trade that took the hit and were ultimately responsible for their losses, as they would have benefitted if this trade had turned a profit; the forces of the market at work.