The short squeeze of death

On Tuesday, Adolf Merckle threw himself in front of a train.

Merckle committed suicide on Tuesday January 6 2009 in the face of a crumbling financial situation.  The German billionaire’s speculation in Volkswagen stock pushed his business empire to the edge of ruin.  Last Fall, Mr. Merckle lost hundreds of millions of euros in a speculative battle with Porsche, the sports car manufacturer, to seize control of Volkswagen. Mr. Merckle had lost a sizable bet that shares in Volkswagen would fall, in a financial transaction known as short-selling. The loss of “the low hundreds of millions” does not seem a huge loss compared to an estimated net worth of $9.2 billion (Forbes 2008). But the agony of defeat at the hands of one of the decade’s most aggressive short squeezes proved too much to bear for Merckle.  He eventually took his own life.

I am not making light of Merckle’s suicide.  As pointed out by Douglas Faneuil on The Huffington Post “though often characterized as the result of some life event, [suicide] is nearly always caused by an underlying mental disorder… 90-95% of those who kill themselves exhibit clear and commons signs of mental illness well before their lives end. Certain tragedies… may trigger an acute depression, which can lead to suicide, but nearly all victims of suicide have… illness.”

Yet the event stands a macabre illustration to the perils of short selling – the short squeeze.  In Do-it-Yourself Hedge Funds I discuss short selling as one of the primary tools of the hedge fund manager but it is equally important to be aware of its perils.  A short is making a bet that the price of the security will decline by selling a security that you do not own. The objective is to buy it back at a lower price at a later date and make a profit. It is a “sell high, buy low” proposition for the investor, the opposite of the traditional “buy low, sell high” axiom—but it can be just as profitable. By selling a security short, you are literally borrowing it (usually from a bank or broker) at ostensibly no cost, and selling those borrowed shares in the market.

The lender to the short seller can call the stock loan at any time, potentially forcing the seller to purchase the stock at significantly higher prices.  Porsche made tens of billions dollars in profits from executing a brilliant tactical short squeeze.  Technically the potential loss on a short sell is unlimited whereas the potential gain is limited to 100% since stock prices can not decrease to less than zero.  Clearly the Porsche short squeeze case is exemplary and worth taking note.

The Porsche family brutally cornered the market in Volkswagen stock.  Porsche acquired a significant amount of VW stock in the open market just like anyone else.  Seeing that the fundamentals of the global car market would deteriorate, “savvy” short sellers, including Merckle, pounced and began short selling the stock thinking that the stock would collapse once Porsche stopped buying it.  But Porsche had a secret weapon.  Porsche subsequently revealed that it not only owned 42.6 percent of the stock, but that it had acquired call options for another 31.5 percent indicating a total ownership of close to 75 percent.

Porsche effectively controlled more shares than could exist on the open market, and then demanded that the short sellers return their borrowed stock. The only way the short-sellers could cover their positions – i.e. buy back the shares they sold – was to purchase shares in the open market…. but the only shareholder who had shares to sell is Porsche. Squueeeeeeze. Porsche basically set the market price at crazy high prices and made a fortune.

Once the squeeze set in, Volkswagen’s stock soared from 210 euros to as high as 1,005 euros a share in just two trading sessions. The spike bankrupted speculators and put many others in financial distress.  Among the known hedge funds that were large short sellers are two large American funds, Glenview Capital and Greenlight Capital.

Sell high, buy low – the short sell strategy – can be a profitable trade, but the short squeeze can be treacherous even in declining markets.  Always check the short ratio – days of share volume necessary to cover outstanding short positions – before shorting a stock. If it is greater than 2, be cautious.

Why is this man crying?

Bernard Made-Off.  With $50 billion.

I have been a little surprised at the lack of coverage on Madoff’s devastating crime of fraud.  The ripples from his crime will reach tsunami proportions for investors around the country and particularly in the towns of Long Island and Palm Beach.

I cannot not imagine how someone like Madoff can sleep at night.  It was a scheme carried out with profound efficiency, hype and arrogance.  Madoff even had a two-year waiting list to get exposure to his supposed performance.  He created a ruse of scarcity value when all the while he probably “let” investors into the fund only to pay off mounting redemptions.  Because of the relative “safety” of Madoff’s returns, there were many families who parked their entire life savings with the firm.

I am deeply suspicious of the rest of the family’s participation.  It seems implausible that they could not have known or were not complicit.  (This is a blog so I can make opinionated statements.)  I have been told that Bernard’s brother, Peter, had the temerity to “show up at temple” this past Saturday, only two days after Bernard was arrested.  As there were no incidents at the temple I can only applaud the restraint of his fellow congregants, many of whom, I understand, were clients.  Perhaps at least one congregant might have thrown his or her shoes at Peter, as was infamously done to W this weekend in Baghdad.

Of my own experience, clients sometimes chafe at the rigor with which my Administrator scrubs a subscription for proper notary signatures, passports, character references and other identifying data.  “I have invested in 20 hedge funds and no one else has asked me for this information,” they complain. But in the world of private funds, rigor, while it is cumbersome and tedious, is your best friend.  I suspect that the SEC will also be found to have been negligent for not pursuing oversight of Madoff more strenuously.

-Wayne Weddington