One of the more peculiar stories of late in these times of turbulent financial markets is how, briefly, Volkswagen became the biggest company in the world. In the process, hedge funds around the world suffered losses estimated at over US$35 billion.
Over the last few years, Porsche has been building a stake in Volkswagen. By November 2007, the size of their stake had reached 31%, much of which was achieved by means of share options* rather than direct share purchases. Significant increases in the Volkwagen share price meant that these options delivered large profits for Porsche, prompting criticism that the company was acting more like a hedge fund than a car manufacturer.
In response, many real hedge funds took the view that, in the light of the ongoing financial crisis, the share price had risen too far and so began betting against Volkswagen. For critics of short-selling, this should have been very bad news for the Volkswagen share price. But things do not always go the way hedge funds plan and events turned out very differently.
In October 2008, Porsche revealed that they had effectively built their holding in Volkswagen up to 74%. In most countries, share-holdings of this size would be subject to continuous disclosure requirements. While Germany is no exception, Porsche had taken advantage of a loophole which exempted cash-settled options (as opposed to options which allow the holder to purchase shares) from these reporting requirements. This had allowed them to build their enormous stake while leaving the rest of the market in the dark.
The problem for the short-selling hedge funds was that all of the banks who had transacted these options with Porsche would had been buying Volkswagen in order to hedge their positions. So, although Porsche did not directly hold 74% of Volkswagen, these shares were effectively tied up. Add to this the 20% stake held by the German state of Lower Saxony and only 6% of the shares in Volkswagen were available for trading in the market. Given that hedge funds had short-sold around 12% of shares in Volkswagen (unwittingly selling to the banks hedging the options they had sold), the Porsche announcement was the equivalent of shouting “Fire!” in a crowded theatre. Every hedge fund manager started running for the door, desperately trying to buy back Volkswagen shares to close out their short positions.
As a result, the Volkswagen share price soared, briefly trading over €1005 (Euro), then closing on 28 October at €945. This put the market capitalisation of Volkswagen at around US$370 billion, more than Exxon Mobil’s capitalisation of around US$340 billion, thereby making Volkswagen the biggest company in the world for a day.
Humiliated hedge fund managers cried foul, claiming the event made the German exchange the laughing stock of financial markets. While the share price has since fallen back to a mere €392, it has been estimated that the experience cost hedge funds around the world over US$35 billion** and, needless to say, generated further profits for Porsche. No doubt some of the fuming hedge fund managers would have found insult to add to their injury as they stared at the Porsche logo on their steering wheel as they drove home.
*UPDATE: Michael Michael has asked for an explanation of share options, so here is a brief explanation. A “call” option is a financial contract which gives the buyer of the option the right to purchase shares at a specified price (called the “strike” price) on a specified date (called the “expiry” date). For example, consider a call option on Volkswagen with a strike price of €200 expiring in three months time. If the share price of Volkswagen at the time was €185, this call option might cost around €2. In three months time, the share price had risen to €220, the holder of the option could “exercise” the option, buying shares from the option seller for €200. Since these shares could immediately be sold for €220 in the market, the option holder has made a profit of €18 (€20 less the €2 cost of the option). If the share price at expiry was only €190, there would be no point exercising the option and they would expire worthless. Exercising these options involves the direct purchase of shares and they are referred to as “physically settled”. A variation would be a “cash settled option”. This is very similar but, in the €200 call option example, rather than buying shares from the option seller, the holder of the option would be paid €20 (the difference between the market price and the strike price). If the Volkswagen share price goes up, the value of a call option goes up as well (whether physically or cash settled), so the buyer of the option makes money and the seller of the option loses money. For this reason, if the seller of the option wants to “hedge” this risk (i.e. reduce the risk as much as possible), one approach is to buy shares, which is exactly what the banks which sold options to Porsche did. Since a holder of a call option has the right to purchase shares in the future, it is common for regulators to require such options to be subject to disclosure rules for large holdings. At first glance, it may not seem necessary to include cash-settled options in this requirement as the options do not involve any direct share transactions. However, as this Porsche/Volkswagen example shows there are in fact very good reasons to include cash-settled options.
**UPDATE: This figure is almost certainly an over-estimate and the real figure is likely to be closer to US$20 billion (thanks for pointinf this out Mark).
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“it has been estimated that the experience cost hedge funds around the world over US$35 billion” but this is an extremely unlikely theoretical maximum. The high was 1005 Euros where the market cap was U$370b. The average level over the past couple of years from your chart is around 200 Euros, so even if the hedge funds closed their short positions at the peak, the loss would be about 80% of their share of the U$370b. But their total share was 12%, giving losses of 0.12×0.8×370 or U$35.5b. It is simply not possible that a substantial fraction of the short positions closed almost exactly at the peak.
I loved your closing sentence though — a hilarious image. For a while, I will think of this whenever I climb into our recently acquired VW.
Problem: I’m [expletive] smart and yet I didn’t understand this post. Please fix. In particular, explain in your or anyone else’s inimitable style:
1) what’s a share option and how is it different from a direct share purchase
2) how is a hedge fund different from a hedge bank
3) explain cash-settled option, or option in general (hint: just using italics _doesn’t_ explain something, it just makes it look scary)
4) why – in Oct 08 – did people feel the share price of VW was unlikely to fall – i.e. is it a ‘good thing’ for the share price that porshe owned so much
Also, is “yelling ‘fire!'” the right analogy? Sure it panicked the short-positioned, but you said Porshe yelled fire, but surely they weren’t panicked, too?
Otherwise, nicely done!
Great to know my little VW is now 74% a Porsche. I feel (more) like a wanker already.
One question … this loophole exempting cash-settled options from continuous disclosure requirements – does that “opportunity” exist in other markets, or is it only in Germany?
@Steve: While I wouldn’t want to make too sweeping a generalisation, as I understand it the loophole is a German peculiarity and, given that German regulators are investigating, it may be closed fairly soon.
@Michael Michael: I take your point, I have assumed too much. I will add a footnote to elaborate on options, cash settled or otherwise.
The reason the price got so high in October comes down to supply and demand. There was not much supply, effectively only 6% of the shares on issue were available for trading (the so-called “free float”) but there was plenty of demand from hedge funds who were losing money on their short positions and had to buy shares to close out their positions. Limited supply, strong demand translates to high price. I am sure that many observers would have concluded that the prices reached were not sustainable in the longer term and there may even have been a few other investors selling at that price and perhaps even a few brave short-sellers, but the sheer weight of numbers was on the side of buying not selling.
As for the fire analogy, what I had in mind was Porsche as the prankster yelling “fire” for the sheer amusement value of watching everyone else panic.
@Michael Michael: and as for hedge funds/hedge banks. Hedge funds are very lightly regulated investment funds which make extensive use of leverage, derivatives and short-selling in pursuit of superior returns for investors (and superior fees for the fund managers). There is no such thing as a “hedge bank”. I used the phrase “hedging banks” to refer to the banks who had sold options to Porsche and were then buying Volkswagen shares in order to hedge these options. I have now rephrased that section to avoid giving the impression that I was talking about a peculiar beast called a “hedging bank”. Hope that clears things up!
So, do you think this was this semi-planned on Porsche’s part, or more of a chain reaction that just happened to work out (very) profitably for them?
@ Steve Reynolds: “Great to know my little VW is now 74% a Porsche. I feel (more) like a wanker already.” I concur. :)
Nice explanation – another question: at which point does the buyer of an option decide whether it’ll be cash-settled or physically settled? By which I mean, are they just buying options per se, and only when it comes time to exercise or not deciding on physical or cash? Cos if all the Porshe ones were cash, I don’t really see how that’s ‘building a[n ownership] stake in VW’. Cos that’d be like saying if I bet on ‘Viewed’ in the cup (which I didn’t) I had an ownership stake in the horsie. No?
Hello from Canada, Mule!
Nice post, but I’ve read three times and am still not crystal clear on what happened or why. That’s what happens when you go get yerself a medieval history degree! Ah well. But I do have a query – today our exhalted (read, stupid) Finance Minister Jim Flaherty annouced another $50 billion bail-out for Canadian mortgages. That, along with the $25 billion announced earlier, puts us on par per capita with the US bail-out. But we are being told all is well, our banks are stable, well regulated, and our real estate market is a survivor. Can I get a view of that from Australia, Mule, please? All of the propaganda here makes it really difficult to get a beat on what’s really going on. Muchas gracias! (At least the Spanish part of the degree was worth something….)
@Bast: Think of “being told all is well” in a relative sense. Canada and Australia are doing well relative to Iceland, which is a basket case. We are also doing well relative to the the US, UK and Europe, whose the entire banking systems were on the verge of collapse but saved at the last minute by, let’s not say it too loud, governement nationalisation. That should cheer you up somewhat.
I’ve never before heard the term “survivor” used in the context of the real estate market. I like it. However, I feel it’s a bit premature to suggest we’ve survived anything as we’re only just entering a global recession the likes of which we have not faced since The Great Depression. Oh. And Australia. We’re cactus. The resources bid lead by China has gone. If only we’d de-coupled from the rest of the world like everyone said we had….
Toyota’s cut in production helped VW take the top spot. Toyota could ramp up manufacturing again as the recession ends and move into the No.1 spot once more.
What a wonderful post. I agree with Steve when he says, “Great to know my little VW is now 74% a Porsche.” I have been a VW owner for many years.