Collateral damage: Volkswagen, a warning from history.
What goes around comes around. The VW Group is about to re-list a 12.5% stake in its subsidiary Porsche AG. VW bought a controlling stake in Porsche back in July 2009 after the sports-car manufacturer’s ill-fated attempt to take control of its larger parent VW through a series of options transactions which fell foul of funding issues during the global financial crisis.
While 2020 gave us quarantinis, home-made haircuts and lots of baking, the massive fiscal and monetary stimulus that was employed to deal with the pandemic also launched the meme-stock phenomenon, with its roaring kitties, laser eyes, diamond hands (and some lettuce hands).
US equity markets were awash with excessive levels of liquidity, and commission-free trading on retail platforms such as Robinhood saw the stock prices of seemingly no-hope companies like Hertz, Kodak and AMC gyrate wildly due to options flow, gamma-squeezes, short-covering rallies and probably quite a lot of manipulation behind the scenes.
While the spikes in the meme stocks in 2020 were a symptom of excess market liquidity, the spike in the price of VW’s ordinary shares (ticker VOW.GY) in 2008 was due to precisely the opposite situation - collapsing global liquidity following the Lehman bankruptcy in September of that year.
Over the course of that summer, VW ordinary shares rose from €200 to a peak of just over €1000 before collapsing again (see graph above). The shares only returned to a price level commensurate with a more ‘normal’ valuation towards the end of 2009. During this period, Porsche AG effectively became insolvent, several hedge funds were carried out of their positions, and sadly at least one suicide was reported in the German press.
The tortured story of VW and Porsche in 2008 offers us some salutary lessons in the issues around liquidity and collateral, especially as central banks aggressively hike interest rates and in particular as the US Federal Reserve starts to unwind its balance sheet in earnest through quantitative tightening (QT).
Porsche’s semi-secret stake building in VW was possible due to opaque rules around declaring ownership in listed companies in Germany. Using a small options-broker in the Netherlands, Porsche began a call-buying spree as a means of building a controlling stake. Those on the other side of the trade had to start buying VW ordinary stock as a hedge, driving the price up. VW ordinary stock ended up trading at around three times the price of the company’s preference stock.
In terms of valuation, in 2008 VW was trading on an earnings multiple three times that of its peers, BMW and Daimler. Hedge funds, seeing this valuation anomaly, began shorting VW ordinary stock, hoping for a mean-reversion event (ie a stock-price fall). Normally in takeover situations, arbitrageurs buy the target company’s shares. But seduced by cray-cray valuations and not fully understanding what Porsche was up to, by shorting VW, investors were in fact unwittingly shorting a takeover target. Nicht toll.
The reasons for short squeezes can be technical, relating to the availability of shares which have to be borrowed in order to settle the short-sale trades. They can also be driven by losses which force short-covering due to risk-management considerations. There is also a psychological element. Major problems arise when lots of investors are forced to buy-to-cover at the same time.
The banks which were funding the hedge funds’ VW short bets normally charge around 10 to 20% margin on equity positions. At 20% margin, a fund with say a 3% short position in VW would therefore only need 0.6% of its cash to post as collateral. All well and good.
During summer 2008, VW’s shares rose fivefold, so left unchecked (un-risk managed), that 3% position could have morphed into a 15% position at the peak in September. In terms of margin, banks tend to demand much higher levels of collateral with highly-volatile stocks. For VW in September 2008, this meant the normal 20% margin level rose to 100% or possibly as high as 200% as the stock went parabolic. That 3% position that had risen fivefold over the summer could theoretically have become a 15% short requiring 30% of the fund’s cash to margin it at 200%. The magnitude of the VW short squeeze suggests this sort of thing was actually happening.
Short squeezes are ultimately about collateral. While the most a stock can drop is to zero, in a squeeze, the rise is technically unlimited, and the short must fund that possibility by posting margin in the form of collateral. With VW in September 2008, the banks themselves were stepping in to ‘stop out’ these hedge-fund short positions, and it was this price-insensitive buying flow which drove VW ordinary stock to €1000 and briefly made VW the world’s most valuable company. A helpful German broker changed their price target to €911. Sehr lol.
Why should we care about the VW story? We’ve already had one in the commodities market this year. The graph above shows the nickel spike in March 2022, although it doesn’t quite do justice to the reality of an intra-day price move to $100,000 per tonne. This was the point at which the London Metal Exchange (LME) suspended trading and then took the unprecedented step of just cancelling trades. The LME is now the subject of legal action by disgruntled investors who were long nickel and unable to realise their profits1.
There are real reasons to be short which go beyond mere speculation. Commodity producers hedge their sale prices by using short futures to ‘lock-in’ a selling price for their goods. Price spikes in futures mean margin has to be posted for the hedge even before the producer has dug or drilled the commodity, let alone sold it. This is what is known as a duration mismatch.
Energy companies likewise use futures to hedge their input costs. Estimates from Norway suggest that utility companies in Europe will need €1.5 trillion additional margin this winter due to the wild prices swings in energy markets 2 . Numbers this big demand government intervention - it is notable that while it was the banks that got bailed out in 2008, this time around it is utility companies and energy providers.
All the while, central banks are in a frenzy of rate hikes. Hotter-than-expected August CPI inflation figures in the US have nailed on the Fed to hike 0.75% in September, with a ‘terminal rate’ of over 4% being priced by the market. The pace of Fed balance-sheet reduction is about to pick up, so not only is the cost of dollars rising in terms of interest rates, but the availability of dollars is dwindling as the Fed pulls reserves from the system. The dollar has been rallying, pressurising both developed-world economies (Japan, Europe and the UK) as well as emerging markets ones, especially those who have borrowed in dollars. This is true even as the rising dollar reduces the price of commodities and central-bank rate hikes reduce demand.
Economists like big words to make themselves sound clever and scientific. The term ‘hysterisis’ is one such word - sounds technical, but normal folk would just say ‘time lag’. Central bank monetary policy works with a time lag, so the effect of this furious pace of monetary tightening has yet to be fully felt.
The risk from the vertiginous rise of central-bank interest rates from zero in 2022 is the unprecedented rate of change given this lag effect. But because of this time lag, the absolute level of policy rates is also a concern, especially in a debt-soaked world used to a decade and more of very-low interest rates. In bond market terminology the issue is one of convexity, where large bond-price moves result from relatively-small moves in interest rates due to the outstanding debt having been issued when interest rates were much lower.
Tightening financial conditions, higher interest rates, the falling value of collateral (due to falling bond prices as rates rise) and the strain this puts on debt servicing all end up having a negative effect on what is a hugely-leveraged and interconnected global financial system. The signs of stress come in the form of higher price volatility and falling market liquidity. The issue becomes critical when the world’s most important markets (oil and US Treasuries) become affected, as they are now.
What remains to be seen is whether this increasingly-blinkered move by central banks to fight inflation through aggressive rate hikes into what appears to be a rapidly-slowing global economy will end up breaking something. With VW in 2008, Das Auto became Das Widow-maker. VW-like events are the symptoms of collateral and liquidity crises. Eyes need to be peeled to look for the signs of something similar heading into winter 2022.
William Langley, Elliott sues London Metal Exchange over cancellation of nickel contracts, Financial Times, 06/06/2022
Marwa Rashad, Europe power companies need 1.5 trillion euros in margin calls, Equinor says, Reuters, 06/09/2022