The 2008 Volkswagen Short Squeeze

It was not straightforward to be an automaker at the onset of the 2008-09 recession. New cars are discretionary purchases that nervous consumers can put off for the future. When shares in Volkswagen kept rising despite this, and there was no reason to think the company should be exempt from the reality afflicting its industry, some thought it wise to bet the shares would fall in value. Unfortunately for them, there was another participant in the market with deep pockets and very different intentions for Volkswagen’s shares.

Volkswagen

Volkswagen, headquartered in Wolfsburg, Germany, is one of the largest automakers in the world. When the 2008-09 recession was damaging the financial condition of its competitors, Volkswagen was not immune. The company was very indebted going into the economic crisis and now prospects for future car sales were souring. Yet, while the share prices of most automakers were at best stalled, Volkswagen shares were climbing rather unexpectedly.

Short Sellers

Because of the divergence in the share prices of the company and its competitors, many hedge funds believed Volkswagen shares were overvalued. It was a popular opinion. Several of them decided to sell short shares of the company. This entailed borrowing shares and selling them immediately. After prices fell, the short seller would repurchase the shares at a lower price in order to return them to the share lender and would profit from the difference in price. It is a way of betting against a stock.

There were also hedge funds taking a more neutral view of the company. They still had a way of profiting from the strange movement in the automaker’s shares. At the time, Volkswagen’s non-voting preference shares, which paid dividends but would not give buyers a say in the company’s management, were trading at a significant discount to the ordinary voting shares. While the preference shares used to trade at between 70% and 80% of the value of the common shares, this ratio fell below 50% in 2008; the former were trading just below €100 in mid-2008 while the latter were approaching €200.

A hedge fund taking the view that these shares should trade at similar levels might sell short the overvalued common shares and buy the undervalued preference shares, betting they will converge again with time. The fund is not taking a view as to whether the price of one or both will rise or fall, just that they will converge regardless of the market’s next move. The fund executing this strategy will make money even if both securities fall, so long they converge while doing so.

Porsche

The most important actor in the rest of this story was not Volkswagen but another automaker. Porsche, headquartered in Stuttgart, was an occasional business partner to Volkswagen. Ferdinand Porsche designed the original Volkswagen Beetle in 1931. Porsche then began making its own cars in 1948; the company later outsourced much of its production to Volkswagen. Between 1993 and 2002, Volkswagen was even led by Ferdinand Porsche’s grandson.

In 2005, Porsche announced it had built a 20% stake in Volkswagen; unknown to investors, Porsche’s shareholders’ committee had approved the acquisition of up to 80% of Volkswagen. Porsche publicly announced that it wanted to increase its ownership interest in Volkswagen further in 2006 and its share purchases contributed to the rise in Volkswagen’s share price over this time. Porsche made a bid for control of the company in 2007 but only because it was required by law once it crossed 30% ownership. The bid failed to obtain much support from other shareholders. Porsche was not yet keen on owning the entire business, so it made a bid it knew would fail; the company kept denying its attempt to take control of Volkswagen. Porsche came to own 31% of Volkswagen common shares by March 2008 and 35% by September that year.

October 2008

During the first half of October 2008, as the financial crisis was afflicting securities prices and bets that share prices would fall were generally paying off around the world, Volkswagen shares were still moving higher, against this trend. On the week of October 20 though, the shares finally fell meaningfully, dropping from €275 to €210. This was the first positive development for the short sellers in a while. However, rather than stop here, short sellers used the beginning of a possible reversal to increase their short positions. After all, many had been losing money on this bet for weeks or months before, so they had lost ground to make up. Unfortunately for them, the gamble was about to take a turn.

Short Squeeze

Porsche announced publicly on Sunday October 26, 2008 that it held 42.6% of Volkswagen’s common shares. It also possessed options to purchase another 31.5% of the shares, meaning 74.1% of the company’s shares were, or would shortly be, under Porsche’s control. The company was eyeing 75% ownership as under German law that would have allowed Porsche to control Volkswagen’s business decisions.

Porsche had acquired this stake by borrowing and by selling put options, essentially writing insurance policies that the Volkswagen share price would not fall. The income from selling these options gave it more money with which to purchase shares. As it happens, Porsche was strained by the prior week’s fall in Volkswagen shares because of the manner in which it had financed the purchases; the company was subject to margin calls almost every day starting from October 15.

The outright ownership of over 40% of the common shares might have been expected given Porsche’s steady buildup of a position in Volkswagen for a few years but the ownership of another 31.5% in options was shocking to many. As it happened, the company built this position over the spring and early summer and their ownership was already over 72% by late July so the announcement came long after it had acquired this ownership in Volkswagen.

However, purchases of these options did not have to be disclosed. Porsche had acquired the option contracts from the German subsidiary of the Canadian firm Maple Financial Group Inc. in order to lock in an acquisition price for shares. To hedge its position, Maple entered into derivative contracts with other banks which themselves held Volkswagen shares to hedge these contracts. Each bank held no more than 5% of the shares so that they did not meet the threshold which would have required disclosure.

Porsche was not the only large holder of Volkswagen shares. The government of Lower Saxony, the state where the automaker was based, owned just a bit over 20% of the company. Together with Porsche’s ownership, this meant that less than 6% of Volkswagen shares were available for purchase in the market. The truth was, it wasn’t even 6% when one considers passive holders like index funds or inactive investors unlikely to sell. By comparison, the volume of shares sold short and thus needing to be repurchased by the short sellers was 12% of the company’s outstanding shares. This means that unless Porsche or the government of Lower Saxony sold them the shares or Volkswagen issued more shares, it would be impossible for all of them to close out their short positions.

Sensing extraordinary trouble with their gamble, following Porsche’s announcement, the hedge funds attempted to close out their positions with whatever shares they could find. This was a ‘short squeeze’, an episode of frantic closing out of short positions. There was so much frantic trading, and the activity was so one sided with more eager buyers than sellers around, that bid-ask spreads, a measure of market depth or liquidity, rose 61%. The price of Volkswagen shares more than doubled from €210.85 to €517 on Monday and reached €1,005 the next day as short sellers were prepared to accept losses, or forced to by their brokers, and bought the shares at high prices. At the €1,005 share price, well over four times the valuation at the end of the prior week, this made Volkswagen the most valuable company in the world, for a moment worth €296 billion.

Source: Bloomberg (Retrieved through Financial Times)

The German regulator, BaFin (Federal Financial Supervisory Authority), announced on October 28 that it was investigating manipulation of Volkswagen shares. The announcement ended the short squeeze because, on October 29, Porsche responded by selling 5% of its interest in Volkswagen by closing out some of its options positions, ending the scarcity of shares that caused the share price to skyrocket. Volkswagen shares more than halved over four days and returned to ‘normal’ levels by December.

Before this happened, short sellers suffered losses of approximately €20 billion. Hedge funds sued Porsche, which may have profited by €6 billion or more, on grounds of market manipulation. As it happened, Porsche found itself in financial trouble in 2009 partly because of the borrowing it had done in order to finance its purchases of Volkswagen shares. The company sought financial assistance in the summer of 2009 from the Emirate of Qatar and Volkswagen itself. Porsche executives were cleared of market manipulation charges in 2016 and the lawsuits of at least some funds, like David Einhorn’s Greenlight Capital, were dismissed.

Lesson

The Volkswagen short squeeze reveals how even sure bets can unravel. The truth is that there is meaningful risk even in ‘market neutral’ hedge fund strategies. Markets aren’t perfect. There is limited availability of any security and when trades become crowded, namely when nearly all investors are taking the same view of a security and positions to profit off that view become difficult to exit, securities whose prices must converge at some point can diverge meaningfully in the meantime as everyone runs for the exit simultaneously.

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Read about other crowded trades that troubled hedge funds the year before the Volkswagen short squeeze, the ‘Quant Quake‘. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.