How Porsche took Volkswagen shorts for a 7 Billion Euro Ride‏

This real life story took place recently has proved that shorting is a very dangerous game. Even Merckle, whose estimated $9.2 billion fortune put him 94th on Forbes’ list of the world’s richest people, was caught in a so-called short squeeze after betting Wolfsburg, Germany-based Volkswagen’s stock would fall.

Adolf Merckle, one of the world's richest men, committed suicide yesterday by throwing himself under a train, Bloomberg reports. Financial difficulties, and particularly great losses he suffered on Volkswagen stock, are being cited as the key reason he ended his life:

[Merckle's company] VEM was caught in a so-called short squeeze after betting Wolfsburg, Germany-based Volkswagen's stock would fall. Merckle lost at least 500 million euros on the bets on VW stock, people familiar said on Nov. 18. VEM lost "low three-digit million euros" on VW stock, the company said in November.

A "short squeeze" sounds inconspicuous enough; you wouldn't tell it by Bloomberg's language, but Merckle's Volkswagen bet lost out to one of the most masterful hacks of the financial system in history.

For those of us who don't live and breathe finance, this is that story.

In 1931, Austro-Hungarian engineer Ferdinand Porsche started a German company in his own name. It offered car design consulting services, and was not a car manufacturer itself until it produced the Type 64 in 1939. But things got interesting for Porsche long before then.

In 1933, he was approached by none other than Adolf Hitler, who commissioned a car designed for the German masses. Porsche accepted, and the result was the iconic Beetle, manufactured under the Volkswagen (lit. "people's car") brand. Today, Porsche's company is one of the world's premier luxury car brands, while Volkswagen (VW) is itself the world's third-largest auto maker after General Motors and Toyota.

Three years ago, Volkswagen found itself fearing a foreign takeover. Porsche, the company, decided to step in and start buying VW stock ostensibly to protect the landmark brand, widely fueling market expectations that it would eventually buy Volkswagen outright. Of course, this isn't quite what came to pass.

For three years, Porsche kept accumulating VW stock without telling anyone how much it owned. Every time it purchased more, the amount of free-floating VW stock would decrease, driving the stock price up slightly; your basic supply and demand at work.

Eventually the share price became high enough that, to outside observers, it wouldn't have made any sense for Porsche to buy Volkswagen. It would simply have cost too much.

To explain what happened next, I'm going to first tell you about a financial maneuver called shorting.

At any given point, only a certain amount of a publicly traded company's stock is floating freely in the market. The rest is held in various portfolios, funds, and investment vehicles. Now, everyone's familiar with the basic idea behind the stock market: you buy stock when it costs little, and you sell it when it costs a lot, profiting on the difference.

But that assumes a company's value is going to increase. What if, instead of betting a company will go up, you want to make money betting the company will go down? You can — by selling stock you don't own.

Say you borrow a certain amount of stock from someone who already owns it. You pay a fixed fee for borrowing the stock, and you sign a contract saying you will return exactly the same amount of stock you took after some amount of time. So, you might borrow a thousand shares of Apple stock from me (I don't actually own any, but play along), pay me $100 for the privilege, and sign an obligation to return my stock in 3 months. At the time, Apple stock is worth $10 per share.

After you borrow the stock, you immediately sell it. At $10 a share, you get $10,000. Two and a half months later, another rumor about Steve Jobs' health sends AAPL crashing to only $6 per share for a few hours, so you buy a thousand shares, costing you $6,000. You give me back those shares. Because you successfully bet the company would go down in value, you earned $4,000 minus the borrowing fee. This is called short-selling or shorting the stock, and the downside is obvious: if your bet was wrong, you would have lost money buying back the shares that you have to return to your lender.

Now things get kinky.

When Volkswagen's share price exceeded the point where it made sense for Porsche to buy the company, a number of hedge funds realized that Volkswagen shares have nowhere to go but down. With Porsche out of the picture, there was simply no reason for VW to keep going up, and the funds were willing to bet on it. So they shorted huge amounts of VW stock, borrowing it from existing owners and selling it into circulation, waiting for the price drop they considered inevitable.

Porsche anticipated exactly this situation and promptly bought up much of these borrowed VW shares that the funds were selling. Do you see where this is going? Analysts did. According to The Economist, Adam Jonas from Morgan Stanley warned clients not to play "billionaire's poker" against Porsche. Porsche denied any foul play, saying it wasn't doing anything unusual.

But then, last October 26th, they stepped forward and bared their portfolio: through a combination of stock and options, they owned 75% of Volkswagen, which is almost all the company's circulating stock. (The remainder is tied up in funds that cannot easily release it.)

To put it mildly, the numbers scared the living hell out of the hedge funds: if they didn't immediately buy back the Volkswagen stock they were shorting, there might not be any left to buy later, and it isn't their stock — they have to return it to someone. If their only option is thus to buy the VW stock from Porsche, then the miracle of supply and demand will hit again, and Porsche can ask for whatever price it wants per VW share — twenty times their value, a hundred times their value — becuse there's no other place to buy. They're the only game in town.

And that, my friends, is called a short squeeze.

Porsche's ownership disclosure sent the hedge funds on such a flurry of purchases for any Volkswagen stock still in circulation that the VW share price jumped from below €200 to over €1000 at one point on October 28th, making Volkswagen for a brief time the world's most valuable company by market cap.

On paper, Porsche made between €30-40 billionin the affair. Once all is said and done, the actual profit is closer to some €6-12 billion. To put those numbers in perspective, Porsche's revenue for the whole year of 2006 was a bit over €7 billion.
Porsche's move took three years of careful maneuvering. It was darkly brilliant, a wealth transfer ingeniously conceived like few we've ever seen. Betting the right way, Porsche roiled the financial markets and took the hedge funds for a fortune.
Betting the wrong way, Adolf Merckle took his life.

How a Ponzi scheme can make you a smarter investor

Unless you've been living on the dark side of the moon, you're aware that New York trading firm owner and sometime investment manager Bernie Madoff by his own admission bilked investors out of an estimated $50 billion.

You're also probably aware that the media is using his record-breaking Ponzi scheme to explain what's wrong with everything from Wall Street to capitalism to Social Security to the Bush Administration -- namely "if it sounds too good to be true, it probably is" (more on that later).

The truth is that the Madoff case, and the circus that's surrounding it, does offer some lessons that can make us smarter about financial advisers and personal finance in general. In my experience, professional investors aren't any smarter than financial consumers, but they do have a much better perspective of how the financial game really works.

So, much as I abhor following the herd, here's my take on Bernie Madoff, why he matters to you, and what you can learn from all this to better protect whatever investment portfolio you have left.

First, let's talk a little bit about Madoff's record-breaking Ponzi scheme. Charles Ponzi was a notorious swindler, who, in the early 1920s, perpetrated one of the most famous financial frauds in history, bilking would-be investors out of millions of dollars (back when $1 million was real money) before he got caught. Today, almost 100 years later, in an ignominious claim to fame, similar cons, such as the one Madoff allegedly ran, are called Ponzi schemes.

Circle game

Brilliant in its simplicity, someone running a Ponzi scheme simply pays his or her investors' a "return" out of the principal he or she takes in from new investors. Since the money isn't really being "invested" in anything at all, the con-person can make the "returns" what ever they want, and pocket the rest

Typically, the returns are attractively high, which enables the cheat to attract new investments, some of which he uses to pay the older investors. The flaw in a Ponzi is that eventually, they can't bring in enough money to pay the returns and the con is revealed. This appears to be what happened to Madoff: when the credit crunch drove the market south, his new investment money dried up, some existing "investors" wanted their principal back, and the whole scheme collapsed.

We may never know why Madoff started his fraud. What we do know is that in early December, he admitted to his partners (who are his sons) and then to the FBI, that his "highly successful" investment management business was a "fraud," that he couldn't keep it going any longer, and that would probably cost his investors around $50 billion.

We also know that those investors read like a Who's Who of savvy institutions and private investors around the globe: The Royal Bank of Scotland, The Royal Bank of Canada, UBS Bank, The Thyssen family, Liliane Bettencourt (heiress to the L'Oreal empire), Mort Zuckerman, and Henry Kaufman, to namedrop a few.

The attraction of Madoff's investments is that apparently over the past 20 years or so, he paid out returns of between 1% to 2% each month -- month in and month out. No bad months, no bad quarters, no bad years. Just 10% to 20% a year for nearly a quarter of century, including the recession of 1991 and the dot.com crash. Does that sound too good to be true? Of course it is.

But here's the punch line: His investors knew it, but they didn't care.

Why? Because they assumed he was illegally using inside information from his stock trading business (one of the largest in the world) to the benefit of his investors.

Too good to be true

So, despite red flags dating back at least to Erin Arvedlund's May 7, 2001 Barron's article "Don't Ask, Don't Tell," (a Google search will reveal a list of cautionary pieces on Madoff and whistleblowers longer than your arm), investors kept pouring money into Madoff's investment funds.

Don't believe it? Here's what Henry Blodget on clusterstock.com recently reported: "For years and years I've heard people say that [Bernie's] investment performance was too good to be true... ...and too high given the supposed strategy.

One Madoff investor, himself a legend, told me that Madoff's performance 'just doesn't make sense. The numbers can't be straight.' So why did these smart and skeptical investors keep investing? They, like many Madoff investors, assumed Madoff was somehow illegally trading on information from his market-making business."

So, the first lesson from the Madoff mess is that just because something sounds "too good to be true," or actually is too good, doesn't mean you won't be tempted to invest in it anyway. Many sophisticated investors did. But the bigger problem with the too-good-to-be-true advice is that most con men know the "too good" thing, too -- so they tailor their pitches to sound just good enough to be true. (Madoff is the exception because he knew that knowledgeable but greedy investors would assume he was cheating someone, just not them.)

The second takeaway here is that when someone is delivering substantially better returns than everyone else, you'd better know exactly how they're doing it.

Contrary to the impression we often get in the media that Wall Street is a good ol' boys club with everyone scratching each other's financial backs, it's far more like a swimming pool filled with sharks who would eat each other in a second, given the chance.

There are tens of thousands of very smart, highly compensated folks out there managing investment portfolios. Sure, a few of them are smarter than the others, but even then, it's only by a very small margin, which then compounds over time. And chances are, the very smartest guys aren't going to be telling you about it; why would they need to?

When you see someone generating investment returns that are a lot better than everyone else, be afraid, be very afraid. A while back a mutual fund manager told me why his fund didn't invest in the Enron disaster: "We have a guy on staff with 20-years experience in the oil business, but we just couldn't figure out what Enron was doing better than everyone else to make those high returns. So we passed." That's a good mantra for all investors -- amateur or professional.

Treasury Bills - why invest in them

Why Invest in Treasury Bills?

Why leave the rest of the money in your savings deposits when you could earn higher interest investing in T-Bills? The current yield for a 3 month T-Bill is better than the local banks' savings rate1.

T-Bills offer flexibility with no lock-in period; thus you will be able to liquidate your investment whenever you need the money. You can even choose to liquidate just part of it (in multiples of 1000 units).

While some fixed deposits might offer higher interest as a promotion, they usually require you to lock up your deposit for the entire tenure, and require a minimum investment of quite a significant sum. Unlike those, T-Bills only require a minimum investment of less than $1000. If you are unwilling to lock-up a huge chunk of your funds in fixed deposits, T-Bills could be suitable for you.

For equities investors, T-Bills could come in useful during occasions when you are standing on the sidelines and waiting for the next opportunity. Make your money work harder for you by parking your spare cash in T-Bills to earn some interest.

How do Treasury Bills work?

T-Bills have a fixed maturity date and have zero coupons. During the tenor, the owner of the T-Bills will not receive any interest payments. Instead, the T-Bills are sold at a discount and redeemed at par value upon maturity.

For example, if you purchase 1000 units of a 1-year T-Bill at a yield of 1% per annum, you will only need to pay $990 and you will receive $1000 upon maturity a year later.

Similarly for 1000 units of an 86-day T-Bill at a yield of 1% per annum, you will need to pay $998 and you will receive $1000 upon maturity 3 months later.

Stagflation

Stagflation is a "Sluggish economic growth coupled with a high rate of inflation and unemployment. ".

In other words, in stagflation prices are going up while the economy is going down. The word was coined during the inflationary period of the 1970's.

Under normal conditions one would expect inflation to heat up the economy. That is one reason the FED generally increases interest rates during periods of higher inflation. This helps to cool the economy and prevent inflation from spiraling out of control.

Of course ,if you have read other articles on this site, you will know that the primary cause of inflation is an increase in the money supply.

So clamping down on interest rates is kind of like stomping on the accelerator with one foot (increasing the money supply) and stomping on the brakes with the other (increasing interest rates).

The net effect is not good for your car. In the same way it doesn't help the economy either. But we digress (back to stagflation).

Remember, under normal circumstances increasing inflation equals an increasing economy as all that new money begins flowing around.

But in the 1970's we saw something unusual, inflation and a recession at the same time. This was so unusual that they coined a new term "stagflation" to describe the situation.

Basically, what happened in stagflation was that there was plenty of liquidity in the system and people were spending money as quickly as they got it because prices were going up quickly, (price inflation).

But the rapid price increases in the price of oil caused many businesses to become unprofitable, so they began laying off workers. This threw the economy into a tailspin as unemployment grew in spite of an increase in the money supply.

The end result was stagflation, i.e. price inflation and high unemployment and a disastrous economy. Finally, the FED cut the money supply, oil prices moderated, and the economy was able to get back on it's feet.

The major problem with stagflation is that the normal methods of increasing interest rates doesn't help the situation. The only reason it helps in times of high economic activity is because it slows the "velocity of money" or the speed at which it changes hands.

In contrast, when the economy is weak the standard medicine administered by the FED is to lower interest rates to stimulate the economy. Unfortunately, it is impossible to stimulate the economy by lowering rates while simultaneously fighting inflation by raising rates.

So there is the catch. What do you do in Stagflation? Well at this point the Government is forced to face the real problem (which isn't interest rates at all but the money supply). It has to reduce the money supply and get the economy back on a firm footing.

That is what finally happened in the early 1980's and that is what is happening now, although not by choice as the market collapses and banks fail the money supply and the velocity of money is contracting.

The current situation is a result of years of inflation because low foreign wages and high demand for US paper debt, were able to keep a cap on our inflation. But finally higher oil prices are igniting the old fires of inflation while the sub-prime mess is unraveling the economy placing us in much the same situation as in the 1970s.

Unfortunately, currently the FED is still in denial about the stagflation situation and is trying to lower interest rates and increase the money supply by using massive bailouts, to fight the stalling economy and it isn't doing very well.

US Annual Job Losses and Gains