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Monday, November 3, 2008

Germans Teach the LOCUST Funds a Lesson

It all started with Volkswagen Short Squeeze, Hedgies Hurting. Slowly word is spreading on the actual damage as facts and figures come to light.

A favorite theory is that the German government and Porsche engineered this mother of all short squeeze to teach the LOCUST funds a lesson.

Eventually VW will fall back to earth as the last few hedgies are carried out bloodied and tattered on their battle worn shields...

Porsche and VW share row: how Germany got revenge on the hedge fund 'locusts': “Gordon Rayner discovers how financial predators became the prey in the audacious multi-billion takeover of VW by Porsche.

With its jaws gaping, poised to swallow its prey, Damien Hirst's tiger shark in formaldehyde takes pride of place in the $700 million art collection of the hedge fund manager Steven A Cohen.
Until now, it had served as a symbol of the killer instincts which made Mr Cohen and his fund SAC Capital one of the biggest predators in the world's financial markets, earning him a personal fortune estimated at $8 billion.

"I liked the whole fear factor," he said cheerily when explaining what had attracted him to the Hirst shark which he bought for $8 million four years ago.

The fear factor is something Mr Cohen, and around 100 other hedge fund managers, are experiencing, like never before, as SAC Capital and others collectively lost a staggering £24 billion with a doomed gamble on Volkswagen shares, according to the Wall Street Journal.

The biters have been well and truly bitten, and in a week full of ironies it was Porsche, manufacturer of the hedge fund managers' transport of choice, which was to blame.

While "hedgies" bet on VW shares falling because of the global economic downturn, regarded by some as "the safest play in town", Porsche had been secretly building up a 74.1 per cent stake in VW through intermediaries.

When Porsche showed its hand, it sent the VW share price rocketing and exposed the hedge funds to breathtaking losses.

"I have had hedge fund managers literally in tears on the phone," said one London-based analyst yesterday. Others likened the Porsche disclosure to a "nuclear bomb going off in our faces", describing the resulting losses as "a bloodbath".

For many impartial observers, the biggest single loss in the history of hedge funds will be nothing less than just desserts for the "vulture capitalists" who were blamed, perhaps unfairly, for helping bring about the demise of HBOS through their controversial practice of short selling.

Together with Connecticut-based Mr Cohen, who recently shrugged off a $100,000 restoration of the Hirst shark as an "inconsequential" expense, this week's losers include David Einhorn, the poker-playing president of the American fund Greenlight Capital, who helped drive down the value of Lehman Brothers shares before the investment bank collapsed this summer.

In London, Odey Asset Management, managed by Crispin Odey, who paid himself £28 million this year, also took a substantial hit.

Many fund managers believe they are victims of a stitch-up orchestrated by the German government and Porsche.

The German establishment has never tried to hide its contempt for them, with a leading politician referring to hedge fund managers as "locusts". One trader went as far as describing this week's events as "payback".

Certainly, Porsche's secretive empire-building would have been illegal in the UK, which has much stricter rules on disclosure. But do the fund managers have a case?

The root of the hedge funds' demise lies, appropriately perhaps, in the murky practice of short selling, in which traders seek to make huge sums by betting on the share price of a company falling.

Traders agree to sell shares in a company (in this case VW) to a third party at a fixed price and by a certain date, then wait for the price to fall before buying the shares and handing them on to the third party.

The difference between the agreed sale price and the price at which the trader buys the shares is profit. But if the share goes up, traders are exposed to potentially limitless losses.

Shorting in financial shares has been temporarily banned, but it remains legal in other sectors of the market.

Hedge funds believed they were on safe ground by short selling VW shares, which they saw as overvalued when all car manufacturers are feeling the squeeze.

What none of them knew was that Porsche had quietly been adding to its 42.6 per cent stake in VW by taking out options to buy VW shares owned by a number of German banks.

Germany's somewhat eclectic financial regulations did not require Porsche to disclose this, and so none of the hedge fund managers had a clue what Porsche was up to.

That all changed with spectacular consequences when the sports car manufacturer suddenly issued an announcement, in German, just after 3pm on Sunday declaring that it either owned or had the option to own 74.1 per cent of VW.

With the state of Lower Saxony owning another 20.1 per cent, this meant that just 5.8 per cent of VW shares were available to buy.

But hedge fund managers had promised to sell to third parties a total of 12 per cent of VW's shares, and 12 into 5.8 doesn't go.

One London-based fund manager saw the news when he flicked through financial websites on his BlackBerry during a Sunday afternoon walk.

"I ran like a madman back to my house," he said. "I assumed the numbers were wrong. I called my broker and couldn't get through.

"But when I finally did speak to him, and he told me he'd had a dozen panicked calls already, I knew it was true."

Across the capital, and in financial centres across the world, brokers rushed to their offices to work out just how big a hit their clients were about to take.

Throughout Sunday afternoon, their phones rang off the hook as traders called them begging for help, undisguised panic in their voices.

Hours before the markets opened here on Monday morning, hedge fund offices in "hedge fund alley'' in Mayfair were already buzzing with activity as traders went through the numbers over and over again, unable to do anything more meaningful until the German stock exchange opened at 8am.

"We knew there would be a bloodbath as soon as the market opened," said the trader. "We knew the price would rocket, widening the exposure of lots of hedge funds – they would be offering their daughters in return for the stock, just to get out of it."

The scramble for shares meant that shareholders could name their price, and VW stock went from 210 euros to more than 1,000 euros in two days, making VW, at one point on Tuesday, the world's most valuable company at £240 billion.

Meanwhile, the fund managers who hadn't managed to buy enough shares to settle their accounts watched with horror as their losses spiralled out of control. Some of the bigger funds are thought to have lost as much as £4 billion.

And as the price of those precious shares quadrupled, Porsche made a paper profit of more than £100 billion, dwarfing the money it makes from selling cars.

Across the world, traders raged at what they saw as a thinly disguised sting operation by Porsche and the German financial establishment. In almost any other country, Porsche would have been forced to declare its hand, rather than secretly building up share options through third parties. The hedge funds are demanding an investigation.

Christian Strenger, a board member of Germany's biggest fund manager DWS, said the German government needed to address the "untransparent" regulations, while Mike Warburton, an analyst at the City firm Sanford Bernstein, described the situation as "arguably an embarrassment for all European capital markets".

Bafin, Germany's financial regulator, insists no rules have been broken.

So should we lose any sleep over the fact that hedge funds have lost their shirts, or should we all indulge in a spot of schadenfreude? The answer, as we should know after months of financial turmoil, is that we are all, ultimately, likely to be losers.

Hedge funds will have to sell shares in other companies to make up for their losses on VW, which is likely to drive down those shares and contribute to the continuing turmoil on the stock market, further damaging the value of pension funds.

Several banks which are thought to have acted as counterparties to Porsche, in effect placing "covering bets" in case VW's share price went down, will also be losers.

Rumours about such exposure led to a 17.5 per cent drop in Societe Generale shares at one point on Tuesday, while Morgan Stanley was down 11 per cent and Goldman Sachs down by 8 per cent.

After a month in which Gordon Brown and other political leaders have called for an overhaul of global financial regulation, the Porsche affair has rammed home the point that, now as never before, the world needs a new financial policeman to make sure everyone plays by the same rules.”

Porsche crashes into controversy in the ultimate 'short squeeze': “For old-timers, the "short squeeze" at the Stutz Motor Company is a favourite from financial folklore.

Combining legendary status - the cars won races such as Le Mans - with speed, reliability and beauty, they were the object of every ambitious young man's desire. But the emergence of mass production competitors at the end of the First World War spelt trouble for Stutz and financiers knew it. The smart money bet that the stock would fall.

Alan A Ryan, who controlled the company through family holdings, secretly started buying stock, often through options and opaque holding companies until, in 1920, he announced he controlled 105pc of Stutz.

When Ryan declared he would settle with the shorts at his price, the whole financial system reeled: as well as the trapped traders, a raft of brokers and intermediaries in the middle of the trade faced bankruptcy too.

Eventually, the New York Stock Exchange intervened, setting the settlement price itself. Ryan ended up buying an expensive 100pc of a declining car company and went bust. Financiers thought they'd never see the trick attempted again.

Extraordinarily, the plot - or the first part at least - was last week almost replayed at Volkswagen. Shortly after 3pm on Sunday afternoon, Porsche, the German maker of the iconic 911 sports car, revealed it had secretly bought 31.5pc of VW through a series of cash-settled options with a range of investment banks.

Added to its known holding of 42.6pc, the options handed Porsche control of nearly 75pc of its bigger rival.

The news shot through the global hedge fund industry. With shares in VW trading far above the company's fair value and a recession hitting every other car manufacturer, traders had bet millions of euros that the stock would fall.

But the statement screamed the opposite. With nearly 20pc of the share register held by the state of Lower Saxony and another estimated 6pc held by index trackers, traders calculated a cornered market.

As one said: "With over 100pc of the stock tied up and nearly 13pc shorted, the correct price of any available stock was infinity. It was the ultimate squeeze."

The stock lurched violently, punishing the rest of the DAX index of Germany's leading companies. Hedge funds were estimated to have taken a €30bn hit, with the investment banks sustaining heavy losses, too.

The German regulator belatedly agreed in the face of the turmoil that there could be a case of market manipulation to answer.
Even so, this weekend the reputations not just of Porsche and its advisers, but of regulators and corporate Germany as a whole, are badly damaged.

Sources close to Porsche insist that the company never intended to cause the rumpus and has acted entirely within the rules.

Other observers disagreed. "This is the culmination of long-held plans to take over VW. Porsche engineered the squeeze as one of the most brilliantly conceived wealth transfers ever: they've got the hedge funds positioned to pay for Porsche's acquisition of VW. The only thing they underestimated was the scale of the fallout," said an insider.

So how has a sports car maker become an options trader? Will Porsche now buy VW, or has it crashed on the last corner? And even if not, will traders ever buy another Porsche again?

The development of Porsche from car maker to financial engineer has been driven by an extraordinary combination of powerful ambitions.

The first is that of Ferdinand Piech, 74, grandson of Ferdinand Porsche, who founded Porsche and also designed the iconic VW Beetle, Adolf Hitler's "Car for the People".

Confusingly Piech, who now controls 50pc of Porsche's equity and 100pc of its voting rights, spent most of his career at VW where he is head of the supervisory board.

After getting a degree in engineering in the 1960s Piech started his career at Porsche and then moved to Audi in1972. In 1993 he became chairman and chief executive of VW until his retirement in 2002 to the supervisory board.

One insider said: "Piech considers VW his life's work and Porsche his family name. He passionately wants to see the two combined before he dies."

His ambition has been matched only by that of the indomitable Wendelin Wiedeking, chief executive of Porsche since 1991.

Mr Wiedeking, reportedly the best paid director in Europe with a paypacket of €72.6m (£56.7m) last year, made Porsche into the most efficient private company in the automobile industry, winning international plaudits.

In addition, unlike the stereotypical German corporate boss, he gained a reputation for being a maverick and anti-establishment.

In his book Anders ist Besser (Different is better) and his autobiography, he laid out his Machiavellian philosophy which revealed a pride in breaking rules, winding up other business leaders and a pleasure in the unconventional. The theme of David and Goliath is one of his favourites, while he shows a withering lack of respect for politicians.

However, despite punching above its weight, Porsche in recent years has fallen behind its rivals, particularly hampered by a lack of access to research and development and technological expertise.

Mr Wiedeking eyed VW's vast R&D capabilities enviously and started hatching a plan to get shared access to it via owning a stake.

One insider said: "Wiedeking's designs on VW were motivated by industrial logic. But the way to pay for it came from Holger Harter."

Mr Harter, Porsche's innovative chief financial officer, started looking at the financial markets as a way of boosting the company's income. He started a radical overhaul of Porsche's treasury operations which he described in 2002 as a "vital milestone" for the company.

Harter's taste and talent for options trading started attracting attention. As early as 2003, Max Warburton, an analyst at Bernstein, had already coined the phrase "a hedge fund with a car showroom" in describing Porsche. Meanwhile Porsche set its sights on taking over the whole of VW. Ostensibly, it seemed an impossible task since the so-called "VW Law" sets the threshold for enforcing a so-called domination agreement at 80pc control, rather than 75pc, which is common for German companies.

Lower Saxony's 20pc stake gave it the power to veto any domination agreement. This was not just an historic holding but one of vital political importance to the state whose stated aim has been to protect its VW workers. In September 2005, Porsche announced it had bought a 20pc stake in VW.

Even then, analysts like Mr Warburton reckoned the amount was probably far more. No one could tell because in buying options, Porsche gained the right to own stock without having to declare it. This suited Porsche perfectly, not least because it could deflect much of the direct anger from Lower Saxony's trade unions who vowed to fight any hint of a change of control.

A year later, pre-tax profits in the year to July 2007 had soared from €2.1bn the year before to €5.9bn, with €3.6bn coming from earnings on stock options trades - more than three times the amount made on selling cars.

Porsche kept buying shares, this time crucially with the knowledge that the vital VW Law was being reviewed and expected to be withdrawn within the next few years.

As one analyst said: "To Piech and Wiedeking buying VW finally looked possible. They needed to buy 75pc of the company and sit tight for the law to change, whereupon Lower Saxony could no longer object. Mr Harter got to work."

Attention from his options trading was distracted by ferocious rows between Mr Piech and his cousin, Wolfgang Porsche, who is head of Porsche's supervisory board, about how a takeover of VW would work.

Meanwhile, VW's shares were attracting real hedge fund investors as well as Porsche. The unusual double class of shares offered the chance of an easy arbitrageur to bet on the spread between the ordinary and preference shares.

The onslaught of the financial crisis, in particular the meltdown among the American carmakers, meant VW attracted even more hedge funds who believed that the stock, which was far higher than others in the sector, was bound to fall.

The emergence of the hedge funds in big numbers presented Harter with a new ambitious financial engineering opportunity. For each VW share they shorted, hedge funds needed to borrow a real one as collateral. By allowing the banks that held their current stake to lend shares, Porsche was already earning incremental income this way.

Secretly, Mr Harter had instructed six investment banks to each buy options on 4.99pc of VW shares to bring Porsche's stake up from 35pc to the magic 75pc level. Now he allowed the banks to lend this stock too to make even more money from the hedge funds. It has been speculated that, as the hedge funds piled in, he foresaw the opportunity of cornering the short-sellers, therefore being able to name his price to settle and force billions out of them, but there is no evidence of this.

In hindsight, hedge funds should have realised something was going on behind the scenes because of the steady share price, but instead they blindly piled in, short-selling 13pc of VW's market value.

Again, Mr Warburton was first to unearth the truth. Three weeks ago, in a note called "Fruit Machine: A Possible Explanation for VW's Inexorable Rise", Mr Warburton said he believed Porsche had now bought options on as much as 75pc of VW; that the daily volume that was being traded in VW was in fact just short-sellers, who were then borrowing stock from Porsche or its banks, and that Porsche was making money out of the transactions.

Stung at being caught out in its clever game, Porsche dismissed Mr Warburton's views as "fairy tales".

Even so, the questions wouldn't go away. Last Sunday, perhaps with a nudge from regulators demanding clarity, Porsche admitted its secret: the company had in recent months lined up six investment banks, buying through each of them options to buy 4.99pc of VW shares. The company said they are "cash-settled" options, meaning that when exercised the banks have to deliver the value of the shares in cash rather than the shares themselves, as in normal options. The cash generated by the options is then used to buy the physical shares if Porsche wanted to.

While Porsche ponders its next move in silence, the extent of the damage of its move is beginning to emerge.

The squeeze on hedge funds was the most visible pain. But behind the scenes, Porsche's six banks are thought to have taken a big knock too. In addition, Merrill Lynch, Porsche's adviser, is being boycotted by hedge funds in protest. The jokes that have already been made about traders now boycotting the cars themselves are not far from the truth.

The volatility also damaged other German stocks and in turn the index trackers.

But the greatest damage is to the reputation of Germany's capital markets where regulators are now belatedly investigating what went on. As one commentator said: "In any other country this would be illegal. And this isn't some small firm, it's Germany's biggest. It's a return to the wild west."

Mr Warburton says the key lies with the VW Law: "If it goes, Porsche can move in and buy its 75pc and take control of VW. If the law stays, we're probably in for a long stalemate of political lobbying."


Anonymous said...

So, in spite of their large fees and plenty of MBA staffers, the hedge funds couldn't be bothered to read up on the rules of the market they were trading?

Anonymous said...

I cannot help feeling some Schadenfreude.

If Porsche played by the local rules - and no details have been forthcoming that it has not - hedge funds got rightly screwed.

Being German I can only guarantee that it was not a sting operation with the government. Our financial regulators are far too innocent to understand such a plot.

But please stop that "not allowed in any other country in the world" .... Every country has its legal tricks and you should know if you play. Especially the US: safe harbor laws, blind SEC, corrupt bankruptcy courts & trial lawyers and all the items which end up in investment banker reimbursments, who gets prosecuted and who not (rarely Goldman). This list could get on and on......

Anonymous said...

if the german gov was involved they just shot themselves in the foot with all the bad/lost money being dumped back on the taxpayer when the banks that loaned margin fail...really stupid.

peterthepainter said...

you might find this interesting-
Porsche beware: history shows the market can hit back...

Anonymous said...

@anon: You seem to believe that the government and taxpayers have the same interests and objectives - they do not!

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