A Stubborn Mule’s Perspective

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).

On the eve of the US election, occasional commenter here at the Stubborn Mule, Michael Michael, sent me links to a couple of articles on Slate on the merits of voting.  Of course, as an Australian citizen, I don’t have the option of voting in the US election, but the issues raised are relevant to democracies around the world.

In the first, Don’t vote, Steven E. Landsburg argued that the chances of your vote determining the result of the election are so slim that it would make more sense to play the lottery. In the second, Vote!, Jordan Ellenberg responds with a detailed mathematical analysis (including a dose of Bayesian inference) to argue that the odds of affecting the result, while long, are better than winning the lottery.

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I feel I am due for a break from the GFC* and so will instead return to the subject of Web 2.0.

Whenever I come across a new Web 2.0 site/application/service I cannot help but sign up. A quick search for the phrase “welcome to” in my gmail archives throws up about 100 messages, representing only some of the debris of this obsession: sites I have signed up for, explored briefly and mostly never visited again.

Among these, however, is a recent discovery that has quickly become an indispensable tool. Alongside gmail and google calendar, Dropbox is now one of my favourite examples of “cloud computing”. In a nutshell, it provides synchronised offsite storage in an extraordinarily seamless way. For a new service, still only in beta, it is very impressive.

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Over the last few months I have written a lot about the global financial crisis. My posts have focused on specific events as news has broken, ranging from a programming bug by Moody’s to the enormous US bailout plan and Government guarantees from Ireland to Australia. Here I will instead take a broader perspective and provide an overview of how the crisis has unfolded and, more specifically, how Australia came to be caught up in the mess.

A year ago, many commentators were extolling the idea that Australia’s economy had “de-coupled” from the United States and Europe, and would continue to be powered by the rapid growth of China and other developing nations. Concerns about inflation meant that interest rates were rising and many felt Australia would escape the incipient economic slowdown in the developing world. Events have instead unfolded differently. The Federal Government has taken the extraordinary step of guaranteeing deposits held in all Australian banks, building societies and credit unions and the Reserve Bank of Australia has delivered an unexpected 1% cut in interest rates, citing heightened instability in financial markets and deteriorating prospects for global growth. This was an extraordinary turnaround. It is, of course, the result of Australia becoming ensnared in the global financial crisis that began in mid-2007 and has intensified ever since. But how and why did Australia get caught up in a mess that started with falling property prices in the US?

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In a post earlier this week, I wrote

The Government was right to step in with the guarantee and it has doubtless provided some stability for a financial system that remains jittery, but the sooner the details are sorted out, the better.

The main outstanding question I was referring to was how the guarantee would apply to wholesale debt. Uncertainty on this point has been creating significant concern for investors in cash management trust and other managed funds. The amount of money moved from these funds to bank deposits may be over $1 billion.

Finally today, the Government announced the wholesale guarantee fee, which will also apply to retail deposits over $1 million. While there had been speculation that the fee would vary based on the time to maturity of each security, the Government has instead opted for a fixed fee. The fee varies with the credit rating of the bank taking up the guarantee.

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Following the shenanigans in parliament earlier this week, the Government has modified their original 12 October media release about the Government guarantee for banks. In the process they no longer list the local and foreign banks covered by the guarantee, so with the help of Google’s cache I am republishing the original list here. The Government has also (finally) announced the terms of the wholesale guarantee, so stay tuned for another post on that subject. Update: here is that post.

Today the Government announced the fees payable for a guarantee on wholesale debt, which will also apply to retail deposits over $1 million. At the same time they announced that foreign bank branches will be able to access the deposit guarantee but only if they pay the fee, regardless of the size of the balance. The lowest possible fee is 0.70% (it varies with each bank’s credit rating) and the bank is sure to pass that on!

Note that foreign banks not in the list below are now also able to access the wholesale guarantee (for short-term debt only) and the deposit guarantee, but the wholesale guarantee fee will apply even on balances below $1 million.

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Apparently the sky is falling, at least that is what stock markets around the world are suggesting.

The Japanese stock market fell 9.6% today, the Korean market fell 10.6% and while the Australian market “only” fell by 2.6%, the Australian dollar is now down below US$0.65. European markets are already down 6-8%. There were dramatic Government interventions in the financial markets around the world earlier this month, which markets took as good news, but it seems they were unable to sustain the initial optimism and have given in to complete despair. The Korean market once had one of the most liquid stock index futures markets in the world, courtesy of the participation of a very large number of retail investors. Today at one point there was simply no bid on the KOSPI. The term used in financial circles when markets simply give up like this is “capitulation”.

The financial crisis, which started in the US has now well and truly spread to the rest of the world. This week the focus of attention moved to Asian and emerging markets, as Argentina announced plans to seize control of private pension funds in what is seen as a desperate attempt to stave of their second default on their sovereign debt this decade. This has driven the price on credit default swaps of insuring against default by the Argentine Government to over 30%. Even the price of insurance against default by the Australian Government has soared from around 0.02% a few years ago to 0.90% today.

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Readers of comments on the Stubborn Mule and other blogs may have noticed the little avatars like the one pictured here. Some may even have wondered how it is that some commenters manage to display a picture of themselves. If you are one of those people, or you are now curious, read on.

These avatars are known as “gravatars”, or globally recognized avatars. Gravatars provide a clever mechanism for frequent blog vistors to have the same image appear with their comments across all gravatar-enabled blogs. To create a gravatar of your own, you simply sign up at gravatar.com and upload an image.

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The actions of Governments around the world to guarantee or recapitalise banks is starting to bring some stability to the financial sector, but markets are now expecting a worldwide economic slowdown and with it a dramatic decline in demand for oil. This has led to a collapse in the US dollar price of oil and, despite large falls in the value of the Australian dollar, even in Australian dollars oil has reached its lowest level this year.

Brent Crude Oil Prices*

On last night’s ABC news report, financial journalist Alan Kohler showed a chart of oil prices and petrol prices and questioned whether motorists were seeing price falls coming through to the bowser. This prompted me to revisit the regression model I have used in a number of previous posts. As I suspected, retail petrol prices as reported by the Australian Automobile Association (AAA) continue to track wholesale prices closely. While the AAA only publishes a monthly timeseries, they do publish a price each day supplied from FUELtrac, so I have also added a red dot on the chart showing today’s FUELtrac price. Contrary to Kohler’s conclusions, it is clear that petrol prices are falling in line with wholesale prices (in Sydney at least) and, subject to the fortunes of our dollar, it looks as though prices will be back below $1.30 per litre before long.

Sydney Petrol Price Regression Model*

*Data source: Australian Automobile Association, Bloomberg.

Treasury Secretary, Ken Henry, appeared before a Senate Estimates Committee today to provide some clarity on the nature of the consultation between the Government, Treasury and the Reserve Bank prior to the 12 October announcement that the Government would provide guarantees for all Australian banks. This followed yesterday’s article in The Australian which claimed that the Reserve Bank and Treasury were at odds on the question of providing an unlimited guarantee. Opposition leader Malcolm Turnbull tried to capitalise on the issue in Parliament the same day and, despite scoring some initial points, he lost the upper hand when he appeared to question Henry’s integrity.

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