How to lose billions

… because Porsche had not declared the proportion of VW shares it controlled, traders may have been indirectly and inadvertently borrowing shares from Porsche, selling them to Porsche, buying them back from Porsche [at a higher price] and then returning them to Porsche.

The above quote comes from a recent article on the BBC news site, and was pointed out to me by a colleague (thanks David). I have added the bit in square brackets to give context and keep the quoted section shorter.

I’ve highlighted it because it is the most straightforward explanation of the dangers of short-selling I have seen. It happened when Porsche performed a very effective take-over of VW in the turbulent market conditions this year. Essentially it goes like this:

Markets are in free-fall (technically called a Bear Market), everyone is being pessimistic. Hedge fund dealers and others make a bet on the fact that VW is as exposed to the market dangers as all other auto-manufacturers. This bet takes the form of short-selling (see the BBC article as it explains this bit quite well). Porsche, being a shrewd and intelligent investing family, (clearly demonstrated by the fact that they made a significant proportion of their money last year from investments¹), decide that this is a good moment to launch a quiet take-over of VW. They do this by buying, in the open market, as many shares as they can. Because they didn’t announce their intentions (and didn’t have to under German law), those hedge funds didn’t realise that 95% of all the shares in VW were owned by Porsche or the state of Lower Saxony. Collectively they had short-sold 15% of the outstanding shares. Ouch.

Shrewd move by Porsche, not only do they acquire the company that they first maneuvered on some years back, they do so at an amazing price and do it with style and panache, forcing the VW stock up at the same time as not taking a complete hammering on their own stocks, and keeping their own borrowing costs low. Very slick. Almost designed you might say.

1. “The significant increase in the balance sheet total of the Porsche Group by 22.245 billion Euro to 45.577 billion Euro is mainly attributable to the increase in derivative financial instruments (mainly stock price hedges), cash and cash equivalents and securities as well as the shares in Volkswagen AG accounted for using the equity method.” - Porsche AG 2007/8 financial Annual Report