Introduction to the Volkswagen Short Squeeze

The biggest investing story of 2021 so far has been the epic GameStop saga that saw Wall Street Bets degenerates make billions of dollars collectively off the backs of short-selling hedge funds.

The GameStop short squeeze was special because of the unprecedented involvement of individual investors, but it was not the first short squeeze that saw hedge funds lose billions. In this video, we’re going to be looking at the epic Volkswagen short squeeze of 2008, which briefly saw the German automaker become the most valuable company in the world.

How does something so insane happen? Why did it happen to Volkswagen in particular? And what can this teach us going forward? These are all questions we will answer in this article.

Historical Context: The Financial Crisis of 2008

To understand the short squeeze, you first had to understand the broader economic and market backdrop at the time. In 2008, the Great Financial Crisis was ramping up. Major banks were on the brink of falling, millions of homeowners were being foreclosed on, and unemployment was skyrocketing. In anticipation of the economic recession, financial markets started free-falling, with the S&P 500 declining almost 50% from peak to trough. During the recession, one of the hardest-hit sectors was the auto industry.

Cars are expensive purchases, and with rising unemployment, many people didn’t have the money to buy new cars. Even people lucky enough to keep their jobs started to save more money into their emergency funds in case they got laid off in the future. This all contributed to a massive fall in demand for vehicles, which tanked roughly 50% from an annual rate of 18 million sales per year in 2005 all the way down to 9 million by the trough in 2009.

That’s just for U.S. markets, but other countries saw similar, if not worse, declines. The hit to auto sales was severe and long-lasting. It took more than five years for sales to finally recover in 2015. This massive disruption was devastating for the auto industry and ultimately caused the Chapter 11 bankruptcies of American auto giants GM and Chrysler.

Volkswagen as a Target for Short Sellers

Given the headwinds facing the auto industry, many hedge funds thought Volkswagen’s business would be significantly impaired over the coming years and started shorting the shares. They believed the shares would go down. It seemed like a safe bet at the time because auto sales were rapidly declining, and it was unlikely Volkswagen’s stock could actually go up in such a tough environment.

Also, a short squeeze seemed unlikely because even at the peak, only 12 percent of outstanding shares were shorted. For reference, GameStop’s short interest was well over 100 percent at the peak.

But it isn’t so simple as just looking at the short interest for the purposes of a short squeeze. The short interest as a percentage of the total shares outstanding doesn’t really matter. What really matters is the short interest as a percentage of the free float. The free float is the shares that are owned by non-strategic investors, such as retail investors and non-activist asset managers.

Non-strategic investors are generally quite willing to sell their shares, so if a short seller wants to cover their shorts, they can pretty easily buy shares from them. In the case of Volkswagen, only 45 percent of the shares outstanding were part of the free float.

Porsche owned a 30 percent stake in Volkswagen as a strategic investment. The government of Lower Saxony, the German state where Volkswagen’s headquarters are located, also owned a 20 percent strategic stake. Because these two shareholders held for strategic reasons, they had no intention of selling no matter how high the price rose.

Additionally, five percent of Volkswagen shares were owned by index funds tracking the DAX index. At the time, the DAX index allocated 17 percent to Volkswagen shares as a fixed percentage, so regardless of the price movements of Volkswagen, the DAX funds would not sell either. This meant that the free float of Volkswagen shares was only 45 percent of the outstanding shares.

So, while the short interest was 12.8 percent of shares outstanding, it was 28 percent of the free float. While this is a quite high level of short interest, it alone can’t explain the squeeze.

Porsche’s Strategic Moves

In October of 2008, Porsche surprisingly revealed it had increased its ownership stake in Volkswagen from 30% to 74%. This was especially surprising because earlier that year they said they would not be increasing their stake for the very reason that it would make the free float too small.

Given that the government of Lower Saxony already owned a 20% stake, with Porsche now owning a 74% stake, the free float declined to one percent of outstanding shares. This means that the short interest of 12.8% was now 1280% or 12.8 times the free float.

The Short Squeeze Unfolds

When short-selling hedge funds found out about this situation, they immediately panicked and rushed to buy Volkswagen stock and cover their shorts. However, because there were so few available sellers, the prices skyrocketed.

Market Reactions and Media Coverage

Here’s the events being covered by the financial press at the time:

“It’s Germany, isn’t it, Linda?”

“Yes, it is. 8.7 is where we’re at at the moment, but we gained nearly 11% at one point this morning. And again, it’s all down to Volkswagen. What is going on here is unbelievable. The share nearly doubled this morning. It reached a level of 1005 euros, and already yesterday, the car maker rose 147%, causing the DAX to stay in positive territory when the rest of Europe was declining.

“What is really going on here is very hard to say. It must be the worst case scenario short squeeze one can imagine. And it’s all about Porsche saying over the weekend that they hold 42.6% in Volkswagen currently and another 31.5% via options. So indirectly, Porsche holds nearly 75%. The federal state of Lower Saxony holds another 20.2%, so just over 20%. So effectively, there’s only a tiny free float left of just under 6%, 5.7%.

“And if everybody is short in a share with such a tiny free float, if those two things come together, then that can cause these severe disruptions that we’re seeing again today. Or, as one analyst put it, each and every short seller in the world is trying to close up their positions, and there is no way they can do it except for trying to buy like mad. So it’s panic among investors.

“Many had bet on Volkswagen share price to fall, so the shares’ recent move is all down to covering of short positions rather than any fundamentals, because they don’t look as good as you might suggest when looking at the share price. And that is also having a severe effect on the other members of the DAX, such as the index heavyweights Allianz, Siemens, and E.ON, because index tracking funds are selling.

“They’re selling the 29 other companies listed in the index to catch up with Volkswagen, and it’s a big embarrassment, in fact, for the German market. Yep, they need to get it done. They need to get it sorted. They need to figure out a way of doing this that everybody can understand.”

“Linda, thank you very much indeed.”

“Indeed.”

Aftermath and Long-term Impact

The share price surged dramatically, jumping from 200 euros to 1,000 euros per share. This surge propelled Volkswagen’s market capitalization above 400 billion dollars, surpassing Exxon Mobil to become the world’s most valuable company. The unprecedented scale of this increase had never been witnessed before, prompting one hedge fund manager to describe it as a short squeeze to infinity, suggesting there was seemingly no limit to how high the share price could climb.

Following the initial surge, the elevated share price persisted for nearly a full year until Volkswagen and Porsche merged officially in August of 2009. The merger meant the two companies were now trading under a single stock, resolving any concerns related to the free float. Consequently, the stock resumed trading normally thereafter.

Hedge Fund Losses and Legal Battles

Hedge funds collectively lost $30 billion from their short positions on Volkswagen, and naturally, they were very upset with Porsche’s decision to secretly acquire Volkswagen shares, ultimately triggering the squeeze.

Some of the largest hedge funds globally found themselves entangled in this crisis, including SAC Capital run by Steve Cohen, which suffered a quarter-billion-dollar loss in just one week from shorting Volkswagen. This incident wasn’t the only time Steve Cohen made the mistake of shorting a heavily shorted stock that squeezed; his hedge fund would later change its name to 0.72.

Additionally, 0.72 also incurred substantial losses in the GameStop short squeeze. Alongside Citadel, 0.72 had to inject nearly $3 billion to stabilize Melvin Capital after it faced significant losses due to its GameStop short positions.

Following these events, hedge funds that had lost money on the Volkswagen trade initiated several lawsuits against Porsche, accusing the company of market manipulation. The hedge funds’ arguments centered on two critical pieces of evidence. Firstly, earlier in the year, Porsche had publicly stated that it would not increase its stake in Volkswagen.

This statement turned out to be false, and many hedge funds alleged that Porsche deliberately misled short sellers into shorting the stock under the false assumption that the free float would remain unchanged. Secondly, Porsche only disclosed its increased position after completing the acquisition, in an October press release.

Porsche claimed the announcement was a warning to short sellers, offering them a chance to exit their positions without substantial risk. However, by the time of the announcement, the free float had already plummeted to one percent, rendering this opportunity effectively meaningless.

Porsche’s Profits and Controversy

It was discovered that in the months and years leading up to this debacle, Porsche actually earned more money from its financial derivatives trading operations than from its car sales. In 2007, they generated 5.86 billion euros in pre-tax profit, with approximately 3.6 billion euros, or about three-quarters of that amount, coming from options trading.

Furthermore, after subtracting the earnings from their stake in Volkswagen, Porsche only made around 1.05 billion euros from selling actual Porsches. This led some observers to liken Porsche to a giant hedge fund that also happens to manufacture cars. Porsche, however, has been adamant about not being labeled as a hedge fund, stating, “We make money from hedging and building cars. The difference is that hedge funds don’t make cars.”

In 2008, the disparity between Porsche’s derivatives trading business and its car manufacturing business became even more pronounced. They reported pre-tax profits of 13.5 billion US dollars, while producing a total of 98,652 cars, setting a record. At first glance, these figures seemed impressive. However, upon closer inspection, a peculiar trend emerged: the profit per car averaged $136,000.

This figure stood out considering Porsche’s vehicle lineup; for instance, their flagship 911 started at approximately $100,000, with popular models like the Boxster beginning at $60,000, and high-end models like the 911 Turbo starting at $171,000 in 2021. Thus, the $136,000 profit per car would have been unattainable without the substantial contributions from their options trading activities.

Legal Outcome for Porsche Executives

Porsche and its executives did not face any consequences for the significant short squeeze in 2016. A regional court in Germany acquitted CEO Wendelin Wiedeking and CFO Holger Härter of all charges related to allegations that they had concealed plans to acquire a controlling stake in Volkswagen and then changed their strategy.

The judge ruled that there was no basis for the claims that Porsche had deliberately misled or concealed information from investors. As a result, the billions of dollars in profits that Porsche garnered from the short sellers and hedge funds remained intact, benefiting Porsche’s shareholders and providing bonuses to those involved in orchestrating the short squeeze.

Conclusion

So, who do you guys think is right? Should Porsche or the short sellers be vindicated? Should Porsche’s executives have faced charges for market manipulation? Feel free to share your thoughts and opinions in the comments section below.