How Porsche Hacked the Financial System & Made a Killing

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.

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.

Where 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 — because  there’s no other place to buy. They’re the only game in town.

Gains

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 billion in 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.