VW trade leaves hedge funds in tears

Posted Oct 31st 2008 1:11PM by Peter Cohan
Filed under: Short Stories, Goldman Sachs Group (GS), Morgan Stanley (MS)

A little noticed trade on shares of VW may cost hedge funds billions of dollars in losses. And several investment banks are also rumored to have been on the losing end of the trade. What happened is that these investors bet that VW shares would fall and they were spectacularly wrong. Besides their own poor judgment, German financial reporting practices are coming in for some of the blame.

Losses could top $38 billion for 100 hedge funds that sold 13% of VW shares short. Specifically, traders shorted the common shares and bought the preferred. The logic was that since the common traded at a 50% premium to the preferred, the common would drop so the spread would narrow. Instead, the common shares soared and the preferred ones collapsed.

Why the short squeeze? This weekend Porsche revealed that it had lifted its stake in VW from 42.6% to 75% using derivatives. This was a problem because it meant that the free float available to cover a short position was reduced from 45% to 5.8%. The resulting panic buying drove VW's market capitalization above that of ExxonMobil (NYSE: XOM). Now shareholders are angry at how Porsche could use derivatives to gain a 45% stake in VW without disclosing them.

Also not disclosed, why stock in Morgan Stanley (NYSE: MS) and Goldman Sachs Group (NYSE: GS) is down so much given rumors that they will bear some of the losses. And one car analyst said, "I have hedge fund managers literally in tears on the phone."

It is sad -- and it wouldn't surprise me if this causes some big surprises for investors around the world. Let's hope the money losers don't come begging Congress for a bailout.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.

Tags: GS, inthenews, MS, Porsche, Volkswagen, VW, VW shorts