My article on Porsche received quite a bit of exposure. Much to my surprise, it was read by 200 thousand people in the last month, which tells me the present economic upheaval has people clamoring for good explanations of the inner workings of the finance world.
While the laborious minutiæ of my imminent move to the West Coast successfully sapped my desire (and the time) to write, there are a handful of top-notch articles that I’ve read recently and thought I ought to share.
Chief among them is Donald MacKenzie’s piece on hedge funds in the London Review of Books, a long — but not too long — explanation of just what it is that hedge funds do. MacKenzie’s writing is dense at times, but this is still the single best piece I’ve seen on the subject, and it goes into certain details of the Porsche/Volkswagen maneuver that I chose to leave out of my own article for simplicity’s sake.
Veteran New York Times reporter Joe Nocera’s piece, Risk Mismanagement: What Led to the Financial Meltdown, is a detailed answer to the key question I’ve had about the financial crisis. Where the hell was the math? Short answer: executives don’t understand that confidence intervals based on relatively short spans of historical data — by definition! — aren’t the right tool to predict rare radical outliers. Long answer: read Nocera’s article.
Finally, Michael Lewis and David Einhorn have a substantial, two-part Times op-ed, titled The End of the Financial World as We Know It and How to Repair a Broken Financial World which answers the other pressing question about the crisis: where the hell were the regulators, and why weren’t they paying attention?
Put together, these articles are some of the very best coverage of what’s been going on. They’re well worth a proper read.
Adolf Merckle, one of the world’s richest men, committed suicide yesterday by throwing himself under a train, Bloomberg reports. Financial difficulties, and particularly great losses he suffered on Volkswagen stock, are being cited as the key reason he ended his life:
[Merckle's company] VEM was caught in a so-called short squeeze after betting Wolfsburg, Germany-based Volkswagen’s stock would fall. Merckle lost at least 500 million euros on the bets on VW stock, people familiar said on Nov. 18. VEM lost “low three-digit million euros” on VW stock, the company said in November.
A “short squeeze” sounds inconspicuous enough; you wouldn’t tell it by Bloomberg’s language, but Merckle’s Volkswagen bet lost out to one of the most masterful hacks of the financial system in history.
For those of us who don’t live and breathe finance, this is that story.
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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.
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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.
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Now 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.
And that, my friends, is called a short squeeze.
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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.
Betting the wrong way, Adolf Merckle took his life.
1.
You’ve no doubt heard of Gottfried Wilhelm Leibniz, the 17th century German philosopher and mathematician who invented calculus, and whose mathematical notation we still use today. But you probably haven’t heard of his friend and contemporary Denis Papin, the French physicist who invented the steam digester, a crude predecessor to the steam engine. In 1705, at year’s end, Papin wrote to Leibniz to tell him of his plan: he would use steam to run a boat. And true to his word, a year and a half later, he had built the world’s first steamboat, a paddled side-wheeler, in the city of Kassel, Germany.
His plan was to sail from Kassel, which lies on the river Fulda, into the Weser river via the city of Münden, then to Bremen, from where the steamboat engine could be transshipped via the North Sea and finally to London, for a triumphant demonstration of his invention on the Thames. The trouble was, the boatmen’s guild in Münden had a monopoly on moving ships from the Fulda into the Weser — a monopoly enacted to protect their business interests with regard to freight ships. Papin’s ship carried no freight, of course. It was a technological proof of concept. But the distinction, alas, proved irrelevant.
When Papin sailed his steamer into Münden, the boatmen’s guild asserted their privileges, and not only barred the boat from entering the Weser, but demanded that the local magistrates impound the ship and turn it over to the guild. This did not come to pass: in the space of hours, the boatmen realized the ship’s steam engine spelled ruin to their entire business model, and decided to put a quick end to the matter. They pulled the engine out of the boat and smashed it to pieces. Some accounts claim Papin barely made it out of the incident alive; what’s known with some certainty is that he never recovered from the loss financially, and died a few years later in London, poor, unknown, and buried in an unmarked grave.
2.
Innovation and technology have been fueling social change for as long as we can remember, and they’ve had their detractors for just as long. But seldom is resistance to change as strong as when money is at stake: obsolete business models do not go quietly into that good night. They go to war.
I know a few people who work on technology just for technology’s sake. Yet the most passionate and competent hackers I know are attracted to computing because they are builders and tinkerers, people who understand technology as a powerful medium for driving social change. Change in how we learn, how we create, how we communicate — change that, if tended to carefully, can ultimately be for better rather than for worse. But here’s the thing about change: someone always gets left behind. And they don’t usually take to it kindly.
Three hundred years ago, when a business model found itself threatened by change, its keepers destroyed a steamboat. Today, a dying business model hires a few hundred lawyers and comes up with a terrible catchphrase.
3.
In a charming historical coincidence, the Statute of Anne, the first ever serious piece of copyright law, was enacted only two years after Papin’s misadventure in Münden. This bears note because our modern computing revolution made it essentially free to copy bits, thus pegging the marginal cost of digital content at zero. Unsurprisingly, how stuff gets copied became one of the most prominent hot-button issues pitting technological innovation against existing business models, and ever since, an army of lawyers have been dragging copyright through the courts six ways to Sunday.
The further technology and innovation get in their efforts to create change, the more people they piss off, and the more existing business models they upset. And much as it warms my heart to think of former RIAA head Hilary Rosen breaking into a nautical museum and taking a crowbar to the engine of some unsuspecting paddlewheeler, in actuality she took out her frustration with Napster in court, seeing the DMCA passed, with a victory in MGM v. Grokster, and getting a handful of other legal acts and treaties passed strengthening legal protections favoring the music industry’s established business models.
Copyright is far from the only high-profile battle being fought, however. The FCC, for instance, has been deliberating for six years whether to allow unlicensed public use of the unused TV broadcast spectrum, with the National Association of Broadcasters rallying all their legal and lobbyist might behind making sure such liberty is not offered to the public. (That story has a happy ending: a month ago, FCC gave the go-ahead.)
There are countless examples everywhere you look.
4.
There’s a wider point in all of this: if you’re a technologist that cares about the intersection of technology, innovation, and social change, you can no longer afford to focus on the technology alone. Innovation and the status quo each have armies, but the battlefield has become increasingly legal. The bodies are buried in the court of law.
I’m not a lawyer. I don’t want to be. But keeping up with major developments and leading thinkers in cyberlaw is something I now regard as a necessity, and there are three key people I follow: Larry Lessig (blog), Jonathan Zittrain (blog), and Yochai Benkler. They are, without a doubt, among the very finest minds studying the collision of law and technology today.
Technology is my passion, and this essay is ultimately a plea: too many of my friends, world-class hackers and tinkerers, do not understand the degree to which the legal arena impacts our field, the innovation within it, and the social change stemming from it. I’ve been for some time on a mission to convince them to pay attention, and I’m telling the same to you: take the time to learn about what the guys above are thinking. Subscribe to their blog feeds. Think carefully about what they have to say. For if you don’t, one day the magistrates may come knocking on your door, telling you your passion is against the law.
Merry Christmas, and don’t let the boatmen win.
