Matt Taibbi, a journalist I once thought of as far left, has a good summary of what's been going on with GameStop. I've modified my opinion of Taibbi. He may be left, but he's not far left. At least he's not so far left that he's on board with jettisoning the truth in pursuit of left-wing causes. He begins with a look back to the financial crisis of 2008.
In the fall of 2008, America’s wealthiest companies were in a pickle. Short-selling hedge funds, smelling blood as the global economy cratered, loaded up with bets against finance stocks, pouring downward pressure on teetering, hyper-leveraged firms like Morgan Stanley and Citigroup. The free-market purists at the banks begged the government to stop the music, and when the S.E.C. complied with a ban on financial short sales, conventional wisdom let out a cheer.
While there are similarities between the short-selling frenzy of 2008 and this one, there is a significant difference. In 2008 there was a serious and legitimate crisis brought about by securitization of real estate financing. That is, by packaging residential real estate mortgages and then selling of shares of these mortgage packages as Mortgage Backed Securities (MBS), financial institutions were doing two things. First, they were spreading out the risks from mortgage default and shifting it from themselves to MBS shareholders. Second, the funds from the sale of MBS products brought more money into the residential real estate market adding more heat to an already overheated market. Mortgages were thought to be a rock solid investment.
The 2008 crisis came to a head when a downturn in the economy burst the growing real estate bubble. A rapidly growing number of homeowners were suddenly unable to make their monthly mortgage payments. Layoffs, perhaps. At the same time real estate prices, which had sky rocketed as the bubble grew, began to fall. Homeowners who couldn't make their payments, also couldn't sell their houses at a high enough price to cover their mortgage debt. New homeowners were often caught in a trap that was laid with the very best of intentions, that of making the American dream of homeownership a reality for more Americans. Low down payment requirements meant that almost any drop in real estate prices would sink the value of a house below the mortgage balance owed. Mortgage defaults began to pile up, eroding the value of for Mortgage Backed Securities. Investors began to shun MBS assets.
Eventually there were certain Mortgage Backed Securities that no one was willing to buy or take as collateral. Not all MBS assets, but a significant number of them. When these securities stopped being traded they could not be priced, and so they were officially priced at $0.00. This was the huge problem. These were the bad assets that were "clogging up" the securities lending market and threatening a systemic crash. Collateral for a significant number of stock loan contracts suddenly became worthless and borrowers were hard pressed to replace it. There was another aspect to the problem. Financial institutions that listed MBS assets on their balance sheets as fulfillment of capital requirements, were suddenly under capitalized and at risk of being shut down for failing to meet regulatory capital requirements.
All of this is to say that short selling bank stocks was not what precipitated the 2008 melt down. In the current situation, massive short selling by hedge founds is at the root of their own problems. GameStop was not in danger of bankruptcy. In a June 28, 2020 article Seekingalpha made these three points regarding GameStop:
1. Share price manipulation and strong short-selling have presented the market with a false perception of GameStop's near to mid-term ability to operate as a going concern.
2. GameStop's real estate provides equity investors with a strong base-line value that will be unlocked in the very near term.
3. The debt exchange will provide GameStop with the necessary financial freedom to operate and adapt its business model to a post Covid-19 world.
In late 2019 and throughout 2020 analysts were expecting GameStop to go the way of Blockbuster. Not everyone agreed. But several hedge funds saw profit opportunity in GameStop's demise continued betting the stock price down through short sales. But then...
The day-trading followers of a two-million-subscriber Reddit forum called “wallstreetbets” somewhat randomly decide to keep short-sellers from laying waste to a brick-and-mortar retail video game company called GameStop, betting it up in defiance of the Street. Worth just $6 four months ago, the stock went from $18.36 on the afternoon of the Capitol riot, to $43.03 on the 21st two weeks later, to $147.98 this past Tuesday the 26th, to an incredible $347.51 at the close of the next day, January 27th.
The Reddit day traders had engineered a "short squeeze," driving the price of GameStop higher by buying, just as big hedge funds were trying to drive the price down by selling short.
Short selling involves borrowing stock, or having your broker borrow the stocks on your behalf, that you then deliver to your buyer. When the stock price has fallen to a suitably low price, the short seller buys the shares, for less than he sold them, and pockets the difference as profit. It's a problem if the price doesn't fall, and a bigger problem if the price goes up. The obvious part is that it's going to cost more to replace the borrowed stock than you make on the short sale. You lose.
The not so obvious part is that when stock is borrowed on the short seller's behalf, the lender of the stock demands collateral in return, usually in the form of cash. Proceeds from the short sale serve the purpose. In fact the short seller doesn't see proceeds from the sale until the borrowed stock is replaced. In the meantime if the stock price rises the requirement for collateral goes up with it. Stock loan contracts are marked to the market on a daily basis. Cash changes hands on a daily basis to keep contracts properly collateralized. The short seller is on the hook, every day, for the additional cash collateral.
The rally sent crushing losses at short-selling hedge funds like Melvin Capital, which was forced to close out its position at a cost of nearly $3 billion. Just like 2008, down-bettors got smashed, only this time, there were no quotes from economists celebrating the “good news” that shorts had to cover. Instead, polite society was united in its horror at the spectacle of amateur gamblers doing to hotshot finance professionals what those market pros routinely do to everyone else.
That's what happens when a hedge fund doesn't hedge. The simple hedge in a short sale situation is for the hedge fund to buy call options on the stock it's shorting. The call option is a contract giving the hedge fund the right to buy the stock sometime in the future at an agreed upon price. The option strike price would be higher than its market price at the time the contract is written, but that would allow the hedge fund to cut its losses should the price do what GameStop's price did. Melvin Capital didn't hedge. Call options cost money and cut into profits.
The press conveyed panic and moral disgust. “I didn’t realize it was this cultlike,” said short-seller Andrew Left of Citron Research, without irony denouncing the campaign against firms like his as “just a get rich quick scheme.” Massachusetts Secretary of State Bill Galvin said the Redditor campaign had “no basis in reality,” while Dr. Michael Burry, the hedge funder whose bets against subprime mortgages were lionized in “The Big Short,” called the amateur squeeze “unnatural, insane, and dangerous.”
The episode prompted calls to regulate Reddit and, finally, halt action on the disputed stocks. As I write this, word has come out that platforms like Robinhood and TD Ameritrade are curbing trading in GameStop and several other companies, including Nokia and AMC Entertainment holdings.
Meaning: just like 2008, trading was shut down to save the hides of erstwhile high priests of “creative destruction.” Also just like 2008, there are calls for the government to investigate the people deemed responsible for unapproved market losses.
The acting head of the SEC said the agency was “monitoring” the situation, while the former head of its office of Internet enforcement, John Stark, said, “I can’t imagine there isn’t an open investigation and probably a formal order to find out who’s on these message boards.” Georgetown finance professor James Angel lamented, “it’s going to be hard for the SEC to find blatant manipulation,” but they “owe it to look.” The Washington Post elaborated:
To establish manipulation that runs afoul of securities laws, Angel said regulators would need to prove traders engaged in “an intentional act to push a price away from its fundamental value to seek a profit.” In market parlance, this is typically known as a pump-and-dump scheme…
Even Nancy Pelosi, when asked about “manipulation” and “what’s going on on Wall Street right now,” said “we’ll all be reviewing it,” as if it were the business of congress to worry about a bunch of day traders cashing in for once.
The only thing “dangerous” about a gang of Reddit investors blowing up hedge funds is that some of us reading about it might die of laughter. That bit about investigating this as a “pump and dump scheme” to push prices away from their “fundamental value” is particularly hilarious. What does the Washington Post think the entire stock market is, in the bailout age?
America’s banks just had maybe their best year ever, raking in $125 billion in underwriting fees at a time when the rest of the country is dealing with record unemployment, thanks entirely to massive Federal Reserve intervention that turned a crash into a boom. Who thinks the “fundamental value” of most stocks would be this high, absent the Fed’s Atlas-like support in the last year?
Inflation, bailouts, climate change, covid lockdowns – all have added billions to billionaire bottom lines. Meanwhile for middle class and below, if you're not financially ruined quickly as in "non-essential businesses" must close, you can expect your buying power to be eroded slowly. Still, Taibbi ends a bit more optimistically than I.
They’ve [the Reddit day traders have] seen first that our markets are basically fake, set up to artificially accelerate the wealth divide, and not in their favor. Secondly they see that the stock market, like the ballot box, remains one of the only places where sheer numbers still matter more than capital or connections.
The ruling class will take care of the ruling class through bailouts, and even election fraud. They will fix the game in their favor.