The Short Squeeze

April 30, 2009 in Finance

It is a favorite chorus of the anti-CDS crowd that CDS can make it more difficult for a company to survive, since bidding up CDS prices can affect the firm's cost of borrowing.

This is about a hair's width away from the oft-cited argument that "short selling is bad because it drives down stock prices," a view that has was disproven in a massive 2005 study as well as multiple studies (pdf) showing the recent ban was actually harmful, not to mention market participants ultimately declaring it a failure.

However - in fairness - there is one time where short selling, or taking a short position more generally (such as through CDS), makes an indisputable impact on the underlying security: the short squeeze.

What happens when investment firms that have bought (potentially) limitless amounts of insurance on another company's debt need to hedge their short position?  They must compete to buy the relatively few tangible assets that can provide that hedge: the company's bonds themselves. And this bidding war is ferocious. CDS driving a company's spread wider is a bit of a wags-the-dog situation.  But massive demand for a company's bonds, that's real. Moreover, it has been a major driver of the recent credit rally, which in turn fuels the equity run.

The most dramatic example of a short squeeze in action is of course Volkswagon, which gained 500% in one day last fall and was briefly the most valuable company in the world after a massively short investor base suddenly realized there weren't enough shares to go around (Porsche had conveniently purchased most of them, and would end up booking a profit).  But here's the key: if short sellers can drive stock prices down, then surely VW - with one of the highest short to shares ratios ever - would have experienced some sort of price depression. But no, the stock hardly dropped in the months preceding the spike.  Instead, this particular example of financial product failure resulted in saavy VW employees becoming millionaires overnight.

One datapoint does not a proof make, but look at today's credit market, or even the recent equity markets rise on decreasing volume, and you'll be unable to ignore the power of short covering to drive real asset prices higher.  The market works on supply and demand; derivatives have a seperate market and so do not affect underlying asset prices except to the extent that people use derivative prices to extract risk information which informs their demand for the underlying. But whenever the derivative market and tangible market intersect, look out! If I own an arbitrary number of CDS and suddenly I need bonds to cover, the market's normal mechanics will be disrupted.  Even the VW example represents a perversion of supply and demand - Porsche was slowly buying up all the shares while other investors were shorting them, restricting supply dramatically. I remember headlines at the time which announced Porsche was actually releasing shares just to placate shorts who needed to cover.

Ultimately, if capitalist markets represent the method by which capital is most efficiently allocated and required returns are most efficiently expressed, then a long-only market is hardly the epitome of that ideal.  But as long as companies can point the finger at "security manipulation" instead of their own performance (expert witness: bank stocks declining despite the short sale ban), we will continue to have this debate.  Not that any company complains when the short squeeze pushes them higher.  Instead, they just issue debt and stock, a behavior which lately has been married to the highest rate of insider selling in year.

So the next time someone tries to claim that CDS, or short selling, can have an adverse impact on asset prices, don't throw study after study at them which demonstrates otherwise.  Just point out that to the extent their argument is true, it's effect is much more dramatic on the squeeze side - the upside - than where their complaint lies.

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