Sunday, December 16, 2007

Porsche AG's Volkswagen takeover

by Ricardo Cabral

First version: November 19, 2007
This version: December 16, 2007 (Text in italics added December 30th, 2007)

Porsche AG's two and a half year campaign to take over Volkswagen AG (VW), a DAX30 and EuroStoxx50 stock, and create an European car and truck giant nearly 20 times its size, with over €135bn of sales, is a daring bet in high finance.[i]
However, the takeover has not been casuistic or innocent. Porsche's actions under CFO Holger Härter show flawless execution, exactly what one would expect from a manufacturer of niche high performance cars. The initial build up of a 27.4% stake in 2005 and 2006 was well timed and achieved on the cheap. The March 2007 low-priced VW takeover offer, which aimed to fail, but allowed Porsche to raise its stake to 31%, reveals innovativeness. But it is the current move, which shows the brilliance of the strategy pursued by Porsche.

The basic assumption when a firm acquires another is that it wants to pay the lowest price possible. What better way for Porsche to achieve its goals than by aiming for exactly the opposite of what the market expects it to do, and to do it in plain sight. In my view, Porsche's objectives were best served by having Volkswagen’s share price rise the maximum extent possible.

On November 28th, 2007, Porsche announced record profits of €5.7bn of which €3.6bn were gains from options investments on VW shares. Based on the half-year letter to shareholders, analysts estimate that €3bn were achieved in the second half of the 2006/2007 fiscal year (FY). To be able to earn €3bn from options, considering the VW share price change from around €85 on January 31st to around €132 by July 31st, Porsche would have had to hold options contracts equivalent to holding about 650 000 “in-the-money” options contracts between these dates. Such large number of contracts, if fully exercised, would correspond to about 65 million shares, or about 22% of the voting capital of VW, and would represent nearly 50% of the total number of Eurex option contracts for VW, 85% of which were puts. This high proportion of puts was unusual. The number of put and call options contracts on any given stock are normally similar.

Porsche could not have made so much money with options had it held a much smaller number of contracts or “out-of-the-money” options. Indeed, since it would be nearly impossible to hold that many options that remained in the money during the entire period, it is likely that Porsche held far more options contracts for only part of the period, and that it used a particular type of options contracts, so-called “deep in-the-money naked puts”. For example, if Porsche sold a €130 “deep in-the-money naked put” contract when the VW share price was €100, it would have received a premium in excess of €30 per VW share, or €3000 per contract. This contract would confer to the buyer, the right to sell 100 VW shares to Porsche, at the price of €130 per share. That means Porsche would not have had to spend any money in building its large options investment.

According to Eurex exchange’s regulations, there are no restrictions to the size of “naked puts” contract holdings, unlike other bourses and its own practice before 2003. On the other hand, so-called “long call” option contracts, which confer the right to buy the share at a given price, face positions limits equal to 25% of the free-float.
[ii] The regulations have been in place since 2003 but were explicitly laid out in an July 2004 circular, which also substantially increased positions limits. This was a surprising policy change, as investments in “naked puts” affect the price of the underlying shares in a similar manner to “long calls” options.

Large sales of “deep in-the-money naked puts” by Porsche would have had the effect of moving the underlying VW share prices higher as if Porsche had directly acquired additional VW shares. This happens because the buyers of the put options, on the other side of the Porsche trades, either own shares or hedge their put options investments by acquiring shares. These buyers would be unwilling to part with their VW shares at prices lower than the exercise price of the puts they had previously acquired. In practice, Porsche would control, by proxy, a large number of VW shares.

Only about 41.4% of the VW shares were theoretically available for trading to start with, the so-called free-float. However, if you account for the large Porsche’s holdings in the options market, and holdings by exchange traded funds (ETFs), which may own up to 25% of the free float, the true percentage of VW shares available for trading was probably well under the 15% minimum required by Deutsche Börse for a DAX30 stock. As a result, small changes in the volume of traded shares would have exacerbated VW share price changes. In fact, the large Porsche’s holdings of VW shares and options may have allowed one or more unknown entities to corner the market for VW shares, leading to large VW share price increases, and to the large Porsche’s options profits.

VW shares rose by 50% to close to €200 between July 31st, the end of Porsche’s FY, and November 1st, during a period of turmoil in worldwide stock markets, in the context several news reports and interviews in Der Spiegel and other newspapers about Porsche’s stated interest to acquire a majority stake of Volkswagen by January 2008. Therefore, assuming Porsche did not unwind its options portfolio before late October, I estimate that Porsche is sitting on top of at least an additional €3.5bn to €4.0bn of profits from options in the first half of FY 2007/2008. According to a Nov. 29, Financial Times article “Porsche profits by CFO’s hedges”, traders have estimated similar options profits in this period.

On November 3rd, a Der Spiegel article indicated that due to conflict with the VW unions and the high price of VW shares, Porsche had decided to postpone the acquisition offer for VW beyond January 2008. In addition, the Der Spiegel referred that CFO Holger Härter preferred to realize Porsche’s options gains since current VW share prices were too high. A Porsche spokesman later stated that it had already cashed in most of its options. To do so, Porsche probably bought back the put contracts it had previously sold, realizing large gains in the process, and with the result that the VW share free float would have increased again.

If my analysis is correct, Porsche’s 31% share of VW, considering the after-tax gains from options investments, did not cost Porsche anything. At current market prices Porsche’s stake in VW is worth about €14bn. But I think the important point is that, while insiders have gained substantial sums, the general public and some investors on the other side of the Porsche trades will make large losses, even if some of these losses have not materialized yet.

While Deutsche Börse and the Frankfurt stock exchanges regulator do not come out of this affair in good light, Porsche has thus far shown perfect command of the German stock exchanges regulations and intricacies. Therefore, there is no doubt in my mind that Porsche’s behaviour has been legal. Nonetheless, it seems as if normal investors have been deceived by the deficiencies in Eurex regulations.

Finally, whatever its next move may be, Porsche seems to have forgotten the dictum often attributed to Abraham Lincoln: “You may fool all the people some of the time; you can even fool some of the people all the time; but you cannot fool all of the people all the time”.

P.S.- Some opinion makers in the US and Europe argue that firms should not be required to report quarterly earnings reports, as they result in businesses having an excessive short-term focus. I believe this case shows that the opposite is true. Porsche fought Deutsche Börse’s requirement for quarterly earnings reports. They release a puny 6-page half-year brief to the shareholders, with little details available. Only with the release of its 2006/2007 FY Press Release on November 12, is it possible to infer Porsche's actions, and that with a delay of three and a half months on the end of their FY. Surely, this does not aid the cause of market transparency. Insiders must have had a feast this last year.

[i] VW has large stakes in the truck makers MAN AG and Scania.
[ii]Eurex Circular 097/04: Position Limits – New Mode of Calculation as of August 2, 2004”, Eurex Deutschland, 2004, (accessed: Nov. 2007)

Copyright Ricardo Cabral, 2007. All Rights Reserved.
This article may be reproduced with appropriate attribution.

Friday, October 12, 2007

Banks face perfect storm*

by Ricardo Cabral

First version: September 24, 2007
This version: October 12, 2007

The current financial crisis follows several years of rapid growth of financial sector revenues and profits. Revenues for large European complex financial institutions grew above 20% in 2006, and profits grew even faster.[1] In the US, the financial sector represented 21% of the S&P500 market capitalization and approximately 30% of the profits. However, the financial sector has been under growing pressure which now comes to light. In reality, what we now face is a banking sector crisis.

Banks derive their revenues from three sources. First, service income from fees, commissions, and other services such as investment banking. The second source of revenues is a pure term premium, the difference between the “risk-free” short- and long-term interest rates, as banks loan or invest long-term their mostly short-term liabilities, essentially a play on the yield curve. The third source of revenues is a risk premium, as banks pay depositors and creditors a reduced risk premium given their strong financial ratings and depositors insurance, but apply these funds in loans or financial assets with typically higher risk, charging for that reason an interest rate spread.

Recent years have seen strong innovation in the financial sector particularly the origination and distribution of credit exposures through structured securities, which in combination with cyclical business such as LBOs and M&As resulted in large increases in the revenues derived from services. For example, according to the Bank of England’s Financial Stability Report, in 2006 large complex financial institutions saw fees and commissions revenues grow 20%, net interest income grow only 5% (from term and risk premia), and trading activities revenues, associated with an increasingly large trading asset portfolio, grow 35% (risk premium). However, the growth in services revenues masked growing competitive pressure on prices and margins of banking services, due to the growing role of “low-cost” banking and securities (e.g., ETFs). The current crisis affects the former revenue streams, and thus in the short run service revenues are likely to fall.

The term premium has basically vanished as central bankers in the developed world raised short-term reference interest rates but long-term rates remained nearly unchanged or even fell. Since 2004 short term reference rates rose from 2% to 4% in the Eurozone and from 1% to 4.75% in the US, after the cut in the Federal Funds Rate last week. On the other hand, German government 10-year bonds yielded 4.11% and US treasury 10-year bonds yielded 4.67% in August 2007. As a result, in August, 10-year term premium spreads over the overnight reference rate were 11 basis points in the Eurozone and -35 basis points in the US. For comparison, the monthly average term premium between the US federal funds rate and 10-year treasury bonds has been 140 basis points since January 1982. Since the reference interest rate in practice functions as a ceiling for the short-term price of money (time deposits and short-term money market), the term premium has historically been one of the largest sources of revenues for the commercial banking sector. In summary, the second source of bank revenues has been under strong pressure since 2004.

The remaining source of revenues arises from the risk premium. The banking sector revenues and profit growth over the last few years can only be explained by the growth in revenues associated with the risk premium, in a period where the risk premium fell significantly. The risk premium fell precisely due to the growth in the supply of credit, as evidenced by the growth in banks’ balance sheets since 2002, but also due to the growth of investment capital willing to “borrow short-term and lend long-term”,[2] in some cases backed by bank credit lines. For example, an often used measure of risk, the spread between junk bonds and 10-year US treasury bonds fell from 11 percentage points in 2002 to under 3 percentage points in the beginning of 2007, while assets of large complex financial institutions rose from under $12 to $23 trillions, with trading assets representing more than 25% of total assets. For comparison, hedge-fund, bank conduits, and structured investment vehicles (SIVs), which it is often argued are a source of systemic risk to the financial system, are thought to hold assets of $2.7, $1.4, and $0.4 trillions, respectively, and thus play a much smaller role in the financial system. Despite the fall in the risk premium, bank revenues grew due to the increase in the volume and average risk of bank assets. Given the current increase in the risk premia and fall in asset prices and capital ratios, banks will have to reduce asset growth, suggesting that the revenues associated to the risk premium are also likely to decline.

Little can be done in the short run regarding service revenues, but price increases for retail bank services and cost cuts are likely. To allow banks to earn again some term premium either short-rates go down or long-rates have to go up. The first option, for example through a massive increase in public debt, would reduce the market price of “risk-free” long-term assets and, if achieved through higher public spending, increase inflation, both not palatable options. Thus, substantial reductions in the short-term reference rates are now unavoidable to prevent a more severe banking crisis, despite the talk emanating from the ECB, the Bank of England, and the Federal Reserve. Moreover, it is important to ensure that the long-term yields do not fall significantly, so as to maintain the increase in the term premium achieved by the reductions in the short term interest rate, and to prevent further bubbles of financial assets. The 10-year term premia have risen by more than 20 basis points in both the Eurozone and the US since August. Furthermore, the yields for the 3- and 6-months bond yields have fallen significantly since July. In the US, the 3-month Treasury bond yield has fallen by 112 basis points. As a result, the yield curves are again positively sloped and the markets, despite the central banks’ reference rates, are again willing to pay some pure term premium, clearly a positive development for the banking sector. Finally, to restore the third source of revenues to banks that have not engaged in risky behaviour and to ensure that the banking sector is willing to extend new loans, policy makers have to let the risk premium rise from its current abnormally low level. Specifically, governments and central banks should not buy financial assets to prevent a rise in the risk premium.

The increase in the risk premium will put the capital ratios of great many banks under strain. While it is often argued that large banks are well capitalized, UK major banks, for one, seem inadequately capitalized with only 4% Tier 1 non-weighted capital ratios, and a similar argument can be made relative to a few of the largest American and Eurozone banks. Since the risk spread for higher quality assets fell to near negligible amounts during the credit expansion, the repricing of risk may cause the market price of high quality assets to fall significantly more than expected because the implied asset yield for higher quality assets rises from a lower base than that for riskier assets. In fact, the market prices of investment grade corporate bonds have already fallen significantly since February, following a rise in spreads of 72 basis points. Given that Bank of International Settlement capital rules for international banks requires much lower Tier 1 weighted capital ratios for higher quality assets (only 0.6% capital allocation for AAA securities), banks with higher quality illiquid assets may paradoxically be more exposed to the repricing of the risk premium than banks with riskier assets. Alas, this issue, rather than simply lack of liquidity, may be one of the main causes of the problems besetting the English bank Northern Rock.

In conclusion, I believe the banking sector is at the origin of the current crisis, which is not a liquidity crisis but instead a revenues and capital adequacy crisis. Therefore, the crisis cannot be solved by liquidity injections by central banks, but by measures that will restore the market incentives for the banking business. Given that a large number of market participants do not know or do not agree how to quantify the extent of their losses on their illiquid assets, bank supervisors should step in and force banks to incorporate in their balance sheets their off-balance liabilities and to re-price illiquid financial assets (e.g., CDOs) using simple, but aggressive discount rules. As usual, should a bank fail to meet minimum capital ratios, the supervisor would require capital increases or in the extreme cases impose bank receivership. While these measures might affect several banks, they would restore the necessary confidence by introducing transparency about maximum bank exposure.

Finally, this crisis raises questions about the reliance of monetary policy on the short-term reference interest rate, and may lead to the ascendancy of the so-called bank capital channel hypothesis[3], a quite recent research topic within the vast transmission of monetary policy academic literature that emphasizes the effect of monetary policy on the capital of banks, and through it on economic activity.

[1] “Financial Stability Report”, April 2007, Bank of England, Issue No. 21
[2] Paul De Grauwe, July 10, 2007, “The eurozone is missing the point”, Financial Times
[3] Van den Heuvel, S. J. (2007) “The Bank Capital Channel of Monetary Policy”, Wharton University, mimeo. This literature focuses on the impact on bank costs of interest rate rises, whereas in this article I take the view that the important impact of monetary policy is through the reduction in the banks margins arising from the compression of the yield curve term premium.

*Copyright Ricardo Cabral, 2007. All Rights Reserved. This article may be reproduced with appropriate attribution.