An insightful anon with a finance background explains the recent fiasco in the stock market regarding the GameStop stock, and some of the possible repercussions that may follow:
This isn’t financial advice and my opinion and analysis is presented for entertainment value, whether you have a long or short position in the market today or are just watching what’s happening and trying to understand it, try to have some fun and appreciate the unprecedented historical events happening. Before making any investment assess what level of risk you can take and do your own research and find a financial advisor you can trust.
At the center of the current situation in the stock market is GameStop stock. The reason GameStop is at the center is because it was a struggling business which hedge funds (large organized investment institutions) figured was going to go bankrupt, so they short sold the stock to try to make a profit (they borrowed shares of the stock and then immediately sold the stock, agreeing to deliver the stock at an unspecified date in the future, anticipating being able to buy shares later at a lower price and profit.)
The short sellers who did this trade shorted over 100% of the available shares, about 140% of the float of shares were shorted when this story started picking up steam. Contrary to some media reports, this short interest hasn’t been covered, its actually expanding, financhill.com reports that 250% of the float is currently shorted, meaning existing shorts actually doubled down.
You might ask how is it even possible that 250% of the float got shorted in the first place. The answer should be that it shouldn’t ever have been, it was extremely risky to do, it possibly was illegal to do, and it most definitely should have been illegal to do. But it happened anyways. (1)
Now, back in the summer, a few smart value investors like Michael Burry of the Big Short fame and RoaringKitty on YouTube saw this level of short interest and decided to start buying stock, recognizing that the price of the shares had been artificially driven down by the high level of short interest and that the fundamental qualities of the business were actually a lot healthier than the share price reflected, so they started buying up stock.
Then once these smart investors made these purchases, other people started to follow suit, either because they saw their analysis of the stock and agreed with it and bought in, or simply because they saw the stock trending in an upwards direction in bought in. Doesn’t really matter. Then other events happened which drove the stock price up higher, like Chewy executives getting involved with the company and GameStop having a good winter because of the new console launches.
At no point in this situation did the short interest decrease significantly, in fact its only increased relative to the float. And the price has absolutely skyrocketed during that time.
Because the short sellers are contractually obligated to buy the stock back at some point, those holding the stock can essentially dictate the price that needs to be paid for it through the market. And since the short interest is so high, those obligated to buy back the stock might not even have enough money to even cover it if they started buying immediately. (2)
Now you might ask, if the funds who were short on gamestop cannot cover their obligations, what happens. Well, because they are contractually obligated, if they cannot continue to post collateral with the institutions they sold the stock short through to cover their rising debts (meeting the margin call), they will be forcibly liquidated in order to try to cover. But since they are short well over 100% of the stock, they can’t cover. So even after they are liquidated, there will still be an unfulfilled obligation, which would be assumed by their prime broker. Prime brokers are investment banks who take on risks like this for hedge funds in the event that the fund makes bad trades and is forcibly liquidated. Because of the 2008 crash (when Bears Stearns failed) counterparty risk is now usually spread out, it’s not assumed just by one bank on behalf of one fund, but by multiple banks to reduce the risk of any one bank failing because of bad trades made by one hedge fund.
However, the level of current exposure the banks have is actually mind blowingly large, and I’ll explain why.
The fund who took the most prominent short position against GameStop in the media is Melvin Capital. Melvin Capital is one of the most known hedge funds that specialize in short selling. They have historically been very profitable for their clients, to the point that there is such a demand from investors (called limited partners in this situation) that the fund has turned away many clients in the past because they don’t need them. This led to a rise in copycat funds who essentially just copy everything that Melvin does and get people who want to invest with Melvin but can’t to invest with them. (3)
So if Melvin’s risk is absorbed by 2 or 3 banks acting as prime brokers for Melvin, the counterparty risk for the trades made by Melvin actually spreads out to increase exposure to potentially every large investment bank which acts as a prime broker for hedge funds, because if they don’t have exposure to Melvin’s risk, they likely have exposure to other funds which copy Melvin.
But the story doesn’t stop there. Because the price squeeze on the GameStop short sellers is enormous and theoretically infinite, GameStop stock is essentially just a money printer which has continually rising value in the market. Because the value of the equity continues to increase, GameStop shareholders are able to borrow more and more money against GameStop stock on margin through their brokers. Recognizing the financial reasons why this trade has gone so successfully in their favor, many of these traders are now using either more of their money or more money borrowed against GameStop stock (which is effectively a money printer) to also buy up stock in other heavily shorted companies to also apply pressure to those short sellers.
So the situation is quickly becoming one where the short sellers cannot cover even their position in GameStop let alone all of their other short positions because they just don’t have enough money. As long as the stock holders continue to hold, the short sellers will not be able to meet their obligation, the value of the stock will continue to increase, the amount of money that can be borrowed against GameStop stock will increase, that borrowed money will then be used to further increase the pressure on other short sellers. (4)
And with so many short squeeze situations simultaneously happening, it is likely that every single bank who acts as a prime broker for these different short sellers who are sold short on different stocks has exposure to all of this risk. Risk that they cannot even cover themselves.
So the end result of all of this is likely going to be that every single investment bank in the country with exposure to this risk, which could be every single investment bank in the country, is forcibly liquidated. It’s an even worse situation for the banks than the housing crash because in 2008 their level of exposure was actually limited, in this situation it is theoretically unlimited.
Check all of the big investment bank stocks, they’ve all been down for several days in a row. At this point in the game, it seems very likely that they’re going straight into the ground. Power to the players. (5)
… (following found from the same anon as part of the same thread, but not in screen cap)
The question of what happens after if the investment banks who took on counterparty risk for the hedge funds are forcibly liquidated trying to cover the obligations of the funds they took on risk for which they cannot meet is one I’m incapable of answering. I don’t know if there is anyone capable of answering it. The system wasn’t designed to have a response for something like this happening because nobody believed it could possibly happen.
Original screen cap: