GameStop, and WTF Is Going On?

Let me just start this is a disclaimer: I am not an expert on finance, and this post is not financial advice.

This post has one purpose: to help people make sense of what is happening in financial news right now. If you hear things like “short positions” and “gamma squeezing” and have no idea what these things mean, keep reading. If you do, share this article and don’t bother reading.

What is short selling?

If you buy a stock (call it ACME) and hold it, then you are “Long ACME”. This means you are in it for the long haul. If ACME succeeds and earns more money from their customers, then more people will buy that stock, driving up the price, and potentially increasing the dividend that gets paid to you, dear shareholder.

This mechanism gives ordinary people a way to vote on companies they believe in. It’s not exactly like a democracy, where everyone nominally has one vote, but like some similar sort of system where some people have more votes than others. This quasi-democratic nature is a thing that I think is worth defending in the financial markets. The ability for people to “put their money where their mouth is” is something good.

Now, what’s short selling? It’s like a bet against a company. If you thought ACME was a crappy company with an overvalued stock price, you could borrow shares of ACME, sell them at the current overvalued price, then buy them back once the stock value drops to a more reasonable level. You return the share to the lender, then pocket the difference.

This can serve a very valuable function, it is a way to guard against asset bubbles. If a bunch of buyers are systematically wrong about how good ACME is, then they cause a bubble, the ability to sell short can function as check on that mass delusion.

How can short selling be abused?

Leverage. That’s a fancy way of saying debt. If you borrow money and then short shares of ACME, you can multiply your profits by any amount up to your credit limit. If this trade happens over a short period of time, then you might even be able to avoid interest payments.

(Or, if interest rates are near 0% because of Federal Reserve policy, then borrowing is almost free)

Leverage gives the ability to amplify small movements in the value of the stock, and if you spread a rumor that causes the stock to drop by 2%, you multiply that by the amount you borrowed.

So short selling has a legitimate purpose, but it can be abused.

How can short selling go wrong?

Here’s the huge risk with short selling: if you go long and buy $1000 worth of stock, you lose at most $1000. But if you go short, the amount of money you could lose is unlimited. That’s because stocks have no maximum value, so if you are on the hook to buy back a stock that you borrowed, and it’s value goes to $1 trillion, then you are on the hook for $1 trillion.

How is this related to 2008?

This is part of what turned the 2008 collapse in the housing market into a global financial system collapse. The summary of the problem was this:

  • Mortgages are called “good debt” because house prices tend to go up
  • Bundling mortgages together into a single bond helps smooth out the risk of default
  • Credit ratings agencies can bless these mortgage-backed bonds with a high rating
  • Large financial institutions used borrowed money to multiply the returns on mortgage backed bonds
  • This system created the incentives to sell bad mortgages (sub-prime) and then launder the risk by paying off the credit ratings agencies and selling the bonds and leaving someone else with a ticking time bomb
  • A bunch of those bad mortgages went into default, causing a Butterfly effect where the losses multiplied because of leverage

The use of leverage is a theme here.

What is going on with GameStop (GME)?

GameStop is like Blockbuster for physical computer games. It’s probably doomed like Blockbuster. So, it would seem like a profitable trade to short GME (GameStop’s stock ticker).

Hedge Funds are small groups of investors (smaller than 50 people to avoid the same regulations that mutual funds have to follow) who take out leveraged long/short positions on all sorts of stocks, and make boatloads of money.

They also tend to make bets against smaller companies, since the larger the company, the harder it is to manipulate the stock. The SEC (Securities and Exchange Commission) has to choose their battles, and for the most part, going after Hedge Funds who bankrupt a company and make less than $500 million is not worth spending taxpayer money on.

Hedge Funds with more than $100 million under management have to publicly list their positions with the SEC, so anyone can see what their trades are. An online forum called WallStreetBets has been sharing this obscure financial information so they can “YOLO their life savings into the stonk market”.

One of the WallStreetBets users looked at a Hedge Fund called Melvin Capital, and that it had a huge short position against GameStop (GME). They posted that everyone there should buy GME, and it turned into a meme. Using leverage, they drove the value of GME up >1000%. On new years 2020, it was around $19 a share. Today it is $190 a share. That means that Melvin Capital will have to buy those GME shares for whatever the price ends up being when they have to pay back their GME shares.

This is how this mob of internet randos is squeezing this Hedge Fund. It's worth noting that Melvin Capital short-sold Tesla's stock, and then bragged about it. Elon Musk hates these guys, and he should, they are playing money games, and Elon is building real machinery that will move human civilization forward. Hedge Funds don't add any real value, besides potentially guarding against real bubbles.

What’s all the outrage about?

If it’s just a localized battle between bored gamers and coked-up Wall Street jocks, who cares? Good question, I’ll start by saying I don’t think this activity will lead to a system-wide failure, since it’s much more targeted and adversarial than the subprime crisis.

The outrage right now has to do with the CEO of Nasdaq coming out in support of the hedge funds and suggesting stopping trading of GME to let the hedge funds recalibrate and weasel out of their trades. It has to do with the stock-trading app Robinhood de-platforming GME, in a move that certainly appears to benefit the hedge funds getting wrecked (this is probably some capital or liability requirement, and possibly not collusion between exchanges and hedge funds, but it does have that appearance).

From the outside, it really looks like Wall Street, the financial news companies, and the exchanges are all colluding to protect mega-rich institutional gamblers like Melvin Capital.

So, if this story is correct, it would mean there is a network of people protecting some market manipulators, the Hedge Funds, but not an open forum of market manipulators made up of ordinary people without fancy Ivy League MBAs or friends in high places. It would mean that if rich institutional gamblers got more rich at the expense of GameStop, that’s fine. But if a bunch of millenials on Reddit are getting rich at the expense of Hedge Funds, then it Absolutely Must Be Stopped.

Conclusion

We don’t have all the facts yet, and it’s totally possible Robinhood had a good reason to halt GME trading, but even if that’s true, the CEO of Nasdaq has shown that they care more about hedge funds than ordinary people. The system appears to be rigged against Main Street, in favor of Wall Street.

I don’t usually condone the sort of mob mentality that is going on here, but if the mob is right, then power to them, and screw the institutional gamblers and their media shills.

The financial industry has a privileged position, but in return for that privilege and power should come a great responsbility: to allocate capital in a way that maximizes economic growth. If instead they are playing games and acting like predators, then they deserve to have that power and privilege taken away.