Independent, Fee-Only Financial Advisor

Independent, Fee-Only Financial Advisor

Saturday, February 06, 2021

Has the Game Stopped?

Ultimately what happened is that both side of the trade faced a risk, and they each pushed until they hit that risk. The short sellers risked a squeeze by shorting so much of a small stock and the buyers risked crashing their brokerage with their activity. Those risks were always there, they were just so far out there and obscure, nobody counted on them.

What happened here?

Gamestop is a video game retailer that you may recognize from the last time you strolled through a mall. From 2015-2020 their share price declined over 80% as their foot traffic, sales and profit declined. In late 2019, with the stock in the low single digits, stock analyst Keith Gill noticed that, while beaten up, the stock shouldn't be left for dead. Noting that there was significant cash on the balance sheet and a new CEO promising transformation, Gill, who goes by Roaring Kitty on YouTube bought and promoted the stock online and on an investment related page of Reddit. Many of those in Gill's audience were newer investors using the brokerage Robinhood.

On the other side of this trade were people who saw Gamestop's declining fortunes and saw an increasingly dark future for the company. Those investors sold the stock short. We talked briefly about this the other day, as the action was heating up. We are approaching a resolution now.

One particularly weird facet of this story is that the "short interest" in the stock was 140%. Short interest is the percentage of available shares that are "sold short." In this case, there were more shares sold short than shares in existence. How could that be? 

To back up a little but, buying long is betting on an increase in stock price. To be "long" a stock is simply to buy it at one price, hoping to sell it for more in the future. To be "short" a stock, you borrow the stock from someone who already owns it, and sell it along to another buyer in the market. The "short seller" receives cash up front, pays a fee or interest to borrow the stock, and hopes to buy the stock back and return it to the original holder in the future. The short seller makes money if the stock price declines.

The "short interest" is a gross exposure. The total number of shares being held long, minus the number of shares held short will generally equal 100%. If the short interest in Gamestop (GME) was 140%, that means there were 240% of the number of shares in existence were being held long in peoples accounts.

Say that person A owns 100 shares of GME because they think it will go up. Person B thinks it will go down, so they borrow the shares from person A and sells those shares to person C. Now, person A and C both show that they have 100 shares, or 200 between them, but it is the same 100 shares! Person B has -100 shares, so the net number of shares is still 200 - 100 = 100 shares. To go further, person C could lend out their shares to person D, who believes the stock is going down and sells it to person E. Now there are 300 - 200 = 100 shares outstanding.

This is possible because short selling is structured like a loan to the short seller: they receive money up front, pay interest, and have to deliver the original shares back in the future. Their broker facilitates this loan, so if the price moves against them, the broker may demand more collateral to support the loan.

In the case of Gamestop, there were a few large funds that were short the stock. There was word that one may have gone bankrupt. That loan is secured only to the account/accounts which sold it. If it goes awry and the fund looses 100% (or more!) if their capital, then the broker who loaned them the money in the first place is on the hook (much like if a bank loaned me money to buy a house, and I stopped paying and the house burned down, they’d have to write that loan off).

If that sounds like a risky loan, you are right! Stocks change price every day and in a much bigger way than say, houses or incomes (what other banks loan against). So, these loans are carefully scrutinized and very restrictive. They are monitored daily, and generally the borrower is required to post fresh collateral every day if the price changes. If the borrower doesn’t post collateral, the broker can reach in their account and start selling things for them (a margin call). There are often strict limits on the loan to value ratio typically starting at 50% or 2X leverage (with an FHA loan I can borrow 97% the value of my house, for 33X leverage) (that being said, there are certainly brokers who will loan more and certainly ways that a creative hedge fund can structure their loans to end up more levered). There are regulations that the brokers are under to watch the overall risk of their loan portfolio.

As the price rose dramatically, Melvin Capital lost a ton of money. They received outside investment from other funds, including Citadel Capital, in order to stay afloat. Citadel has two business lines - one is a hedge fund that made the investment in the short sellers, and the other side is a clearing broker that processes trades for Robinhood - the brokerage preferred by many of those buying GME.

This all came to a head when Robinhood stopped people from trading GME, amongst other stocks. This looks like a clear conspiracy, wealthy funds losing money and forcing the brokerage to stop letting people buy, bringing the price back down.

In reality, this is another interesting facet of market structure! Personally, I say let the people have their fun. While I do believe that everyone in the finance industry (advisors, brokerages, etc) have a duty to help maintain a well functioning market to protect investors and encourage participation, this is not like a pump and dump on a penny stock. This is just… misguided fun?

When you place a trade, the brokerage goes out and buys/sells the stock on your behalf. They immediately report to your account that you have the shares, prices, etc. However, it is actually two days before the trade settles. Settlement is just the day that the money and shares actually change hands on the exchange (we call this T+2 settlement, all very fine and normal, they could settle faster if they want, but it gives everyone time to do the ‘paperwork,' effectively). So, for the two days from purchase to settlement, the broker has extended their credit to you. Normally, this doesn’t lead to any issues because buys and sells match up well, brokerages discourage rapid trading (there are regulations to stop that too) and generally a single position doesn’t grow to be too big of a part of the broker’s risk pool.

HOWEVER, with several brokerages, Robinhood primarily, GME had become a very large part of their risk pool. Robinhood is also a smaller, newer brokerage with less capital to call on when things get tight. The DTCC (Depository Trust and Clearing Corporation, through whom trades are cleared) needed a larger deposit to handle that risk, a deposit that was apparently more than Robinhood could stump up. They were then forced to go and cancel client orders and sell positions where they deemed the risk too high.

Ultimately what happened is that both side of the trade faced a risk, and they each pushed until they hit that risk. The short sellers risked a squeeze by shorting so much of a small stock and the buyers risked crashing their brokerage with their activity. Those risks were always there, they were just so far out there and obscure, nobody counted on them.

Where does that leave us? Reports on how many people are short a stock come out with a two week lag, so it is still too soon to know for certain how these trades have turned out. There are already stories of investors, large and small, making a fortune from the dramatic rise in GME. The brokerages facilitating the trading frenzy have made a fortune as well.

Where will Gamestop go? The stock is still much higher than it was last year, but I do not know that the fortunes of the company have changed. A decline in share price, due to short sellers or other market action, is not enough to put a company out of business. While there is some indirect effect of a declining share price on executive and employee morale, companies go out of business because they don't make money. If Gamestop needed more investment to succeed, their rising share price presents an opportunity to raise money cheaply.