Making sense of the GameStop mess kicker: Your money
Unless you have been in a jungle somewhere, without a smart phone, for the past week, you have heard of the youthful group of stock trading investors acting like a flash mob. I cannot pretend to understand all of the communication technology that enables the group to coordinate. But I can shed light on the issue of whether their trading was stopped to aid the poor hedge fund operators who were losing their fortunes.
The bare bones of background are these. As you know, the Federal Reserve and the U.S. Treasury think that zero interest rates (or as close to zero as they can enforce) are necessary and healthy for the United States economic welfare. They both want to incentivize people to take risk, to start new businesses and to invest in companies through buying stock. Many young people are laid off, underemployed, working from home or just waking up to the gambling aspects of stock trading.
The hedge funds have made it a habit in the past several years at least to announce their intentions of driving down the price of a target company, recently GameStop Corporation (GME) and AMC Entertainment Holdings, Inc. (AMC Theaters) among several others. Why this is legal, I have no idea. They decide upon a victim company, borrow shares of its stock from a brokerage company, sell the stock and then later buy stock shares (hopefully at a much lower price) to replace the ones that they borrowed and sold. This is known as shorting a stock.
The profit they make is the difference between the price at which the stock sold initially and the price they pay for the stock to replace those shares sold. Let me give you an example of some from the late 2000 decade that were golden for this practice.
In late August 2007, Bank of America (BAC) was selling at $52-plus. It began to descend soon after. If shorting, you would have borrowed shares, assume 100 shares, sold them at $52. Then you would have waited and watched in glee as the price dropped down to a low of $2.53 per share. In a perfect world, you would have bought your 100 shares back for $253 to replace those you sold at $5,200. Your cost would have been interest on the borrowed $5,200, perhaps about $650 for a year and a half at 8 percent.
When the hedge fund raiders announced their victims and began to bad-mouth them to destroy the stock value, some heroes recently appeared on the scene under the banner of wallstreetbets. On the Reddit chat website, they decided to take on the raiders by buying GameStop and AMC in sufficient numbers as to make the stock prices rise instead of fall. So successfully that from Oct. 30 to its peak last week, GME went from $10 plus to a top of $483.
If you had shorted the stock at $10, you were now losing over 4,000 percent on your bet! Hedge fund guys are really smart and are not supposed to let that happen to themselves, only to the sheep they are trying to shear.
But at that point on Thursday, Robinhood, the primary trading brokerage for the youthful traders, halted their ability to buy and only allowed orders to sell GameStop shares. Critics said it was in order to protect the hedge funds. Although it may have stopped the bleeding, this was not the reason.
Brokerage firms are required by law and regulation to have enough of their own money in reserve to make sure all transactions are funded and able to be cashed out, so to speak. Many traders had bought their shares on margin, borrowing as much as perhaps 80 percent of their purchases. When the price continues to rise, all is well.
But when GME was rising and falling by a couple hundred dollars a day, it was apparent that some traders would lose money and go broke, not be able to pay back the 80 percent they had borrowed. Robinhood was unable to guarantee all the cash to settle up the trades. In fact, on Thursday night, it raised $1 billion of new capital so it could continue in business.
The story is still continuing. As of early this week, GME was back down to $87 a share. There have been thousands of winners and losers. The fundamental value of GME is said to be still around $10 or so. But with apologies to the late, great Paul Harvey, now you know a little more of the story.
(Price data from Worden Bros., Inc., TC2000, 2021.)
(Past performance is no guarantee of future results. The advice is general in nature and not intended for specific situations.)
Ron Finke is president of Stewardship Capital in Independence. He is a registered investment adviser. Reach him at email@example.com.