I have said many times before that I don’t really understand how the stock market works. I mean that I understand in theory about how it should work. Companies sell stock to raise money to grow the business. If the company is well run and makes money, its value, and the price of its stock, goes up. If it is run poorly, then its stock price goes down. For an investor, the goal is to identify companies that show promise of growth and success and buy its stock so that when the price rises, you can sell it at a profit. But the modern stock market has in practice so many layers over that basic idea that the relationship between cause and effect, what causes stocks to go up and what causes them to go down, has become highly opaque.
The problem with the above simple model is that you can only make money as an investor if you can identify a company whose stock is likely to rise in value so that you can buy it in anticipation of the rise. If you think a company’s stock price is likely to go down, there is nothing you can do. If you already own some stock in it, you can sell it quickly to avoid further losses. But if you do not own any stock already, there is no way to make money from your prescience about its future downturn.
Enter the short selling innovation. In this case one borrows that company’s stock with the promise to return that same amount of stock before a set date in the future. One then sells the stock at today’s market price (even though one does not own it) and, when the price drops, buys back that same amount of stock on the market at the lower price and returns it to the lender on the date, making a tidy profit. Since you only borrowed the stock initially and did not buy it, you are not limited by how much money you have to start with. And this is what turns the stock market into a real casino. You can borrow a huge amount of stock and make a huge amount of money. This is what the big hedge funds do.
The catch is that if you bet wrong and the stock price rises, you can suffer massive losses since you now have to buy back the stock at a higher price than what you sold it for. The big hedge funds have huge amounts riding on these things and they have the financial power to drive the companies’ value down by various means, since selling large amounts of stock will tend to reduce its price, and they also usually have access to media where they can bad mouth a company and persuade people to dump its stock. Ideally, for them, the company will go bankrupt so that the stock becomes worthless. Of course, that means that the employees lose their jobs and the investors who had stock in it will also lose. But the hedge funds don’t care as long as they make money. They are willing to drive struggling but still viable companies into the ground in pursuit of their private profits. That’s free market capitalism, baby! This kind of thing happens so routinely that it is hardly worth news mention. We are expected to just suck it up.
So what happened with GameStop? In this case the tables were turned on hedge funds. A Reddit forum known as WallStreetBets consisting of a large number of small investors moved together to shore up the GameStop stock that a massive hedge fund named Melvin Capital had targeted for short selling. As a result, its stock price rose dramatically, threatening Melvin and other short sellers with losses estimated at around $20 billion.
But then a trading app named Robinhood that is used by small investors stepped in and prevented the buying of GameStop shares, thus causing its share price to plunge. This resulted in howls of protest at this development and today comes news that Robinhood has restored trading again, leading GameStop shares to rise rapidly once more. It is possible that Melvin dumped its holdings during that brief period when the stock price plunged in order to limit its losses.
Why did a supposedly neutral player in the market intervene in a way to shield a massive hedge fund? Because the playing field is never level when it comes to the oligarchy and the markets are tilted to favor the wealthy. When hedge funds treat Wall Street as a casino and manipulate the markets and ruin small investors in the process of making vast sums of money, it is hailed as the working of the free market. But when they are hurt after they make a bad bet, they demand protection from the consequences of their acts. It is the same logic as was revealed in the 2008 financial crisis.
How the government responds to this issue is going to be a test of whether we learned anything at all from the 2008 financial crisis, where the government rushed in to save the big banks while doing little for the homeowners who lost their homes. This time, while there is going to be a big fight over passing the stimulus plan to help ordinary people, it will be interesting to see if Congress and the Biden administration come together quickly to help the big hedge funds like Melvin Capital that are, of course, now complaining that they are the poor victims.
One interesting thing to keep in mind during this is that former Fed chair and current treasury secretary Janet Yellen earned $810,000 in ‘speaking fees’ from the Citadel hedge fund which is suspected of being involved in this business.
Citadel does business with Robinhood, the trading app that helped fuel the massive stock activity that hit Melvin Capital. Robinhood said Thursday investors would only be able to sell their positions and not open new ones in some cases, and Robinhood will try to slow the amount of trading using borrowed money.
These huge ‘speaking fees’ are how wealthy firms buy favorable treatment from officials as they rotate in and out of government. It is a form of legalized bribery.
Stephen Colbert spent part of his monologue yesterday discussing the GameStop issue..
Reader Jeff Hess sent me this link to Glenn Greenwald explaining the complexities of what is going on with GameStop stock.
Greenwald says that we should not take at face value the story that this was entirely a battle between small investors against big hedge funds and that there may be other hedge funds betting against Melvin. His video seems to have been made before the trading app Robinhood stepped in to prevent further purchases of Game Stop.
As has been truly said, especially when it comes to politics and high finance, it is not what is illegal that is a scandal but what is legal.