Is L’affaire GameStop a Morality Play?

Where were you when you heard the news about GameStop?

When it showed up in your Twitter feed, you were probably shocked. Senator Cruz agreed with Representative Ocasio-Cortez, with both saying that what Robinhood did was unacceptable. Clearly, it must be really bad. Then Senator Hawley joined the fray in an article over at First Things titled “Calling Wall Street’s Bluff.”  The narrative quickly became that of a good, old-fashioned morality play, in which the “Elites” are attacked by a ragtag bunch of “Ordinary People” and the ordinary people win, raiding the castle and carrying off some ill-gotten loot. The Elites are unhappy. Fortunately, our elected representatives are here to stick up for the regular folks. Congress is scheduling hearings. Janet Yellen is launching her own investigation.

Truth be told, as the whole story was unfolding, I laughed. It was so fun and crazy—a real-life video game revolution. The names themselves are priceless: Reddit and Robinhood and WallStreetBets vs. Melvin Capital and Wall Street. Coming soon to Netflix. (That is not a joke: Netflix really is planning a show. So is MGM.)

Alas, sober reality is not nearly as exciting as all of the foregoing makes it sound. Not everything in life is a morality play. Sometimes it is just a bunch of technical details that really don’t lend themselves to a story with good guys and bad guys. Sometimes there are good guys and bad guys on both sides. So, before rushing off to change policy and enshrine the ordinary people as heroes for beating the dastardly elites, let’s pause and look at the details.

Demystifying Wall Street

One of the reasons this event made for such theatrical fun is the mystical-sounding terms involved. Short selling and hedge funds and margin calls are, for most people, mysterious secrets of the Wall Street Temple, known only to the Masters of the Universe, a term immortalized in Tom Wolfe’s Bonfire of the Vanities. So, to begin, let’s demystify the stock market.

Stock represents ownership of a company. If a company has 100 shares of stock, and you own one, then you own 1 percent of the company. You would buy a share of, say, United Airlines if you think the company will be profitable. But you also know that if oil prices rise, the airline industry will suffer. You could protect yourself against that possibility by also purchasing shares of ExxonMobil. Now if oil prices rise, your airline stock will fall, but your oil stock will rise. This is called hedging. You have hedged your bet on the airlines by purchasing oil stock.

Or, instead of buying shares in an oil company, you might prefer to purchase an insurance policy. You pay $1 now, and if oil prices rise, you will receive $20: enough to compensate for your losses on the airline stock. There are all sorts of arrangements like this, which are called hedges. Hedges are really good things if you want to protect yourself from risk.

You don’t actually have to buy the airline stock, though, to buy the hedge. Let’s say you think oil prices will rise, causing an oil stock currently selling for $100 to rise to $120. You could buy the stock and gain $20. But, instead, for $1 you can buy the hedge that will pay you $20 if oil prices rise. If you bought 100 hedges with your $100, you get $2000.

Buying hedges is obviously risky. If oil stock prices don’t rise, then the hedge has no value; if instead you had bought the stock, you would still have it. Instead of only buying one type of hedge, you might like to buy different hedges, hoping some of them pay off. Even better, you could pool your money with lots of other people and buy many hedges; this is called a Hedge Fund. If you didn’t know what a hedge fund was before this, you probably are not extremely wealthy; hedge funds usually have six figure minimum deposits. They are very risky.

Where does GameStop come in? This is a company that sells video games, an industry that is three to four times larger than Hollywood. GameStop is an old-fashioned brick and mortar store chain trying to survive in an age when video games are moving online. Many believe that GameStop will go the way of the old Blockbuster video rental stores.

Suppose you think GameStop has no future. Is there a way to profit when a stock falls in value? Of course! Find someone who currently owns GameStop stock, and borrow their stock for a short time, paying a small fee. The owner wants to own the stock, and now can get an extra payment for lending it to you. Once you have borrowed the stock, you immediately sell it. When the loan period ends, you buy the amount of stock you borrowed and give it back to the person from whom you borrowed. If you were right about the price fall, this can be very profitable. Suppose you pay the owner $1 to borrow the stock, sold it at $20, and bought it back at $12; you just spent $1 and earned $8, which is a really great return on your initial investment. An arrangement like this is called Short Selling. Hedge funds do this a lot.

What Happened with GameStop

So far, so normal. Now enter Reddit, which is an online group chat site popular with the types of people who play lots of video games. On their phones is the app Robinhood, which allows people to buy and sell stock with no fees. (Robinhood profits in the way other apps do—by selling you premium services or your data to someone who can use it.) The fun thing about the Robinhood App is that using it is like playing a video game, complete with virtual confetti when you achieve certain goals.

In the Reddit Forum “WallStreetBets,” people decided to start buying lots of GameStop stock, which would cause the price to rise. Normally, this is a lousy way to make a profit. Sure, the stock price rises, but when everyone sells, the price just falls right back down. This time, however, it became a game. As the price rose, the hedge funds who had short selling deals found themselves in trouble. If you borrowed a stock priced at $20, sold it, and you have to return the stock when it’s currently selling for $400, that is . . . not good. As the price starts rising, to reduce your losses you rush out to buy it before it rises further, which increases the demand for the stock, which drives the price even higher.

Hedge funds short selling GameStop lost. If you were an investor in a fund that lost, you were not too happy. If you were a manager of such a hedge fund, you were really, really not happy. Will people keep letting you manage their money if you just lost half of it because a bunch of video gamers on Reddit were having a merry time?

Now we get to the part that made people so upset. As the price of GameStop was rising, Robinhood suddenly prevented users from buying the stock. If you had been having a great time buying GameStop stock and watching its price rise, your ability to do so was frozen. Immediately, the stories started circulating—this is, after all, taking place on the internet, where stories spread fast. Who paid off whom to stop all the little guys from profiting at the expense of the elites? Great drama here.

Alas, as the details came out, it looks like it wasn’t anything nefarious at all. To see why, we have to look at another set of details. You imagined that you would pay $100 for a stock selling for $100. But suppose you could buy it for $10 by borrowing $90. This is called buying on margin. If you have $100, you can buy ten shares of the stock by borrowing $900. How is this profitable? Suppose you have to pay 1-percent interest on the loan. Now, imagine the price of the stock doubles. If you paid the full $100 price when you bought it, you now have $200, and you are happy. But, if you bought it on margin, your ten shares of stock are worth $2000. You pay back the $900 you borrowed, plus $9 interest. You now have $1091, and you are really happy.

Robinhood allowed people to buy on margin. This created a problem. With the rapid increase in purchases of GameStop on margin, Robinhood’s lending was rising quickly. If the price of GameStop suddenly fell, it was quite possible that the value of the stock would be less than the amount a user borrowed. What would happen then? What if these hard-to-trace users just walked away? It didn’t take long for people to start asking whether Robinhood had enough funds to cover all these purchases. This is known as a margin call. They did not. So, Robinhood had to restrict the trading activity, because it literally did not have enough cash on hand.

Moral Lessons?

Where does this all end? Consider the “ordinary people” involved in the GameStop purchase. They started with a few thousand dollars and now they have GameStop stock worth tens of thousands. But in order to spend the funds, they have to sell their GameStop stock. What will happen when they all go to sell their stock? Time it right, and you come out ahead. Time it wrong, and you lose. This is the classic picture of a bubble. Has the Reddit frenzy changed the value of the company? A lot of people who were rejoicing at the price peak will learn that paper gains are not the same as real gains.

What about the elites who lost? Suppose you were a hedge fund manager who was betting against GameStop when it was $18, because you thought it would fall even lower. You don’t think anything about the company has changed. You think that sooner or later, the Reddit crowd will move on to more exciting things, like the latest Call of Duty. Can you think of how to make a small fortune on a stock selling for $400 that you believe will fall to under $20 in the near future?

It is a bit premature to be celebrating the victory of the ordinary people over the elites. But is it even right to frame the question that way? After all, are Reddit Gamers morally superior to Wall Street Bankers? If so, why?

There are two possible answers. First, we could frame this as an example of greed. If the rapacious Wall Street Banker is the cartoon portrait of Greed, then Hedge Fund managers are like Greed on steroids. But what exactly is propelling all the Reddit users to try to turn $2000 into $50,000 overnight? Greed is a pretty common thing. It is one of the Seven Deadly Sins. If you want to spin this as a tale of Greed, there is not an identifiable Good Guy in the tale.

The other possible answer is that this is an example of Wall Street vs. Main Street, a trope that has a lot more currency than it should. Is using Reddit to gather a group of people using the app Robinhood to buy stock on margin an example of Wall Street or Main Street? Everything in this story, every person and every transaction, only arises because of having a well-developed and complicated financial system. This is not local butchers and bakers vs. the bankers. It is simply a bunch of people playing in a complicated financial market.

While it gives a certain amount of frisson to frame this as the Good Guys beating the Bad Guys, the details just don’t fit that story. It is really important to think about the moral implications of economic activity, but it is equally important to get the details right. A lot of harm can be done by mistaking every economic event as fitting into a predetermined moral script.