With-a-fountain-pen Dep’t

How did the underwriters of the Facebook IPO make $125 million in trading profits in addition to their $176 million in underwriting fees?

Facebook went public at $38 per share, and is now trading at $30. So Morgan Stanley, the lead underwriter, and its accomplices partners at Goldman and J.P. Morgan, did an excellent job for their customers (Facebook and its selling shareholders, including Goldman itself) while leaving the public – including Morgan Stanley’s own retail customers at Smith Barney – holding the bag for something north of $3 billion.

They also did quite nicely for themselves, thank you: $176 million in underwriting fees plus $125 million in trading profits.

It’s the trading profits that leave me puzzled. The WSJ reporter writes, “Morgan Stanley and the other banks made additional money through their attempts to buoy the faltering stock early on.” But attempting to “buoy” a stock means buying it. How do you make $125 million buying a stock that opened at $44 and is now trading at $30? They must have sold into any temporary rally generated by their support efforts. So it sounds to me as if the banks figured out a way to fleece the suckers twice.

As the man said, “There’s no such thing as a gentleman when real money is on the table.”

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: Markarkleiman-at-gmail.com

15 thoughts on “With-a-fountain-pen Dep’t”

  1. I first heard this saying attributed to Mark Twain. I like that better than the apparent truth of the matter.

  2. Is it insider trading if you, the underwriter, are buying and selling stocks in order to manipulate the market? Or just normal fleecing the sheep.

    1. Yeah. This isn’t so much fleecing anyone as it is a part of the fees the underwriters collect, just disguised as trading profits. Now, you might think that it’s a travesty that we’ve allowed the underwriters to find risk free ways to make money; I do, but I was a trader and we’ve never really liked investment bankers as a group. But it is largely above board and the overallotment is public knowledge.

      1. Right. In a sense, they make trading profits on whatever they sell, because they “bought” at a discount.

      2. After reading Salmon, one thing is unclear to me. Morgan sold 63 million more shares, at $38, than they bought. It sounds like they had a call against Facebook and its investors for those 63 million shares at $37.58. Is that right?

          1. Both of the Anonymous comments above are me. Forgot to fill in the info lines when posting from my new laptop.

        1. Sounds like an over-allotment option (or “green shoe”; the reason it’s called that really isn’t very interesting, trust me). It’s completely standard; I can’t think of a share deal that is done without one, except for some European rights offerings. Basically, in an SEC-registered public offering in the US, you need to tell investors how many shares you are going to sell. But thanks to an (at this point very old) SEC interpretation, you can exceed that amount by up to 10%. This allows you to accommodate unexpectedly high demand, etc. In principle, anyway; the reality is that, in any successful placement, it’s a given that you will sell the shoe (which, of course, means that you are technically shorting the share, because you have sold 10% more of them than the underwriter and/or selling shareholders have, till that point, given you).

          The underwriters will need to cover their short position, of course. So they have the option, for up to 40 days post-closing, to buy the extra shares from the issuer/selling shareholders at the same price they paid for the IPO shares. It’s essentially protection from upside risk. If you sell the IPO shares at 25 and they go up to 35, you exercise the option and buy the extra 10% at 25; if the price goes down to 15, you let the option lapse and cover your over-allotment by buying shares in the secondary market instead.

          The same thing is done in many underwritten unregistered private offerings and in non-US offerings, even though those do not need to adhere to the full complement of SEC rules.

          One can question the wisdom of permitting over-allotment options, but the practice long pre-dates the more predatory banking ethos of recent years, and in any event is in no way peculiar to the Facebook offering. The thing is, if you decide as a matter of policy that the use of over-allotments is desirable, then the upside protection aspect is a must-have (or else nobody would over-allot)*. In much the same way, underwriters are permitted, for a short time post-closing and subject to a good bit of regulation, to stabilize — that is, to buy/sell the share in an effort to influence the price. Market manipulation? Of course. But it’s permitted because it is seen as good manipulation — for a couple of weeks post-closing, the share price has training wheels, as it were.

          * Not to say that underwriters over-allot out of selfless love for mankind. They can and do profit from it. They try to keep all the profits for themselves, but an issuer with enough leverage can sometimes force them to agree to split them.

  3. So it sounds like the big underwriters don’t know how to manipulate the market, or front run, and there’s no grifting. Or, if they DO know how to grift, they wouldn’t.

    Hahaha. Funny like a family tossed out of their house, onto the street.

    If we had any balls left in America, the men would be out in the streets.

    1. Or they grift, but with enough care to not make it too obvious.
      Or maybe the big grift is Facebook here.

  4. Here is my question: Who on god’s green earth thought that Facebook at $42 was a good investment? I am still struggling to wrap my head around this, perhaps someone can explain it to me. Last year they held something like 3 billion in cash and cash equivalents, and look like they will probably make just south of a billion dollars per year for the next few years. Enter James Wimberly, whose writing I usually have trouble reading because I am not used to unpacking that much thought and data per sentence, with a comment that went something like “but Facebook is a cash machine with very good margins.” Sure, its a high margin cash machine that spews out about 1/100th of its IPO valuation or less per year selling a product that is not physically anchored to human endeavor or industrial progress (remember myspace). When I look at investments, a stock for which the increase in shareholder equity should be approximately 1/3rd the rate of inflation per unit time looks like a really really horrible deal to me. Why don’t you just go get a 6 month CD at 1 percent? At least the muslim-in-chief/racist christian (wright)/ atheist would insure your deposit, unlike Facebook which can and should devalue rapidly. A “cash machine” that produces 1 billion per year is a great investment if someone wants to sell it to you for 15 billion or less. Say I owned literally the single best, most efficient small business in the world which netted around 1 million per year, and would probably continue to do so for the near future. Would you buy my super awesome small business for 120 million? I sure would sell it to you for 120 million, which is exactly what the insiders and early investors in facebook just did. I don’t understand the way people think when it comes to stocks I suppose.

    1. Student:

      I like the pseudonym, and hope it’s a reference to the inventor of the t distribution.

      I think you are absolutely right. Buying Facebook at either 30 or 40 was almost certainly a mug’s game. As Ross Douthat noted, for once perceptively (via piggybacking on a John Cassidy article that I haven’t read):

      “As The New Yorker’s John Cassidy pointed out in one of the more perceptive prelaunch pieces, the problem is not that Facebook doesn’t make money. It’s that it doesn’t make that much money, and doesn’t have an obvious way to make that much more of it, because (like so many online concerns) it hasn’t figured out how to effectively monetize its million upon millions of users. The result is a company that’s successful, certainly, but whose balance sheet is much less impressive than its ubiquitous online presence would suggest.”
      (“The Facebook Illusion,” New York Times, May 26: http://www.nytimes.com/2012/05/27/opinion/sunday/douthat-the-facebook-illusion.html?_r=1)

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