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Who profited from Facebook’s flop?

As Facebook shares continue to plummet, dropping another 4% last night to SU$19.16 (around half their float price of US$38), it turns out not everyone is disappointed by the dour share price performance of Mark Zuckerberg’s social network. As insiders like Peter Thiel sell their stock (Thiel reportedly reaped US$400 million last week from offloading his remaining Facebook shares), bankers who advised the company have actually benefited from the stock’s drop.

Advisors on the Facebook float collected US$176 million for their sage advice on the IPO. However, as The Wall Street Journal’s Lynne Cowan explained, lead underwriter Morgan Stanley actually made another US$100 million on top of their US$50 million in fees through a “short” position on Facebook shares. Cowan noted:

In IPOs, underwriters are allowed to sell about 15% more shares than the total deal size to investors the night before a stock begins trading. This creates a short position of shares sold that the banks don’t actually own, and it can stay on the bankers’ books for 30 days. The short position is created to allow underwriters to stabilize the stock in its early days of trading.”

Just to clarify (and Morgan Stanley foe Henry Blodget also does a good job), underwriters like Morgan Stanley don’t take a naked short position like a hedge fund such as Jim Chanos or Henry Paulson. That would be too egregious, even for a Wall Street bank. Instead, they use what appears to be completely legitimate mechanisms to profit at the expense of their clients and investors.

As Cowan explained, underwriters are permitted to sell 15% more shares in a listing company than are actually available as part of the float. This is part of what’s called a “greenshoe”. In essence, if a company’s shares drop immediately after listing, to “stabilise” the price (in other words, stop the share price falling too much), the underwriter will buy shares to keep the price up. Banks explain the purpose of this as to prevent volatility (others who are less polite may call it market manipulation).

Fortunately for the bank if the shares go up in value, it can simply rebuy them at the float price, so it bears no downside risk — but the kicker is if the share price falls, the bank can rebuy at the market price — crystallising a windfall profit. As Blodget noted:

The fact that Facebook’s underwriters made an extra $100 million on the Facebook IPO from shorting Facebook’s stock — while the clients who bought the stock lost their shirts — is just yet another example of the heads-we-win, tails-you-lose structure of Wall Street.”

Blodget isn’t fully correct. Morgan Stanley has two clients: the first, Facebook, is the one paying the bills and awarding the mandate; the second, Morgan Stanley’s retail and wholesale clients who actually buy the securities they’re selling. For the first group of clients, the Facebook float was a remarkable success, with investors paying what appears to be far more than the intrinsic value of the company. Or to put it another way, insiders sold shares for a lot more than what they were worth to gullible outsides. Of course, when this happens, the second group of clients lose a lot of trust in banks like Stanley (and they wouldn’t be impressed to know that their broker is profiting at their expense either).

If this seems unfair, it is. But don’t expect any changes coming from Washington. As Bloomberg reported earlier this year, “President Barack Obama’s largest campaign donors last month included employees of Wells Fargo, JPMorgan Chase and Goldman Sachs Group” while “eight of the 10 biggest donors to Romney … worked for banks and investment funds”.

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