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And Now Facebook's Bankers Are Divvying Up The $100 Million They Made Shorting Facebook's Stock

August 18, 2012
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Source: Business Insider

Boy it doesn't suck to be a banker.

Every time I forget how much it doesn't suck, I'm reminded of some other magical cash-printing tool I had forgotten about that allows Wall Street to coin money no matter what.

And this latest one is a beauty.

Remember the Facebook IPO? Yes, it was one of the biggest IPOs ever. It has also now become a colossal disaster that has vaporized half of investors' capital in three months.

Wall Street bankers were paid extremely handsomely to sell the $16 billion of stock they sold on the Facebook IPO. Specifically, they were paid $176 million in fees.

(Investors who bought Facebook's stock on the IPO, meanwhile, have since lost $8 billion).

But that was only the beginning.

Right now, reports Lynn Cowan of the Wall Street Journal, while Facebook investors digest the fact that the stock has now dropped to $19 from an IPO price of $38, Facebook's bankers are divvying up another $100 million they made on the Facebook stock, this time in a much less visible fashion.

How did the bankers make this second bonanza?

By shorting Facebook's stock.

By, in other words, selling Facebook stock they didn't own and then cashing in when the price dropped.

Seriously!

Wall Street didn't call this "shorting" the stock, of course. Because "shorting" is widely understood to be a bet that a stock will drop. And obviously bankers don't want to be seen as "betting against the clients" they just sold IPO stock to.

Instead, the big short position that Facebook's lead banker, Morgan Stanley, took in Facebook's stock at the IPO price is described as engaging in "price stabilization" (details below).

Also, "shorting" stocks generally entails risk: If you short a stock that goes up, you lose money. And bankers don't like to take risks when they can coin money without taking risks. So this particular cash-printing tool enables Wall Street to short the stocks without taking the risk that the price will go up and they'll get hosed.

"Price stabilization?" "Risk-free stock shorting"? How does all this work?

Through something called the "overallotment option."

The "overallotment option," also known as the "green shoe," is a mechanism Wall Street banks use in most IPOs. This mechanism gives the banks the option to sell up to 15% more stock than is initially expected to be sold in the IPO. The stated goal of this option is to enable the bankers to more closely match supply with demand and, thus, reduce the volatility that might otherwise follow the IPO pricing. This option also allows the bank to buy stock in the after-market without taking undue risk--thus "supporting" the price of the stock.

In other words, when there appears to be "excess" demand for stock on the IPO, the lead underwriter has the ability to sell 15% more shares than it has already agreed to sell. In selling these shares, the bank takes a short position in the stock, by selling shares it doesn't yet own. If the bank were doing this as a "naked short"--selling shares it didn't have a right to buy later at a specific price--the bank would be taking huge risk: The stock might go up, forcing the bank to buy back stock to cover its short at a much higher price. But the "overallotment option" allows the bank to buy another 15% of shares from the company at the IPO price, thus allowing it to sell additional stock on the IPO without taking the risk that the stock might go up.

Importantly, the bank gets paid its full IPO commission on the extra shares it sells if exercises its option, so it has an incentive to sell them regardless of how much excess demand there is. And there's no risk to the bank if the stock price jumps, because the bank can cover its short buy buying the stock back at the IPO price.

And if the stock drops after the IPO?

Well, then the bank really cashes in.

Because then the bank makes money from:

  • IPO commissions
  • And proceeds from shorting the stock at the IPO price and then buying it back at a lower price.

And that's just what happened with Facebook.

With Facebook, we all remember, the underwriters "supported" the stock for the first day, helping it close just above the IPO price. Then the underwriters gave up on supporting it. And the stock has traded pretty much straight down from there.

And at some point, shortly after the IPO, the underwriters covered the short position they established by "over-allotting" Facebook stock on the IPO...and they covered at a lower price.

The net gain from this little trade, the Wall Street Journal reports, was $100 million.

And Facebook's bankers are now divvying up those proceeds.

The "over-allotment option" has been a standard mechanism used in IPOs for as long as anyone can remember. To the extent that it does help underwriters stabilize the price of an IPO, there's nothing sinister about it, and its existence is clearly disclosed.

But 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.

It's no mystery why, even given all the travails Wall Street has gone through in the past 5 years, the Wall Street firms are still coining money. And it's no mystery why everyone still wants to be a banker.

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