Morgan Stanley’s $2.4 billion Facebook short

By Felix Salmon
May 21, 2012

Matt Levine had a very wonky post on Friday afternoon about the dynamics of the Facebook IPO in general and of the very misunderstood greenshoe option in particular. Now that we’ve all had a nice relaxing weekend, it’s maybe worth revisiting that greenshoe, because it’s actually possible, given Facebook’s tumbling share price today, that Morgan Stanley will make a substantial amount of money on it.

First, it’s worth explaining how the greenshoe option is meant to work. In the IPO, the underwriting banks — there were lots of them, but let’s just call them all “Morgan Stanley”, for simplicity’s sake — sold 484 million shares of Facebook at $38 each. At the same time, they bought 421 million shares of Facebook from the company and its investors, at $37.582 each. The underwriter’s fee of 1.1% is the difference between those two numbers: if you buy at $37.582 and sell at $38, then you end up creaming off 1.1% of the total amount raised.

You’ll note that Morgan Stanley sold more shares than it bought. That’s the greenshoe. When you sell more shares than you buy, you’re short that stock, so when a bank exercises its greenshoe option, as Morgan Stanley did in this case, it is going short the stock in question.

Why would a company like Facebook want its banks to be short its own stock? Partly because when there’s a big short in the market, that provides upward pressure on the share price. Shorts need to cover their short position — which means they need to buy stock. But more generally, the greenshoe is a way to provide the market with a nice extra slug of shares, which everybody wants if the stock trades substantially higher than its IPO price.

The greenshoe does, however, raise certain existential questions — not least, how can 484 million shares be sold, if only 421 million shares have been issued? Do those extra 63 million shares exist?

It’s a good question, and the answer is that they’re in a kind of quantum limbo, a bit like Schrödinger’s cat. In one possible world the shares trade happily on the open market, in which case Morgan Stanley will exercise its option, and force Facebook and its investors* to cough up the last 63 million shares; at that point, they certainly do exist. In another possible world, Morgan Stanley ends up buying back those 63 million shares on the open market, thereby reducing the number of shares actually trading to the original 421 million. In that world, the 63 million shares never had much of an existence: they were sold by Morgan Stanley and then bought back by Morgan Stanley, and all that’s left at the end of the day is nothing.

Given where Facebook is trading right now, you can be sure that Morgan Stanley will not exercise its option, Facebook and its investors will not issue those extra 63 million shares, and that in a few days’ time, the free float of Facebook shares will be 421 million, not 484 million.

Which in turn means that over the course of the first two or three trading sessions, Morgan Stanley will have ended up buying 63 million shares of Facebook on the open market. It sold those shares at $38, remember. So its total profit on the greenshoe operation will be zero if it bought all 63 million shares at $38 exactly. If it bought some of the shares above $38, then it could end up making a loss. And if it ends up buying a slug of shares below $38, then it’ll end up making a profit. That’s what happens, when you go short at $38 and then buy back at, say, $34.

This is a very big trade: 63 million shares at $38 each comes to $2.4 billion. On the other hand, there’s very little doubt that Morgan Stanley was doing a lot of buying on Friday. 43 million shares were bought at $38.00 exactly, and another 28.5 million shares were bought at $38.01. It’s reasonable to assume that most if not all of that buying came from Morgan Stanley, supporting the share price.

So the chances are that at the end of the day, Morgan Stanley is going to end up pretty flat on its trade, selling the shares at $38 and then buying them back at $38. But if it bought more than 63 million shares on Friday, then it is sitting on a substantial mark-to-market loss right now. And similarly, if it bought back fewer than 63 million shares on Friday, then it’s actually making a profit on its greenshoe short.

Chances are, no one outside the company will ever know for sure what Morgan Stanley’s P&L on the Facebook IPO ends up looking like. But it would make sense, if Morgan Stanley saw a lot of selling pressure on Friday, for the bank to keep onto at least a little bit of its short position into Monday morning. At which point it could make a tidy profit on that plunging share price.

*In this case, it’s actually just the investors: Facebook wasn’t participating in the greenshoe scheme. But it could have, if it had wanted to.

Update: Levine has a great response. A taster:

The greenshoe is a non-zero-sum way of adding value with optimal risk-shifting: it takes some uncertainty about aftermarket performance from skittish investors and gives it, in the form of uncertainty about deal size, to an issuer who is probably better able to bear it (because selling 15% more shares at the price you agreed on three days ago is rarely a tragedy). The structure of the greenshoe, though, adds an additional conflict, in that banks can hoard the value of the greenshoe for themselves rather than spending it on their investor clients. The fact that they basically don’t do that suggests that motive and opportunity aren’t everything: sometimes banks just do the right thing for capital allocation and risk shifting, even when they could make more money doing the wrong thing.

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Comments
49 comments so far

Pretty good, Felix. An admirably small amount of hand-waving for an arcane backwater of the markets.

But the greenshoe–or, more formally, over-allotment option–per se is an option granted to the underwriters by the company or insider shareholders to buy up to 15% more shares in the offering *to cover the underwriters’ naked short*. The greenshoe is not the short itself.

You are correct: the economic incentive for the underwriters to exercise the full greenshoe only comes when an IPO outperforms its offer price. If Facebook ends flat or down from $38 per share, you can be certain the underwriters will not exercise the shoe at all. The underwriters can only profit if they cover their initial short by buying shares at prices substantially below the market, but that means they do not need to exercise the option to buy them from the company, hence they would not need the shoe.

It is also worth noting greenshoes typically last 30 days, so Morgan Stanley has quite some time to let this play out. Depending on the stock’s behavior in coming days and weeks, MS will decide when to break the syndicate and its natural stabilization bid, and only then will Facebook shares begin to trade normally.

Posted by EpicureanDeal | Report as abusive

Thanks TED. Since you’re here, you can maybe answer a question for me: why would the likes of Peter Thiel participate in the shoe at all? If they want to sell their shares at $38, why not just sell their shares at $38 (or rather, $37.582), as part of the deal? If they *don’t* want to sell their shares at that level, why give Morgan Stanley the free option to buy them at that level?

It seems that the investors are guaranteed the worst possible outcome: if the shares soar in the secondary market, the option will be exercised even though the investors would be better off holding the stock. And if the shares slump, then the option will NOT be exercised, even though the investors would be better off it if were. So how do the bankers persuade the investors to take part in these things?

Posted by FelixSalmon | Report as abusive

@Felix – the selling shareholders grant the green shoe option because it’s part of the package – they want the deal supported! It’s the overallotment option that allows the underwriters to over-allocate and provide natural support as described…

Posted by KidDynamite | Report as abusive

You’re making another great argument for not allowing people to sell shares of stock they don’t own. Did any of the underwriters tell their retail customers they were effectively shorting the stock their brokers offered to them? I’m guessing no.

I’ve heard the argument here for allowing the shorting of stocks – it helps price discovery, it keeps management accountable, blah, blah, blah. But it also distorts the price of stock, as it allows more shares to be offered for sale than actually exist. I don’t understand why that’s allowed.

Posted by KenG_CA | Report as abusive

Felix, the system ought to help produce a “successful” IPO? If the market supports the higher price, then they float a few additional shares into it. If the market is weak, those shares are pulled back out (supporting the price).

Only 20% of shares are trading right now anyways, so an additional 15% “greenshoe” ought not be a big deal for the investors. More important to them to get a healthy market going.

Posted by TFF | Report as abusive

Look at it from the IPO investors’ point of view: if the underwriters allowed insiders to sell in the primary offering, that means the insiders get their money whether the IPO performs well or not. If their participation is restricted to the shoe, then by definition they only get to sell if the stock trades up from the offering price. The latter looks much better optically, since insider selling has a slightly unpleasant smell in general, and investors are much more inclined not to balk if it only happens in scenarios where they have made money, too.

So, often, the underwriters often strongly encourage insiders who want to sell to participate only in the shoe for reasons of optics. Also, as in this case, the issuer itself (Facebook) often does not need or want any more money from issuing primary shares, so the insider shareholders become the only available supply of shares for the greenshoe option.

It’s a pretty old system, and it has stayed stable because it usually works pretty well.

Posted by EpicureanDeal | Report as abusive

KenG, the underwriters weren’t truly shorting the stock unless they oversold their greenshoe. No risk to them as long as they hold options to cover their short.

And the shares do exist, they just haven’t yet been delivered. No great scandal, just a situation akin to Schrodinger’s cat. Uncertainty about HOW the shares will be covered, no question that they will be covered at a profit (or at least break-even).

Posted by TFF | Report as abusive

*Clarification of first comment*:

“… underwriters can only profit if they cover their initial short by buying shares at *market* prices substantially below the *initial offering price*…”

Heaven forfend I imply (falsely) that underwriters can buy shares below market price. There are enough conspiracy theorists out there already.

Posted by EpicureanDeal | Report as abusive

“Did any of the underwriters tell their retail customers they were effectively shorting the stock their brokers offered to them? I’m guessing no.”

Guess again – the overallotment option is always mentioned explicitly in the prospectus.

Posted by dsquared | Report as abusive

KenG — IPOs are one of (the only?) types of offerings where the SEC specifically allows underwriters to do naked short selling (selling shares they haven’t borrowed and/or which don’t yet exist). It is one of the tools by which regulators specifically allow underwriters to manipulate the initial market for newly-issued shares. This is called stabilization, and the intent is to support the IPO in its first few days and weeks of trading.

Posted by EpicureanDeal | Report as abusive

@KenG_CA – I want to point out two things about your comment:

1) as TED noted, the point of the syndicate “shorting” stock is so that they can provide a natural bid for the stock. The point is obviously not so that MS can make a mint when the price crashes – that wouldn’t lead to a lot of repeat business… (Levine made note of this in his post)
2) You seem bothered that this is “selling more shares than exist”

note the irony, as normally people make that argument when they think that someone is trying to short shares to suppress the price of a stock. This case is the opposite: the short (over-allocation) position (protected on the upside by the presence of the green-shoe option) is designed to provide a BID for the stock!

Posted by KidDynamite | Report as abusive

TFF, ok, maybe they weren’t “truly” shorting the stock, but they were able to sell shares they didn’t own yet. Having the option to buy them is not the same as owning them. If they executed that option, there would be more shares in circulation, and the price wold have been lower.

dsquared, maybe you can tell me how many retail customers read the prospectus. Go ahead, you can count on your fingers (I’m not trying to insult you, I’m just saying it’s a small number).

In any case, the underwriters sold more shares they they initially bought. That’s not the same as having an option to buy more so they can sell more. It’s shorting the stock. They didn’t buy all the shares they sold because they thought the price would go down. When they asked their “clients” (you know, the people one broker calls muppets) if they wanted to buy shares at the IPO, do you think they told them they were going to sell more shares than they were buying? The overallotment means they could have bought more if the stock went up, and even though the stock briefly rose, they still bought less shares than they sold. They shorted the stock they were selling to their clients.

Posted by KenG_CA | Report as abusive

Interesting that all the wise beards have come out in this post. I want to contra this to Felix’s post on Friday about the FB pricing. It seems to me, based on reading these two posts, that this is yet another instance of heads I win, tails you lose phenomenon that so many rail against… By which I mean, by pricing FB at $38, the i-bankers did a pretty solid job of making sure that the company and insiders scoop up pretty much all of the premium while largely leaving the speculators out in the cold. Yet as Felix points out here, it also serves the dual purpose of potentially making the collective i-banks a lot of money should they decide to “short” FB as described here. Or am I being far too cynical?

Posted by GregHao | Report as abusive

@KenG – I think the problem here is that the underwriters have to support their clients, either by exercising the greenshoe to make more stocks available to be traded (should the value pop) or step in to preserve the floor. And if they have to step in to preserve the floor, the ability to make some (you know, it’s all relative) more money is just an unintended benefit.

Posted by GregHao | Report as abusive

Greg, why didn’t they buy all of the shares they initially sold from FB? It wasn’t a question of exercising the greenshoe, as it never even got close to them having to do that.

TED, so would a 10% drop the day after the IPO be considered stabilization? What grade would they get for their stabilization efforts? At least they are admitting they are allowing market manipulation.

KD, I don’t think they found a natural bid for the stock – the undertakers, I mean underwriters, were buying shares back on Friday to keep the price from dropping below IPO price. It sounds like the natural price would have been a lot lower. Besides, if that were the goal, couldn’t they have done an IPO like Google’s (although it’s unlikely they would be willing to copy anything Google does)?

Also, the over-allocation is not the same as a short (at least I don’t view it that way). The over-allocation only gives the underwriters the backing to short the stock (wow, if it’s not the Fed that has their back, it’s the SEC)- they know, as Greg points out above, it’s heads I win, tails you lose. My take from Felix’s post is that they could have bought 484M shares, but chose to only buy 421M. And then they bought shares back from their IPO customers (which they might have sold today, who knows).

I get your irony comment, but it’s still distorting the supply of shares for sale, which messes with the whole supply and demand part of a market economy. And if my broker was saying, sure I’ll sell you shares of Facebook, but I’m not going to buy them just yet because I think they’ll be cheaper tomorrow, then my “broker” is not a broker, but a guy on the other side of the table, and that relationship should be made more clear.

Posted by KenG_CA | Report as abusive

Who profits when the shares fall — the company or the investment bank? Does MS really get to profit if the shares fall below the issue price and they can cover their “short” at below market? Or does MS have to pass that money along to the company or selling shareholders?

Posted by Cowboy9 | Report as abusive

@KenG –

as Matt Levine noted in his post, the point clearly isn’t just for MS to financially rape all parties to the maximum of their abilities – that wouldn’t be good for business. On the contrary, they want to make sure that the sellers (the company/insiders) get a good price, while at the same time making sure that the buyers don’t get completely hosed. It’s an art as well as a science. The Green Shoe option helps them do that by giving the underwriters a little margin for error to put themselves in a situation to naturally support the stock without having risk of getting hosed if the stock rips higher. That’s also why MS stepped in and supported the stock at $38 on Friday, when their max profit would come from letting the stock crash and covering their short in the market at lower prices – that wouldn’t be good for business at all, right? They had to at least try to stabilize the stock – they tried on Friday, and they clearly knew that when they walked in this morning that they had failed.

I think that the buyers of this IPO had their chance to get out on Friday. I think that this IPO in particular was the epitome of retail greed and ignorance – the deal was upsized multiple times both in terms of share quantity and share price – and demand seemed to be regardless of price. People thought they’d have a shot to get rich quick – all IPOs like this go up 100% on the first day, right? (wrong, obv…) However, those ignorant greedy piggish buyers STILL got their chance to get out with their hides intact on Friday. Oh – by the way – I was one of those buyers… even though I only got a teeny allocation, I had the opportunity to get out if I didn’t like it, thanks to the $38 support late in the day, as a result of everything discussed above.

you wrote: “It sounds like the natural price would have been a lot lower.”

well yes – in hindsight – now everyone knows that! That’s because way too many of the buyers I mentioned above weren’t real buyers! they were flippers and get-rich-quick dreamers… Buyers already only got a tiny fraction of the shares they asked for – should MS have priced the deal even lower and cut out a huge chunk of the buyers due to even higher demand at lower prices? that’s the tricky part about syndicate!

ps – retail customers not understanding the deal or not reading the prospectus is, of course, no excuse.

Posted by KidDynamite | Report as abusive

“If they executed that option, there would be more shares in circulation, and the price wold have been lower.”

Huh?!? By short-selling (covered by the option), there *ARE* more shares in circulation. They are simply shares that can and will be withdrawn if the demand is not there to support the IPO price.

“would a 10% drop the day after the IPO be considered stabilization”

No, that would be considered an overpriced IPO.

“it’s heads I win, tails you lose”

Not really. If they work to defend the IPO price (and there is indication that they were doing so on Friday), then they don’t really profit from a falling price. To the extent that they “cover their short” at $38, withdrawing the oversold shares, they merely break even.

If the stock rises, then they execute the option and float the extra shares that the demand clearly warrants. But again, they sold (and exercised) at the IPO price.

They CAN bet against the stock by overselling the IPO and refusing to defend the IPO price. Or they can bet on the stock by holding back a portion of the allotment for their own books. (Assuming that neither behavior is prohibited by the SEC.) But no evidence has been offered that they were doing either one in this case.

Posted by TFF | Report as abusive

@KenG –

ps – you wrote:

“Also, the over-allocation is not the same as a short (at least I don’t view it that way). The over-allocation only gives the underwriters the backing to short the stock”

no – the over-allocation IS the short. The Green Shoe option is what gives the underwriters the backing to short the stock. By “over-allocation” I mean allocating 484MM shares to customers when FB was only selling 421MM shares. that’s over-allocating.

Posted by KidDynamite | Report as abusive

for all interested, Levine wrote another post as a response to this post from felix. Latest is here:

http://dealbreaker.com/2012/05/this-is-a -post-about-greenshoes/

key quote:

“People talk about the IPO “pop” as the incentive for investors to take a risk on a new company, but the greenshoe is part of the same package of incentives: the expectation of a pop gives investors some upside for taking that risk, while the underwriters’ stabilization efforts gives the investors some near-term downside protection. Losing it, either by not having a greenshoe in the first place or by having underwriters primarily concerned with gaming it for short-term profit, would make investors angry, and less interested in buying.

We’ve talked before about how securities offerings are a nice clear case of a key conflict of interest within investment banks, who are charged with helping both their issuer and investor clients even when, as in an IPO, issuer and investors are more or less playing a zero-sum game where every dollar saved by the investors is a dollar lost to the issuer. The greenshoe is a non-zero-sum way of adding value with optimal risk-shifting: it takes some uncertainty about aftermarket performance from skittish investors and gives it, in the form of uncertainty about deal size, to an issuer who is probably better able to bear it (because selling 15% more shares at the price you agreed on three days ago is rarely a tragedy). The structure of the greenshoe, though, adds an additional conflict, in that banks can hoard the value of the greenshoe for themselves rather than spending it on their investor clients. The fact that they basically don’t do that suggests that motive and opportunity aren’t everything: sometimes banks just do the right thing for capital allocation and risk shifting, even when they could make more money doing the wrong thing.”

I will also note that I disagree with Levine’s theory that MS is more likely to have bought MORE than the shoe amount than LESS than the shoe amount on Friday.

Posted by KidDynamite | Report as abusive

KD, you make some valid points, others I don’t buy. They did a great job of getting FB the best price possible, and I guess that’s good for them, as that’s what they’re getting their $175M fee for. Yes, MS tried to stabilize the price, and they failed, but that failure didn’t cost them anything, did it? With a deal like that, why do they even get the fee for underwriting?

Yes, there was plenty of greed by people who thought they were going to make a killing on this IPO. Their brokers obviously didn’t disabuse them os that notion. The size of the IPO was upsized, but someone I know at one of the underwriters told me they were offered a bigger allotment of shares on Thursday – a sign that demand was going to be lower than expected. Maybe that’s why the underwriters didn’t buy all 484M shares? They had an idea it wasn’t going to be a big seller?

I’m not shedding any tears for those who bought the shares, its’ primarily their fault. But it just bugs me that these same firms that get guarantees from the treasury and/or Fed also get a guaranteed profit on these IPOs that also generate substantial fees. Where is the risk/reward part of the system here?

TFF, MS and friends only bought 422M shares from FB, and sold 484M. They should have bought all 484M shares they re-sold, but they didn’t, so only 422M shares were floated. Yet the stock reached a price that was set because the market thought there were 484M shares out.

Yes, they worked to defend the IPO price, but remember they sold 62M shares short. They’re not going to lose money unless they bought more than 62M shares at $38. If they did that, then they failed miserably as the lead underwriter, and should lose money.

KD, on your last point – the over-allocation is a short by FB, not the underwriters. They’re saying to MS that they don’t have to buy all of the shares they sell, they can sell the shares short and come back for more if the price rises.

Posted by KenG_CA | Report as abusive

KD, you type faster than I do. Now I see why Google did a dutch auction IPO, as it eliminated much of the conflict of interest, and quickly established a market price for their shares. So why don’t others use it?

Posted by KenG_CA | Report as abusive

KenG –

“Yes, MS tried to stabilize the price, and they failed, but that failure didn’t cost them anything, did it?”

sure – if the people who bought the stock think that they got screwed, it cost MS a bunch of customers. That’s a point Levine addressed in both of his posts, and the “delicate balance” I was trying to get at…

I don’t want to argue about it, but the over-allocation is not a short by FB – FB has no exposure – it’s the underwriters that have to cover their short: although as some have noted elsewhere, the underwriters don’t really have financial exposure precisely BECAUSE of the green shoe option.

Posted by KidDynamite | Report as abusive

KenG – re: dutch auction: fair question! I think if you read Levine’s latest post, maybe there will be SOME answers, although I’m not saying there are great answers.

I guess the “answer” is that the underwriting/syndicate is a service… maybe they can get the company a higher price (maybe not).. ironically, I think that if FB was done with a dutch auction, the price could have been even higher, and the buyers could have gotten screwed even more…

Posted by KidDynamite | Report as abusive

@KenG – the reason google used the dutch auction system for their IPO is because they had the heft to do so, it is a system that only works for the largest and best known IPOs. And since it essentially screws the i-banks, nobody is out there pushing it as a good way to IPO a company. But you’re right that FB is one of those rare issues which has enough of everything to do it the dutch auction way. And I also agree with KD that buy and hold believers of FB would have really been screwed because the price would have been bid to astronomic levels.

Posted by GregHao | Report as abusive

Um, KenG_CA, if you think its all so easy, why don’t you try underwriting the next IPO?

Posted by niveditas | Report as abusive

KD, I don’t know if the people who lost money on the FB IPO will blame the underwriters; if they are paying that much attention, they probably wouldn’t have bought the stock in the first place.

You can call it a green shoe, and say it’s not a short, but the underwriters sold shares they didn’t own at the time. And since the stock went down, they were able to buy them for less money a day later. And if they didn’t go down, well, they could have bought them for the IPO price. So call it what you want, it’s a pretty good deal.

nivedeas, it takes trillions or maybe just hundreds of billions of dollars other people’s money, backed up by a government that won’t let you fail, to be able to take on the “risk” of underwriting an IPO. If it were really difficult or risky, you wouldn’t have firms fighting over the right to underwrite them. Suggesting I should do that is not very much of an argument.

Posted by KenG_CA | Report as abusive

It’s also worth considering how these things get put together as you gather together your syndicate in the beginning. Some will over or underestimate their demand and their clients can change their minds or their circumstances. This might be at the last minute or soon after issue. The last thing you want is a substantial amount of stock going back into the market because of circumstances that may be completely unrelated to the issue. Nor do you ideally want that to happen when you may know of demand elsewhere that didn’t get their desired allocation. So, with or without the greenshoe option, dispensations are made in the cause of an “orderly market” that allow you to know of both sides. The greenshoe, if anything, makes this less personal and less information intensive. As for the conflict of interest, one thing that militates against this is the extraordinarily nervous nature of a new issue. One really is glad just to get it all away safely and, especially if you are the lead, you are extraordinarily busy, hearing from all your clients just about at once. Managing that properly leaves little time to game it – if indeed you knew which way to go. My guess is that there is greater danger of insider stuff later on, when you know just about where all the stock is and what everyone’s intentions are.

Posted by ChristianThomas | Report as abusive

It’s also worth considering how these things get put together as you gather together your syndicate in the beginning. Some will over or underestimate their demand and their clients can change their minds or their circumstances. This might be at the last minute or soon after issue. The last thing you want is a substantial amount of stock going back into the market because of circumstances that may be completely unrelated to the issue. Nor do you ideally want that to happen when you may know of demand elsewhere that didn’t get their desired allocation. So, with or without the greenshoe option, dispensations are made in the cause of an “orderly market” that allow you to know of both sides. The greenshoe, if anything, makes this less personal and less information intensive. As for the conflict of interest, one thing that militates against this is the extraordinarily nervous nature of a new issue. One really is glad just to get it all away safely and, especially if you are the lead, you are extraordinarily busy, hearing from all your clients just about at once. Managing that properly leaves little time to game it – if indeed you knew which way to go. My guess is that there is greater danger of insider stuff later on, when you know just about where all the stock is and what everyone’s intentions are.

Posted by ChristianThomas | Report as abusive

“Yet the stock reached a price that was set because the market thought there were 484M shares out.”

First, that is an odd factor to emphasize in pricing a company. The “headline” number is 1.2B shares — the fraction of the company a stockholder is entitled to. And that isn’t changed by the over-allocation.

Second, this is standard practice and disclosed in the prospectus. Since IPOs are entirely the playground of insiders, it is a stretch to suggest that anybody was surprised.

Third, by the time the shares stabilized on Monday, there likely WERE only 424M shares remaining out.

Tempest in a teapot.

Posted by TFF | Report as abusive

TFF, if the supply of a commodity is 15% greater than the demand, the price will fall. It doesn’t matter how many shares are outstanding, what matters is how many shares are offered for sale vs. how many shares people want to buy. If there were only 1000 shares for sale, that people absolutely wanted to sell, but buyers for only 100 of them, the price would drop, even if there were a millon shares outstanding. That doesn’t mean the market value is set by the last price paid for those 100 shares, but that is what those 100 shares were worth that that time.

I now realize this is standard practice for IPOs, and that’s what I’m saying is BS. I generally avoid new issues, and really don’t care that some people lost money betting on a quick rise, but I don’t see why letting a select few firms manipulate the process is a desirable thing. It’s a distortion of the free market. And the fact that it is disclosed in the prospectus is irrelevant; people just don’t read the fine print.

Maybe the shares were stabilized by this morning, but that’s not the issue. People get to sell shares they don’t have, and that affects the price. If you don’t think that having 15% more buyers than sellers will affect demand, watch what happens to oil prices the next time production drops even 5%, or should the global economy ever recover (for an example, see early 2008, when oil prices reached $130/bbl. To see what happens when demand drops below the supply, see oil prices in early 2009).

Tempest in a teapot? We know now that for JPM, it was a lot more than that.

Posted by KenG_CA | Report as abusive

KenG, as you say, it is to everybody’s benefit to have the supply match the demand. Since the demand for an IPO is uncertain/developing, then there needs to be some mechanism for the supply to adjust. You can’t expect to predict it accurately before the stock starts trading. Allowing the insiders to offer a conditional supply (conditional on the price rising from the IPO) seems a sensible mechanism.

What you are missing in all of this is the implied commitment for the underwriter to trade COUNTER market swings. If the price rises, then they supply additional shares to meet demand. If the price falls, then they withdraw shares from the float. And yes, this is a “distortion of the free market”, but it is in a situation where the “free market” has not yet had time to be properly established. Everybody benefits from this.

“People get to sell shares they don’t have, and that affects the price.”

Can you please be specific? It doesn’t seem that the over-allotment option will be executed in this case. In fact there is a really good chance that it was fully withdrawn by the end of trading on Friday.

Given the aggressive pricing on the IPO, perhaps they should have gone with a smaller initial float and a larger over-allotment? Might have had an easier time supporting $38 if there were fewer shares out there.

And what the heck does JPM have to do with any of this?

Posted by TFF | Report as abusive

TFF, the underwriter sold 484M shares, but only bought 422M shares from Facebook. Isn’t that specific?

If the goal was to match supply with demand (I’m not saying it should be, just that when it doesn’t, the price gets affected – that’s your free market system for you), it can be accomplished without giving anyone a benefit like the underwriters get. FB wants to go public and sell 422M shares, they say we will take orders for shares at $38M, and you have to have your orders in by 5 pm on Thursday, and the first 422M orders get them at $38 on Friday. If they want a day to sell all of the shares, there is no trading allowed for that first day. Underwriters aren’t necessary any more now that we have computers and the internet.

JPM? I thought your comment about “a tempest in a teapot” was a cut at Jamie Dimon, who said that a few back about their $2B loss.

Posted by KenG_CA | Report as abusive

Forgive my ignorance. In the underwriters’ contracts with the company is there a commitment to support the price of the stock for a period of time? In the standard deal do underwriters purchase an inventory of shares that they bought at a (presumably) lower price prior to the IPO? If so, does that coupled with the shoe align the interests of the underwriters more closely to the buyer’s interests?

Posted by JLRII | Report as abusive

KenG, you also claimed that “the price will fall”. You definitely need to elaborate on that.

Unless you have evidence to the contrary, let’s assume for the sake of argument that MS covered the short on Friday, as the trading repeatedly dipped to $38. If that is the case, then the “depressed price” would be seen during trading on Friday, with the “natural price” being seen on Monday after the float was reduced.

Except that deduction runs contrary to fact. The price was HIGHER on Friday and LOWER on Monday. Do you believe there were more shares trading on Monday than on Friday? If so, please present evidence?

I suppose there are different mechanisms that could work, but you haven’t done a great case of showing flaws in this one. The mechanism seems to be stabilizing, not destabilizing, and I generally favor stabilizing mechanisms. If you don’t like the way that IPOs trade in the opening days, why not just stay away from them?

Sorry, I wasn’t aware that Jamie Dimon was also experiencing teapots. At $6B-$7B, that would be a mighty big teapot!

Posted by TFF | Report as abusive

TFF, when sellers outnumber buyers, the price drops. If ten people want to sell their share of Facebook, but only five people want to buy it, the people who really want to sell their share will lower their price.

I don’t have evidence to the contrary, my comments were based on Felix’s post. I also don’t see why the volume is of importance in this context.

I also didn’t suggest that the system as it is wasn’t stabilizing (the stock is down again for the 2nd straight day, though), just that it isn’t fair. If MS wants to be the channel for FB to sell shares to the public, they should have to buy all the shares that they sell, rather than selling them first and then deciding, after a “natural” price has been reached, whether to buy more from FB or to get them on the open market. But as I think about it, I don’t believe the system isn’t a stabilizing force – a lot of the attention the IPO has received includes people calling it a failure because the stock didn’t go up a lot – people expect IPOS to skyrocket, and if that’s the norm, then the system obviously typically doesn’t stabilize stocks on opening day.

And if we want to talk about stabilizing the stock market, we should eliminate the practice of artificially inflating the number of shares of a stock that are available to own. That (shorting) is not a stabilizing mechanism.

btw, I do stay away from IPOs on opening day. They’re almost always over-priced, and I would rather let the market “discover” the “natural” price. But I don’t eat meat, and I still don’t want meat producers to put unhealthy substances in the meat they sell.

Posted by KenG_CA | Report as abusive

The sentence “I don’t believe the system isn’t a stabilizing force should be “I don’t believe the system IS a stabilizing force”

Posted by KenG_CA | Report as abusive

KenG, both short and long positions can be either stabilizing or destabilizing, depending on how they are executed. Buying NFLX at $300 is destabilizing, because you are driving a high price even higher. Shorting NFLX at that price is stabilizing, because by creating shares you are slowing the rate of escalation. In general, momentum trading is destabilizing. Value trading is stabilizing.

So which better characterizes this situation? If the price suffers, then the short is withdrawn. If the price rises, then the option is executed. Definitely seems to me to be a stabilizing trade.

I’m not sure how to interpret the claim that it is “not fair”? If MS uses this option to defend the IPO price, then they aren’t particularly profiting from it. They sold the shares at the IPO price, and either buy them at that price (executing the option) or buy them off the market (defending the IPO price). Neither action justifies the headline claim.

MS definitely isn’t acting as a typical market participant in this, but we already knew that. The underwriter of an IPO is in a unique position — more of a “market maker” than a “trader”. Both the buyers and the sellers desire stability (at least some assurance that they won’t get caught in a crash with no ability to bail out), so a system that helps to assure that is beneficial to both sides.

The real question isn’t whether or not you eat meat — do you eat fish? Is more relevant to swimming with these sharks!

Posted by TFF | Report as abusive

Felix,
I just want to repeat a comment I left on an FT Alphaville post related to this subject:

http://ftalphaville.ft.com/blog/2012/05/ 22/1010411/greenshoes-facebook-phantoms- and-etf-magic/

“the “existence” of the green shoe shares is a red herring..

of course the shares exist! it’s just a matter of who owns them. before the green shoe option is exercised, the selling shareholders (or company) own those shares. After the green shoe option is exercised, the bank exercising the option owns them (although, as has been explained at length, that bank has already sold them to others!)”

Posted by KidDynamite | Report as abusive

TFF, you’re comparing apples and oranges when you talk about short and long positions. Markets are created for buying and selling of things. A short is not a thing, it’s an artificial creation, and isn’t necessary for the functioning of the market.

Buying NFLX at $300 is not necessarily de-stabilizing, because other people don’t have to follow suit. But if you sell 10M shares of a stock that I own and you don’t, you are impacting the price of the stock without even owning it. If you want to bet that the stock will go down, I don’t have a problem with that, go buy a put, it doesn’t temporarily inflate the number of shares in existence (or is that how they are constructed, via short sales?).

So Felix has educated me once again, on how underwriters are legally allowed to manipulate the stock, and these comments have also enlightened me, as I can see how many people think selective manipulation is o.k. I get it; we want free markets, but some markets can be less free than others, as long as the right people benefit from the loopholes. (Facebook was down another 9% today, so you’ll have to work harder to convince me of the stability thing).

Posted by KenG_CA | Report as abusive

KenG_CA, your comment was “why is MS getting paid for underwriting this when they’re not taking any risk?” If they’re not taking any risk, the poor taxpayers aren’t backing any of that non-existent risk either. So why don’t you step up to the plate and underwrite the next FB for the bargain fee of $10mm? I’m sure you’ll be able to drum up lots of business.

Posted by niveditas | Report as abusive

KenG, you are too smart to confuse association with causation. Yes, the Facebook IPO was overpriced and has proven unstable. But unless those over-allotment shares are still trading on the market, you are chasing the wrong cause.

Moreover, the price did not fall below $38 until Monday. If you foolishly participated in the IPO at the inflated price, you had every opportunity to GET OUT on Friday. This opportunity would not have existed without the green shoe option.

Buying overpriced properties isn’t destabilizing? Truly? You have a decade of recent experience with bubbles, and you still believe that? Shorting stocks didn’t cause the Dot.com bubble. Shorting real estate didn’t cause the housing bubble. LONG positions are implicated in every major instability we’ve seen in the markets.

If I sell 10M shares of a stock that I don’t own, that will drive down the price. If they began at a fair price, then you should thank me and buy more at a discount. Eventually I will need to cover my short — and you will make a handsome profit. So where is your problem with that? Short-selling is only profitable when the shares are ALREADY overpriced, pushed into instability by the “long-horn” herd.

I agree, a short is an artificial creation, not necessary for the functioning of the market. However a market that includes short positions ought to be fundamentally more stable than a market that does not. Even for a strictly long investor like myself, that is a positive attribute.

Please don’t try to sell me on the purity of free and unregulated markets. You don’t believe in them any more than I do.

Posted by TFF | Report as abusive

KenG_CA, you’ve got the supply/demand completely backwards. The existence of the greenshoe means that 15% MORE shares were sold to investors in the IPO than Facebook originally wanted to sell. That doesn’t drive the price up, that drives the price DOWN.

If the system is as you think destabilized because IPO investors think the price is going to pop on the first day, then making more shares available if it does, IS stabilizing. If it doesn’t work to stop the pop, maybe you need a 30% greenshoe instead of a 15%, a 0% greenshoe is going completely in the wrong direction.

Posted by niveditas | Report as abusive

TFF, I never meant to imply that any part of the IPO process caused the instability, only that it didn’t prevent it. And when a stock climbs 50% after its IPO, that is also just as unstable, but only the company is short-changed (although it makes millions of people think they need to be in on the next big IPO).

You know the price did not fall below $38 on Friday because MS was buying shares at that price. Once they stopped buying shares, the price dropped. It’s entirely possible that they bought all of the shares they sold short at $38, breaking even. So they really didn’t assume any risk, did they?

Paying too much isn’t necessarily de-stabilizing, unless a lot of people do that. It’s not the long positions that cause instability, it’s the positive feedback that is inherent in market-based systems that causes instability when unchecked. When people think a stock will go up, they buy it, which drives the price up. When they think it will go down, they sell it, driving the price down. It works in both directions, so it’s not necessarily being long. And besides, you can’t own a stock without being long in it.

My problem with the short sale is that misrepresents the number of shares for sale. If done in enough volume, it is self-fulfilling. What if I have a stock that is shorted, and the shorts drive the price down, and I get a margin call? I’m not going to thank you. I’m not saying we need to prohibit short sales to protect leveraged speculators (I’d rather they don’t exist), I’m just providing an example of how not every shareholder benefits from the shorts. If the stock is over-priced, then it shouldn’t require short sales to bring it to reality. Let those who own it decide to sell it and right-price the stock.

Yes, you know very well that I don’t believe in purely unregulated markets, I was only being facetious. It seems like those who cry the loudest for less regulations are the ones who benefit from the regulations that allow these legal market manipulations.

Posted by KenG_CA | Report as abusive

nvidetas, no, there weren’t more shares sold than FB wanted, they allowed an over-allotment of 15%. However, the underwriters only bought 422M, not the 484M that were sold on opening day. I didn’t say that would drive the price up, only that the underwriters were protected against the loss that would occur by having too many shares out there.

I didn’t say the system was de-stabilized for any reason, only that the system didn’t prevent instability, which is the alleged justification for allowing underwriters to sell more shares then they buy from the company going public.

I did suggest that the IPO process is obsolete, that there is no reason why, with computers and the internet, an IPO couldn’t be scheduled – just like any other round of investment. A company going public could set a price and a date, and anybody wanting to buy shares at that price could commit to the price being demanded. The shares would be allocated on a first-come, first serve basis, and once the allotment was fully subscribed, the shares could be distributed and trading could begin. But that would eliminate easyt profits, wouldn’t it?

Posted by KenG_CA | Report as abusive

“I never meant to imply that any part of the IPO process caused the instability, only that it didn’t prevent it.”

I never said that it WOULD prevent instability, merely that it was a stabilizing force. IPOs are inherently unstable in their early days of trading. Some mechanism to get the supply right (or closer to being right) is helpful. Doesn’t mean it will always be successful.

“It’s entirely possible that they bought all of the shares they sold short at $38, breaking even. So they really didn’t assume any risk, did they?”

They only assumed risk if they bought back MORE shares than they had covered by the green shoe. But then, they only profited from the “short” if they failed to defend the IPO price. I see no indication that they either assumed risk or profited from this arrangement.

“When people think a stock will go up, they buy it, which drives the price up. When they think it will go down, they sell it, driving the price down.”

The limitation here is that you are dealing with a fixed supply. If you have 1 thousand shares available, and 1,100 people are convinced that it is a great deal at any price, the price shoots to the moon. Allow short selling and the other million people are able to chime in on the opposite side of the equation, creating enough new shares to satisfy the 1,100 zealots and a few more to bring the price back down to a reasonable level.

Posted by TFF | Report as abusive

“I did suggest that the IPO process is obsolete”

Quite possibly true — but “obsolete” is not necessarily bad, just sub-optimal.

Even in your model, IPO advisors would be needed to help establish the price. So I suspect the “easy profits” would still be there.

Finally, when I buy shares in a company, I am buying a fraction of their current and future profits. To a first approximation, it doesn’t matter to me who owns the other shares, or whether the fractions sold add up to 100% or not. As long as there is a solvent party guaranteeing my share of the profits, I’m happy. Synthetic shares are fine.

Beyond that first approximation, I am uncomfortable owning shares in a company that is held/controlled by insiders (who may not have my interests at heart), especially when the insiders are busily selling shares into the open market and thus increasing the float. Stocks in that situation tend to trade poorly.

Stocks with a large short position are in the opposite situation. If the shorts accidentally pile in on a solid company, fairly priced, then they get run off the road in short order. The rapid withdrawal of shares from the float caused by a short squeeze can generate large short-term gains.

Heads I win, tails they lose. If the company I buy is solid, then I get either get an exceptional earnings yield on a low price or I get rapid capital gains on the short squeeze. Either way, short activity doesn’t bother me.

Posted by TFF | Report as abusive

“I never said that it WOULD prevent instability, merely that it was a stabilizing force. IPOs are inherently unstable in their early days of trading. Some mechanism to get the supply right (or closer to being right) is helpful. Doesn’t mean it will always be successful.”

I think they’re rarely “stable”, just because it’s new, and will be that way, with or without the manipulation.

“They only assumed risk if they bought back MORE shares than they had covered by the green shoe. ”

But that’s not part of the IPO process, that’s their own proprietary trading. If that action is expected by newly listed company, then I guess they should be paying big fees.

On your second comment, obsolete means there is something better available. The iphone 4 is not obsolete because the 4s is out, as the 4 is less expensive. It’s not the same solution, and meets the needs of some customers. The current IPO process meets the needs only of the underwriters. Who aren’t really necessary. A company advising on the initial price wouldn’t get paid anywhere near what the current cost of the IPO is, and there are probably better ways to figure out a reasonable price than asking totally conflicted brokers driven by self-interest.

I’m with you on owning shares controlled by insiders. But I’m not against shorting because of what it does to me, but rather what it does to the stock. I know people in the financial industry and many investors like it, as it is a useful tool (or weapon), but from an engineering perspective, it is a dangerous element to design into a complex system. While positive feedback is generally a bad thing for systems that you would like some amount of control over, not all negative feedback is good (especially when the negative feedback loop has its own positive feedback loop on it, which is how I would characterize short selling).

Posted by KenG_CA | Report as abusive

“I think they’re rarely “stable”, just because it’s new, and will be that way, with or without the manipulation.”

Absolutely. Doesn’t mean that the manipulation can’t take the edge off it. Even if it was an utter failure in this case.

“there are probably better ways to figure out a reasonable price than asking totally conflicted brokers driven by self-interest.”

Sure, you are welcome to consider those alternatives for your next IPO. I would be interested in seeing something like that happen. Surely the SEC can’t mandate the present process?

Posted by TFF | Report as abusive
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