Friday’s news was dominated by the Facebook (FB) IPO. I don’t have much to say about Facebook qua Facebook or IPOs: not my area. I will just say that it is hard to justify the valuation. The only rationalization I could provide is that the $100 billion plus market cap is the premium on the option to monetize its huge base of users. I say option, because its clear that the existing sources of revenues can’t support the stratospheric evaluation. There is a tremendous amount of uncertainty about the ability to devise such a monetization strategy, and that can support some high option-driven valuation-but $100+ billion? I’m skeptical. (And if there are doubts about the ability to monetize Facebook’s user base, what does one even say about Twitter?)
I will comment on companies associated with the IPO that are closer to my comfort zone: NASDAQ and the underwriters, specifically Morgan Stanley.
The IPO was beset by technical hitches, with a delayed opening, difficulties in handing the avalanche of orders in the opening process, and a consequent delay in sending out trade confirmations-something that is guaranteed to generate extreme angst among those trading the stock.
This suggests that despite its extraordinary efforts to prepare, NASDAQ had insufficient capacity to handle the huge interest in Facebook. This, in turn, harkens back to an issue that was the subject of the first SWP post, almost 6.5 years ago: exchange capacity and capacity outages. I seriously doubt it would be efficient for NASDAQ to invest in sufficient capacity to handle such an extreme case without any hitches. That is, in an efficiently scaled system, there should be occasions when capacity is maxed out. It doesn’t make sense to build capacity to handle all contingencies.
The benefit from investing in the additional capacity to handle the FB IPO would redound almost exclusively to FB and those who wanted to participate in the IPO opening. It doesn’t make any commercial sense for NASDAQ to pay for that. The investment is pretty much specific to FB, so if it wanted the additional capacity, it should have paid for it.
This raises another issue that I’ve discussed from time to time, although in a slightly different context: the pricing of exchange services. What should NASDAQ have charged to handle the IPO, and what price would FB have been willing to pay to reduce the likelihood of SNAFUs? This raises some interesting industrial organization issues as well, as in this context it involves the arms-length negotiation of a specific investment. Integration is often the efficient response to such a situation, but that appears problematic to me in this context.
Insofar as the secondary market trading is concerned, this is an example (the Flash Crash being another) of the implications of the SEC’s “information and linkages” market structure choice inherent in RegNMS. This approach results in fragmentation and locked and crossed markets during periods of extreme market activity.
The alternative is a central limit order book, but a CLOB would likely have experienced different problems, likely similar to those experienced in the NASDAQ open, since the huge amounts of trading activity likely would have taxed and perhaps overwhelmed the CLOB’s capacity.
Again, the exceptional nature of the FB IPO would have likely stressed any market mechanism. What happened yesterday is how the information-and-linkage approach behaves under stress-fragmentation and crossed markets.
On to Morgan Stanley. It is evident that the underwriters-of whom MS was the leader-bought large quantities of stock to support the $38 issue price. The exact total amount, and the amount bought by any of the underwriters, is not known, but it could represent billions of dollars. The underwriters can’t afford to grant free puts for very long, so it is quite possible that Facebook will trade below the issue price, thereby imposing losses on the underwriters.
This experience triggered my historical reflexes, and I thought about the experience of another legendary underwriter-Jay Cooke. There are some superficial similarities between Cooke and MS. I don’t take them too seriously, but one can hear echoes.
Cooke was the lead underwriter of another innovative entity with a dicey revenue model: the Northern Pacific Railway, of which Cornelius Vanderbilt said “you can’t build a railroad from nowhere to nowhere.” Jay Cooke & Company underwrote sales of the railroad’s bonds, and ended up taking ownership of large quantities of them, in anticipation of selling them-and selling them particularly to Europe. But it proved unable to market the bonds, due in large part to economic shocks emanating from Europe: there were several bank failures in Europe in Vienna that spread to other European countries. Moreover, there was a monetary shock emanating in Germany-namely, that country’s decision to cease minting silver coins-that had averse consequences for the US. Furthermore, Germany demanded a large reparation from France in the aftermath of the Franco-Prussian War, which was also financially destabilizing.
Once Cooke & Company’s depositors became concerned about the company’s inability to market the bonds, a run commenced, and the firm suspended and went into bankruptcy. This sparked a broader financial panic in the US-the Panic of 1873.
So, in both 1873 and 2012 a big investment bank takes a large position in a company with a highly speculative revenue model, against the background of financial crisis in Europe.
We saw what happened in 1873. We will see what will happen in 2012. Almost certainly the outcomes will be quite different, because even if MS took a multi-billion dollar stake in Facebook, this is not a bet-the-company investment in the way that Cooke’s foray into the NPRR was. It may cause some discomfort for MS and its shareholders, but likely nothing more than that.
And of course, the biggest difference between 1873 and 2012 is that there was no Fed in 1873. Again, I do not consider it at all likely that Morgan Stanley would be mortally harmed even if Facebook stock falls well below $38, but if it were the post-Lehman-we’re-not-going-to-let-that-happen-again-Fed would no doubt ride to the rescue, raising the question: would it take Facebook shares as collateral?
This seems like a highly speculative question, and perhaps even an idle one, but in these times one cannot rule out anything, no matter how fantastical it appears.
Addendum: The most likely reason why the Fed would be taking FB shares as collateral is if Europe well and truly implodes, and threatens to take down US institutions along with it. The risk of a FB position alone is not great.