Based on the facts alone, Cyprus is not Lehman... unless everyone believes that it is.

Greek Islands have a history of hiding monsters in labyrinths: first minotaurs in mazes, now creditors in balance sheets. 

In trying to explain the world, particularly the European world, I often find myself drawn to the works of Alan Furst. In his novel, Red Gold one of his characters is trying to explain why something that seems obvious may not be: "It should, logically it should. But the world doesn't run on logic, it runs on the seven deadly sins and the weather." This is how I feel about the question of whether Cyprus is a catalyst for the reignition of the Euozone crisis or not.

On Monday I wrote that Cyprus was not a big deal, that because of the unique scope and purpose of the Cypriot financial system the decision to require the, largely non-EU, depositors to contribute to the rescue of the financial system was indeed a one off and that this treatment could not be generalized to the depositors in Spain and Italy. Initially the markets seemed to agree with me and during the day on Monday the markets made back all their losses from Sunday night and monday morning.

But, with the typical Mediterranean flair for the dramatic, the Cypriots decided not to depart center stage of the Eurozone financial crisis. No, no and they really wanted their 15 minutes of fame. No more playing second fiddle to Greece or red-headed stepchild to Turkey. This is their moment to shine. So, rather than knuckling under to the Germans and their troika henchmen and henchwomen they sent the bill authorizing the depositor levy down in flames. I'm sure that felt awesome... for about fifteen minutes.

And that's because while it's one thing to tell the Germans and their henchpersons that you refuse to be a party to their nefarious scheme to raise the 15.6 billion Euros necessary to stave off the collapse of the Cypriot financial system it is another thing entirely to raise 15.6 billion Euros all by your lonesome, or even the 5.6 billion you need to unlock the troika 10. Especially if the total value of all the goods and services produced in your economy is only 18 billion Euros per year, and your government only takes in 7.4 billion Euros per year of which it has already committed to spend 8.2 billion Euros meaning it already has to borrow 800 million Euros just to stay in business. Add to this the fact that the government is already in debt to the tune of 14.4 billion Euros. Then ask yourself, given all the excitement in Greece last year, what are the chances that someone is going to lend them another 6 billion EUR so that they can rescue their depositors? By Monday? I feel pretty comfortable answering that one: zero.

Still, they need the money and I think it makes some sense to discuss the how and the why of that. As a person I do not like AT ALL has nonetheless correctly pointed out, Cyprus has a variety of problems. First of all, as mentioned it has a relatively high debt to GDP ratio of 80% and an annual budget deficit of 4% meaning the finances of the state are a bit complicated. Second, as mentioned in my previous blog post, that has a banking system about six times the size of it's economy owing to the fact that it serves as a banking center for Russian companies which are domiciled there on account of the tax treaty with Russia.

It is important to keep in mind what I mean by this. I do not mean to say that this is some kind of illicit haven, the vast majority of the Russia related financial activity is simply to take advantage of the fact that Cyprus has a tax advantaged status within Russia, is withing the Eurozone, and has a robust rule of law. The way in which the banks in Cyprus are related to Russia is not even that they primarily lend to Russia, though they do, but rather that they provide banking services to the many many Russian companies and special purpose entities which are incorporated there. For example Mark Kurtser, is a Russian doctor whose medical company is incorporated in Cyprus, listed on the London Stock Exchange, and does all it's business in Russia. When it needs to do business in Cyprus, it has a bank account there for the purpose.

So simply because the economy of Russia is so large the businesses which do business in Russia but are incorporated in Cyprus have a lot of need for banking services and there are two important implications of that. First of all is that when you are looking at the official records of the Cypriot banking system a lot of what appears to be a Eurozone deposit is in fact a Russian deposit. Dr. Kurtsers company is an EU entity incorporated in Cyprus doing business in Russia. For regulatory purposes, it's accounts are counted among those of EU residents. So when the EU officials are trying to figure out who is who among the depositors in these banks, it's not so easy to do and is probably why they came up with the broad levy in the first place.

The other implication of this is that since most of what the Russian entities in Cyprus need the banks to do in Cyprus is simple cash management the Cypriot banks have a lot of deposits and therefore haven't really needed to issue other forms of capital and so in the event of an insolvency there isn't much of a capital cushion before you hit the depositors. Have a look at the balance sheet of the Cypriot banking system as a whole . You can see that there are 126 billion EUR in assets. Of those, deposits of Euro area residents (which includes locally incorporated Russian entities) are 72 billion, or 57% of assets and external liabilites, that is deposits that are from outside the Eurozone are 34.7 billion or 27% of assets so 84% of the balance sheet is deposits. To give you some perspective, JP Morgan funds only 49% of its balance sheet with deposits.

So here we have situation in which the entire banking system has only 1.7 billion Euros of bonds outstanding. While there is an item on the balance sheet that says the capital and reserves of the banking system are 15 billion EUR I think the fact that the market cap of the Bank of Cyprus, the largest in the country with a 38 billion balance sheet, has a market cap of 371 Million EUR I think we can say that the equity part of the capital structure is 1 billion EUR tops. So we have 1.7 billion in debt, 1 billion in equity and a 120 billion balance sheet. So in the event that asset prices drop 2% the entire non-depositor capital structure is wiped out. This is why the EU/IMF/ECB demanded that the depositors be part of the mix: there isn't anyone else.

And that includes the Cypriot state. We don't know how big the hole in the banking balance sheet is but given the fact that a 15.6 billion number has been discussed we can assume that it is at least that much and is probably more. Let's call it 20 billion. Now let's imagine that the Cypriot state decides to nationalize the banking system. They step in wipe out the stockholders and the bondholders, they're still in waaay over their heads.  They take over assets worth 100 billion (120-20) but owe the depositors 117.3 billion, or they're 17.3 billion in the hole. So the simple act of nationalizing the banks cannot be done without clipping the depositors for more than they would have lost in the levy. That vote isn't looking so smart now is it?

Thus when the Cypriot parliament, themselves in the hole for 14 billion EUR, told the troika where to go with their 10 billion EUR rescue package, they set themselves a real problem of where to get the money. Their first idea was Russia, and you can see why, the folks who stand to lose the most in a depositor levy are the Russian depositors. The thing the Cypriots forgot about is that the Russians don't feel bad at all about their people going broke and sometimes they even lend a hand.The other thing to know about the Russians is that if there are assets to be had, they wait until AFTER the fiasco to snap them up on the cheap. What's more, as anyone who has ever owned a GKO can tell you the Russians know a thing or two about putting the creditors against the wall and they probably think the Cypriots are cowards for even asking for help before an actual default. So as you might imagine, the Cypriot emissaries to the Kremlin have got bubkus.

Well, as I write this the Cypriot parliamentarians are probably rocking out of bed to go legislate their newest plan which is to carve the banking system in two: a good bank and a bad bank. They'll put the insured deposits and the performing assets in the good bank and hope it keeps trundling along. Then they'll put the uninsured deposits and the sketchy assets in the bad bank and slowly wind it down. The key word here is slowly. As you can see from my favorite document, 80 billion of the 120 billion are loans, there are only 10 billion in securities. So the bad bank is going to have to liquidate a loan book which will probably take a lot of time. For this reason the parliamentarians are going to have to limit the capacity of people to remove their money from the bad bank since it will be instantly highly illiquid. Capital controls in an Eurozone state, even if temporary, are a serious source of concern and might make people think that the 10% one time levy might have been better. Yep, that vote looks less smart by the minute.

So then there's the question of whether this is a "Lehman Event" for the Eurozone. I don't think so, even in a worst case scenario where the good-bank/bad-bank thing doesn't work out and you have a sovereign default and Euro exit by Cyprus. I believe this for three reasons.

1.) Scale-- when Lehman went bankrupt it's balance sheet was $639 billion, that's five times the size of the entire Cypriot banking system. The CDS auction to determine the likely recovery rate yielded $0.08 on the dollar implying over $500 billion in losses. This is not even remotely that large. Even a Cypriot sovereign default would not be the end of the world, it's total debt is only 14 billion Euros and at this point I doubt very highly that there are any highly concentrated holders of Cypriot paper outside of Cyprus who would be pushed to the edge by taking a loss on it.

2.) No transmission mechanism-- Lehman Brothers, and with it AIG were major players in the global financial system and had massive counterparty exposure to virtually every other bank in the world. The speed and the potential breadth of the contagion were massive. What's more there were a lot of securities on the Lehman and AIG balance sheets that might be dumped into illiquid markets which were nonetheless used to mark the books of all the other banks in the world which could cause a chain reaction simply through mark to market losses. None of that is possible in this case. Not only are the notional amounts low since almost the whole asset side of the balance sheet is loans just working out of them to pay off the uninsured depositors is probably going to provide lifetime employment for the 8,000 finance sector workers in Cyprus. Unlike a real player like Italy or Spain the scale of the sovereign debts of Cyprus are not large enough to take down any of the European banking system.

3.) Cyprus is a unique case-- as I have repeatedly argued in this and my previous post, there are many things that set the Cypriot banking system, balance sheet, fiscal situation and political circumstances apart from the rest of the Eurozone. I think the ECB, EU and IMF are serious when they say that the solution they proposed in this case was uniquely tailored to the circumstances that prevail in Cyprus and that they are not likely to be used in the case of Spain or Italy. It is disturbing to set the precedent of harming the insured depositors but it was the least bad of most options for the depositors themselves. I think that it's possible that the markets think this if this weeks auctions were any indication.

So though I think this is a special case and I continue to think that this is not even remotely as dangerous as the Lehman/AIG fiasco in September 2008, if enough big investors just read the headlines and don't pore over the balance sheets of the banking system, if they refuse to take the ECB and the EU at their word and decide that a Spanish depositor is just as at risk as a Cypriot then whether I've made a logical argument or not won't matter at all. Market psychology has a logic all it's own and in the event that the markets decide to punish the troika for this then there's no argument anyone can make. If only a few investors panic, then this could be a great buying opportunity. That said if the panic becomes general then, as in 2008, there's no telling where it ends.

Logically, this should be a minor event but, the world doesn't run on logic. It runs on the seven deadly sins and the weather. Thanks for your time.

Why Cyprus Doesn't Matter

Shhhh!!! Don't let them hear your Russian Accent...

So yesterday the Eurozone member states, the ECB and the IMF shocked the world with their demands that depositors in Cypriot banks take a haircut in order to help pay for the rescue of the country's financial system. The shock comes because the nature of what was asked was that uninsured depositors take a 9.9% haircut and, and this is the main point, the INSURED depositors should take a 6.75% haircut. This is unprecedented, the whole point of having deposit insurance is that insured deposits are supposed to be the safest assets there are, you literally cannot lose money because in the event that the bank folds the government is supposed to make you whole.

In a piece of excellent reporting the FT described how this came to pass: it was essentially a coordinated ultimatum from Germany, the power behind the EU since it is the largest contributor to any rescue, the ECB, and the IMF.  The decision produced instant outrage and, to some extent, unreasoning fear in the markets. The Euro dropped a big figure and the Yen rallied 2% as money fled the Eurozone and headed for "safe havens." Pundits in the twitter-sphere high fived each other for beating the Wall Street sell side analysts to the punch in declaring this a terrible precedent that could well push the Euro-zone back into crisis. When the S&P futures opened Sunday night, they were down a percent before Asia even opened. It was a panic.

At the same time as the news was coming out so was a lot of punditry that drove the panic. Various financial journalists were appalled that the Germans, the ECB, and the IMF would collude to destroy the small depositors in Cypriot banks. Not only that, they were demanding that the Cypriot depositors pay up before the bank bondholders and shareholders would have to pay. This seemed like an outrage. What's more, if you imagined that this was going to be the modus opperandi for future rescue packages from the European Stabilization Mechanism then the odds that other countries would choose to apply for them, and thus receive massive speculator destroying ECB bond purchases would decline thus increasing the probability of a reignited speculative attack on the solvency of the Eurozone countries. Pandemonium was on the way and this is why the markets crashed last night and early this morning.

The trouble is, and I pointed this out on twitter yesterday afternoon, Cyprus is a VERY VERY special case and the troika went after the depositors in Cypriot banks for very specific reasons that do not apply to any other country in the Eurozone. Everyone in power knows this but the general reader and the average financial journalist does not. So I will spell it out for you.

The first thing to know about Cyprus is that since the 1990s it has had a very special tax treaty with Russia. The original purpose of this tax treaty was to prevent double taxation of income from investments in Russia which originated in Cyprus, it has had the effect however of making Cyprus an offshore tax haven for Russians both to invest in Russia and to have their money technically outside the Russian legal system. As you might imagine this has had a profound impact on the financial system in Cyprus. Remember that the economy of Cyprus is small. It has a population of 1.1 million, a labor force of about 450,000, and a GDP of about 16 billion EUR. This tiny country has a banking system with 107.8 billion EUR in deposits or 660% of GDP. In the US, bank deposits are about 83% of GDP. So here you have a massive financial system, which actually employs 7% of the working population in Cyprus, funding Russia and providing safe haven for Russian depositors in its banks. What's more E35 billion of the deposits on the Cypriot banking system are in amounts under 100,000 EUR which means they are insured by the Cypriot state.

Now since the financial crisis in 2008 Cyprus has had many of the same problems as Greece with regard to it's solvency and some of the problems of Iceland and Ireland with regard to it's banks. This past weekend those problems came to a head and Cyprus was forced to seek help from other Eurozone members. This presented the IMF, the ECB and the Eurozone member states with a very serious problem. Is the Cypriot state deeply mired in debt? Yes. Will it need to be rescued? Most likely. Is the Cypriot banking system insolvent? Yes, the largest bank in Cyprus is in such bad shape it no longer qualifies for the ECB emergency funding program established in December 2011. Is the Cypriot government capable of making whole the $35 billion of deposits under $100,000 in it's banking system? Not even remotely, Cypriot central government revenues are about $10 billion and it's expenditures are already $11 billion. So what we have here is a collapse in the banking system which, through the deposit insurance scheme will lead to a collapse of the central government finances, which will in turn lead either to a government default or a Eurozone exit either of which may very well result in the reignition of the general Eurozone panic. Time to call in the cavalry: the IMF, the ECB, and the ESM (primarily Germany.)

 It might be tempting to draw a comparison with Greece, which the ESM (nee EFSF) did rescue. There are two differences with that which make Cyprus more complicated. First of all, the main problem in Greece was that the day to day operation of the Greek government was unsustainable. In the case of Cyprus, which does have fiscal issues, there is an acute crisis in the banking system which is forcing the hand of the government early. Second of all, the primary beneficiaries of a rescue of the Cypriot state, and with it the Cypriot banking system aren't even Cypriots, they're not even Eurozone members, hell, they're not even members of the European Union. They're Russians.

According to the ECB, 35EUR billion of the 108EUR billion deposits are from outside the Eurozone, ie Russia. Of the remaining, it's pretty hard to know because Russian money may well be behind an EU incorporated SPV. To come up with an estimate, lets imagine for a moment that the amount on deposit in Cypriot banks by actual Cypriots is similar to that in the Germany which has a 130% bank deposits to GDP ratio, that would mean that something like 80 billion EUR is on deposit in Cypriot banks from Russian account holders much of that is probably decomposed into several accounts below the 100k EUR insurance level to take advantage of the insurance.

I can see the Germans connecting the dots and thinking: "Hold on just one second here. In order for us to defend the Euro and prevent a Cypriot default and potential exit we have to make a bunch of Russians whole on 80billion Euros? What kind of interest rate have they been making on these Cypriot deposits the past few years? 8%? Meanwhile back in Germany depositors in our domestic banks earn next to nothing. And we are going to tax them to rescue these guys? Oh HELL NO! I've got a better idea, why don't we make them pay for their own bailout by confiscating about 10% of their deposits? They'll never miss it, I mean what is that? 5 quarters of interest? To hell with them, let's charge 'em." And that's why they did what they did.

"But wait!" You can hear the financial press exclaim. "What about the retail Cypriot depositor? What about them?" Well, let's look for a second at that. If there are 35 billion EUR in "retail deposits" and 450,000 working age Cypriots that would mean that the average Cypriot has about 78,000 EUR or 5 times the percapita GDP of the country in the bank. Is this likely? Not at all, in fact it's impossible. It is by far more likely that a majority of the accounts under the 100,000 EUR threshold are not retail Cypriot accounts at all but, as mentioned, are Russian accounts purposefully trying to take advantage of Cypriot deposit insurance. So by going after the "small depositors" the Germans are actually going after the more clever Russians.

It is also important to keep in mind that no one can say that this is what is being done. Still less can the implement a policy which specifically targets Russians. There is some effort being made to make the tax 0% on deposits under 20,000 EUR which would probably protect most Cypriots, but the troika had to appear to be addressing everyone equally. Remember, Europe still depends on the goodwill of Russia for it's gas supplies and Russia has many ways of making life difficult for the Eurozone generally.

So what can you take away from this? Well first of all, Cyprus is very much a special case because in its rescue the Germans are being asked to save an EU member state by rescuing depositors in an EU banking system who are themselves based outside the EU and they are saying no. This is not at all an equivalent to what would happen in the event that something similar were to happen in Spain or Italy, both contributors to the ESM, Eurozone members, and EU members. So I don't think anyone should worry about this decision being used as a precedent for other Eurozone states and as people begin to understand that more fully I think the markets will recover. The other lesson is that when the banking system is too large for the government itself to rescue, terrible things happen and as I have written, that is the case in pretty much every state in the Eurozone. So while this will blow over, the larger storm is still coming.

Italian Voters Sack Markets in the Rest of the World

The markets today were blindsided by events in the Italy. The Italians had an election yesterday that has returned a split between the lower and the upper houses such that a government cannot be formed. Not all the results are in but it looks as though Silvio Berlusconi is going to win a blocking plurality of the Senate and the centrist Bersani is going to win the lower house. This is something of an upset. Originally Bersani was favored to win but a last minute surge for a Beppe Grillo, a comedian turned anti-corruption and anti-austerity activist, pulled votes away from him and left Berlusconi with a majority in the Senate. Due to the nature of the Italian Constitution there is some ambiguity as to who will be invited to form a government and if there is not enough clarity new elections in May might be needed. What is clear is that the Italian electorate is not a big fan of government austerity nor by implication the broader strategy of the EU in handling the Eurozone crisis.

So what was the reaction to all this? Well, it was something close to panic. Markets which had been up decently in the morning fell and then more or less crashed. The S&P touched a high of 1525 this morning then pretty much fell all day to close on its lows of 1488, down about 1.8%. European markets got totally destroyed. Why is this? Well, if you recall, the main story in world markets for most of the last three years has been a series of near death experiences of the Eurozone. First Greece went through a near death experience and then, for the private sector bondholders at least, an actual death experience. Then for most of 2011 and the first half of 2012 Italy and Spain were in something of a race to see who would be pushed into bankruptcy first and these bankruptcies were in a race with the EU officials and the European Central Bank to see who, if anyone could put the pieces back together again.

In Italy there was a lot of concern that the country would fold and since its economy is very large that it could take the whole EU down with it. So great were these fears that in November 2011 Silvio Berlusconi was forced from office and replaced by Mario Monti who then enacted a number of unpopular but necessary reforms and began to calm the Italian markets but the panic then moved to Spain.  Then about six months or so ago Mario Draghi the president of the ECB basically said that he would do everything in his power to ensure that the Eurozone did not break up including, conditional on a troubled country taking a rescue from the ESM and imposing its conditions, buying outright the bonds of that country similar to what the Fed is doing in the US with its quantitative easing. Since then the markets have breathed much much easier, Spanish and Italian bond yields have fallen and people have begun to think that the worst was behind us.

Yesterdays election, by showing that the people of Italy are somewhat less inclined to support the continuation of the Monti reforms, much less the draconian policies that would be required under the terms of an ESM rescue package that would trigger ECB bond buying just let the air out of the Draghi hope balloon and resurrected the spectre of a voluntary default or Euro-exit by a major European economy. Either a default or a Euro-exit (which, since the debt is denominated in Euros, would be swiftly followed by a default) would almost certainly destroy the European banking system and with it the European Economy and with that the stability of the world economy. Ergo: mass-hysteria in the worlds equity, currency, and bond markets. Now keep in mind we are in fact a long long way from any of these negative outcomes actually happening and it may well be that cooler Italian heads will prevail (in the event that cool headed Italian is not a contradiction in terms.)

Something that is worth pondering though, if you are an avid reader of Paul Krugman or pretty much any of the people decrying the coming sequester battle you might just ask yourself, "gosh, if the Italians are voting down austerity, shouldn't that be a GOOD thing? I mean, Krugman says that what is destroying Europe is austerity, surely a step away from this would be good. And also didn't President Obama just go on TV today and say that these budget cuts would be bad for the economy?" The trouble with the views of Krugman, and less so Obama is that once you have enough debt you can't just vote your way out of austerity. Stimulus can only be paid for in so many ways: taxation, borrowing and money printing. Italy can't print it's own money. It doesn't want to pay taxes or cut spending. OK fine but what do the bondholders have to say? Well, until Monti arrived on the scene and Draghi announced his intentions to buy the bonds of countries that imposed austerity they were saying, "that's all well and good but we would prefer to not buy your bonds. Actually, not only that, we're prefer to sell the ones we already have. What's more, once we're done selling all our Italian bonds, we'll take it a step further and sell the hell out of Italian banks that we know are loaded to the gills with Italian bonds and can't sell them. 

So even if the voters try to vote "No!" to austerity their vote is not the final one cast. The final one is cast by the bondholders and their vote is probably going to be "Ciao!"

By the way my fellow American Generation Xers and Millenials, this kind of thing is coming within our lifetimes to a Republic near you.

Ackman, Icahn and Herbalife: no longer a blitzkrieg, now a siege

So by now now most people are familiar with key events in the Herbalife drama: The conference call questions by David Einhorn, The massive Ackman powerpoint, The entry of Dan Loeb, the televised Ackman/Icahncatfight, the Icahn 13D, the Ichan CNBC interview, the HLF earnings and the HLF conference call at which Pershing Square may or may not have been prevented from asking questions David Einhorn style.

The drama of the personalities has been so intense I think that many investors who watch this stock, think that there will be some kind of quick dramatic resolution. In this post I will argue that there will not be. I do think that the odds favor one side over the other but I think that we are a very very long way from a resolution, and when it comes most people who trade the name will not be part of it.

First, let's have a look at Ackmans position. He has done 18 months of research and has made a massive presentation outlining it. When the company responded that he simply didn't understand their business he sent them a list of 284 follow up questions and dared them to answer them. In summary, the Ackman thesis is that Herbalife is nothing more than a pyramid scheme. An extremely well managed one, but a pyramid scheme nonetheless.

He claims that the primary rewards to distributors are generated not by actual sales but by recruiting new distributors. In support of this thesis he points out that the company does not really track sales to end users and accuses the company of overstating the value of its sales by recording them generally at the suggested retail price when in reality many of these products are available on the internet not only below the SRP but also below the levels implied by the distributor discounts. 

He also makes the following additional arguments if I may paraphrase his executive summary: 1.) the company exaggerates the chances of success as a distributor, 2.) the company exaggerates the rewards of being a distributor, 3.) there is a high failure rate for distributors, 4.) Herbalife has been the subject of litigation on this issue 5.) the company targets the poor, 6.) the company hides its true nature through obfuscating its compensation scheme, 7.) Herbalife distributors quickly saturate their markets, and 8.) the top 1% of distributors earn almost 90% of all rewards.

Of course, as is well known, Ackman did more than just claim this was a pyramid scheme. He announced his belief that all pyramid schemes are ultimately destroyed, either by running out of new suckers to become distributors or by legal action on the part of the regulatory authorities. Ackman expressed his belief that one or both of these outcomes was likely in the near future. As a result he decided to short 20% of the float of the company, about $1 billion worth. He announced that his target price was zero. As you might imagine the shares of the company cratered, falling from the $40s to the $20s in short order but then began a rather miraculous levitation and have whipsawed around $35 with all the recent news.

Ackman is an excellent dramatist and clearly his firm is thorough. The presentation is well made and has a good narrative arc. It is very long but it doesn't feel like it takes a long time to read and at first glance it seems pretty convincing. There are a number of factors, aside from his research and presentation skills, which help Ackman in this case. 

First of all is the way that the regulatory authorities work with regard to pyramid schemes. They never come out and say “this company is NOT a pyramid scheme.” This is quite logical because there would be nothing to stop someone from then turning such an officially sanctioned firm into a pyramid scheme. So the only proof that the authorities will not intervene in HLF is that that are not intervening, which they may do at any time. Thus there is no way for them to definitively disprove Ackman. 

Second there are a great many regulators involved. The FTC and the SEC at the federal level and all 50 state Attorneys General, so Ackman has 52 bullets and as he has said, all it takes is one. This is quite true. Ackmans publicity campaign, if successful enough, also has the capacity to materially harm Herbalifes ability to recruit new distributors or frighten old ones thereby hastening the effect that Ackman claims is already underway. Ackman is also helped to some extent by the company itself. Whether it is a pyramid scheme or not it certainly does not keep records clearly enough to instantly demonstrate that it is not one. So, Ackman talked a good game and once you read the presentation you can see why the stock went over a cliff after it.

That said, there are a few very important weaknesses to Ackmans case, some of which were pointed out in the Loeb letter. Loeb pointed out that no pyramid scheme has ever survived for more than 10 years and that the majority of those that the FTC shuts down are exposed in less than 5 years. HLF has been in business for 30 years, that's quite a lot of time for a pyramid scheme to survive. While the Loeb letter makes some interesting points I think he is remarkably silent about some of the other weaknesses of Ackmans position.

The first weakness I think is the most glaring: the size of the position itself. HLF has about 108 million shares outstanding. Ackman is short 20 million of them. Now remember before HLF became the darling of the daytraders it traded about 1.5 million shares a day, and let me assure you that once it's known that Ackman is a buyer that's the same side the day traders will be on, so that 1.5 million shares is a good estimate for the real interest in the name. That means that in order for Ackman to close his position he would have to be, under normal circumstances, 100% of the buyside volume for an entire month. Even in the event that he was able to do that in secret, he would almost certainly drive the price much higher. In the event that he was not able to keep it a secret so many people would try to front run him he would soon have to seek an off exchange accommodation with someone who happened to have a lot of shares. I think his price target is zero for a very good reason: short of the company going to zero he can't get out. 

Then there is the issue of the catalysts which would send the stock to zero, remember: it is not enough that Ackman be correct that HLF is a pyramid scheme, it must be a pyramid scheme that comes undone on a time horizon that rewards him and his investors. If HLF keeps the thing going for another 30 years he's in big trouble.

There are basically two things that could kill HLF and Ackman correctly identifies them: regulatory intervention or total market saturation and/or a depleted supply of idiots/distributors. It's true that Ackman gets 52 bites of the regulatory apple but lets look at that a little more closely. He correctly points out that HLF targets the hispanic community. The company has something like 360,000 “distributors” and 90,000 “sales leaders” there's some confusion as to what this means but these people believe that Herbalife is a business they own. Let's imagine for a moment that you are a state AG, how eager are you to shut down a business which has millions of end users and tens of thousands of micro-entrepreneurs, who just happen to be members of an extremely important voting bloc? What's more, even though Ackman has promised to give his share of the spoils to charity, whoever kills HLF will be seen to have done the bidding of a New York billionaire hedge fund manager. You'll need an alchemist like Axelrod to live that down but Axelrod probably won't take your calls. 

“But wait!” our hypothetical AG might exclaim, “I'll be a hero if I shut this thing down because obviously it is victimizing these people.” Will he? Is it? HLF has 90,000 sales leaders, around and a 50% "retention rate" meaning 45,000 of them fail every year but that 90,000 number is pretty consistent so they are also replaced by another 45,000, every year. Yet the FTC has received only 210 complaints over the past several years. How can that be? In the past 5 years hundreds of thousands of these micro-entrepreneurs have failed but generated only a handful of complaints. Not a powerful motivator for our hypothetical AG. “But wait!” he might think, “Even though the damage may not be material, this company is giving them false Hope! We have to stop that.” Now hold on a second, what was the slogan of perhaps the most persuasive political candidate in the adult lifetime of most people reading this? What was his campaign slogan? Hope. Let me assure you, if there is one thing the American political system is not prepared to deny the voters, it's hope.

Well what about the possibiltiy of HLF running out of "suckers" to peddle their products? Well, the trouble for Ackman is that, as far as suckers go, there's another one born every minute. Not only that, though we may have more than our fair share, they make suckers outside the US as well and HLF is all over them. The company operates in 88 countries and though their main growth is in established markets they're not going to run out of people who are concerned about their waistlines or want to be millionaires any time soon. This is borne out by the earnings of the company which have been remarkably consistent as you can see.

So where does that leave Ackman? Well, he has a massive position that is cost prohibitive to close in the open market, he may have seriously misunderstood the incentive structure in which the regulatory authorities operate, and he may have to wait for HLF to run out of countries to open in before the economics start affecting the stock price. This isn't a great position to be in, but it's actually worse than that.

If I had to bet, I'd say that what drew Loeb into this wasn't the economics of HLF but the size of the Ackman short. As Kyle Bass mentioned, being on the other side of Dan Loeb is bad enough, but then Carl Icahn hopped into the mix and now everyone is talking about a “short squeeze.” For a discussion of this and why I think it's unlikely I need to talk a little about what precisely a short squeeze is, so bear with me. 

Short selling is where you borrow the shares of a company from someone and sell them in the open market. Then at a later date you buy them back, hopefully at a lower price, and return them to the person from whom you borrowed them, keeping the difference in price. The lender of the shares is paid a small fee for this called “the borrow cost” which varies with the supply of shares that can be lent and the demand for borrowing them. The way the market generally works is that as part of the custody agreement that an investor will sign with his custodian the investor gives the custodian the right to lend out his shares an the custodian might share some of the proceeds with the client.

It was probably quite easy for Ackman to borrow the shares as the vast majority of the shares of HLF are held by institutions who are more than happy to lend out the shares for a little more edge or lower custody fees. There are, however, a few technical issues that the short seller faces. First of all, the rate at which he borrows the shares can only be fixed for a certain amount of time maybe overnight or maybe Ackman negotiated longer terms with his prime broker but it's not forever and so it is possible that the cost to him over time might increase. Ackman might have to pay higher costs if borrow gets tight but he's well enough financed that increased costs alone will not be able to force me out of the trade.

The more serious threat is that the HLF shareholders from whom Ackman borrowed might want their shares back in a hurry.  In that case Ackman would have to go out and buy them at whatever price he could get or make a off exchange arrangement to get them from a large holder. There are two  ways in which Ackman might be forced to close his short at what would be, given the lack of liquidity, ruinous prices. 

The first is one where all the shareholders needed to have their shares in their physical possession, such as in the case of a tender offer. In the event of a take-private transaction, someone would make a tender offer for the shares, say at $55 a share and everyone who wanted to get $55 would have to get possession of the shares and tender them to the buyer. So when Fidelity or some other company goes to their custodian to get the shares, the custodian would turn around to Ackman and say, “OK, games over, give us the shares back, we have to turn them over to their original owners.” Then Ackman has to go get them at whatever price he can which, as discussed, might be quite high indeed. 

Interestingly the tender offer doesn't even have to be for the whole company, even a partial tender would destroy Ackman. Imagine the following scenario: the company says, “OK, we've got $787 million left on our buyback. Here's what we're going to do. We're going to take $750 million of that and offer to buy 15 million shares at a price of $50 from anyone who tenders their shares to us on March 31^st. In the event of an oversubscription shares will be bought on a pro-rata basis from those who tender their shares.” 

That is let's say you have 1,000 shares of HLF. You tender them to the company and let's say that they get a total of 30 million shares tendered to them, twice what they are offering to buy. What happens is this: they send you a check for $25,000 and your other 500 shares back. With the stock trading at $37, I think quite a few people would tender their shares at $50 even if they knew the tender would be oversubscribed. As mentioned, they would need actual possession of the shares to submit them to the tender. Thus their custodians would have to deliver them to the company which means they would have to get them back from whomever they lent them. So you see, a partial tender is just as dangerous for Ackman as a full take-private transaction. 

That said, I don't think either a partial or full tender are likely to happen. From their recent 10Q, the company only has $350 million in cash. Sure they could borrow the money from Icahn, but it might be hard to justify in subsequent lawsuits why you spent the shareholders money buying back shares for $50 though a tender when the shares are out there in the market offered at $37. I also don't think that Icahn is likely to tender for the whole company. Even in the event that it's actually worth $70 a share or more, that doesn't provide nearly the margin of safety required to handle the additional debt the company would have to take on in order to buy back the shares.

The second thing that might force Ackman to close is if enough holders simply refused to let their custodians lend the shares drying up the pool from which Ackman is borrowing. This is the theory that people who are rooting for a squeeze post the Icahn options exercise believe. It's true that Icahn will probably withdraw his shares from the borrow pool once he exercises his options, but I don't think that will decisively affect Ackman's borrow cost.

First of all, while it's true that institutions are probably selling HLF and hedge funds who think the stock is cheap and/or subject to a squeeze are buying them, you would need an awful lot of people to cooperate in order to lock up enough stock to force Ackman to close. Even at it's zenith the short interest in HLF was 37 million shares leaving more than 60 million out there. At the time, you could still borrow it, it was expensive, but it could still be done. So even if Ackman and Lobe both locked up their shares and as many people piggy backed Ackman as in late December, there are still more than enough shares for Ackman and let me assure you he is getting better terms than any of the other shorts so he'll be the last guy to get forced out. 
 
What's more is that engineering a short squeeze is a non-trivial undertaking and it requires a high level of trust among the participants. Imagine the following. You're a hedge fund manager and you've been following this whole thing. Then one day you get a call from Icahn who says that he's putting together a team to run up the stock price of HLF and try to squeeze Ackman. He asks for you to participate by buying some shares of HLF and locking them up, preventing Ackman from borrowing them. Let's say you do this and sure enough the stock starts floating, then leaping, then screaming higher.

This presents everyone involved in the short squeeze with a dilemma: do I close out, take the money and run, or do I stick around and wait till Ackman folds? The trouble for the squeezers is that if enough of them close out, the squeeze is over before Ackman gets pushed out and the stock crashes back to Earth burning them all. This isn't even the worst case scenario. Imagine a world in which Ackman is able to negotiate with a few of the squeezers in order to safe himself and he does an off exchange transaction to close his position. Everyone who is not in on it is holding the bag when it is announced that the squeeze is over because Ackman is out. Then remember that the leader of the anti-Ackman faction is Carl Icahn, is he the kind of guy you would have to be worried about cutting a separate deal for himself with Ackman? Yes he is. Thus I think it will be very very hard to engineer a squeeze. 

The last thing that might force Ackman to close out is that he just runs out of money to maintain the position. Recently there was a  bizarre Reuters article that claimed that since Ackman put up cash to fund his short position in HLF that he was not vulnerable to a short squeeze. This is preposterous. It's true that he's not borrowing money, but it is also true that he IS borrowing shares and therefore there is a price at which he may have to buy back those shares which would exceed his capacity to do so. His prime broker is well aware of this fact and so in the event that the shares go higher he is going to have to put up more cash in order to maintain the position.


The thing is, for Ackman, it doesn't even have to be losses on HLF itself that force him out. Ackman is the head of Pershing Square Capital, a hedge fund that has concentrated positions in a number of companies. Even in the event that he fully funded the HLF short with cash as Reuters alleges, it is important to remember that Ackman's positions are almost certainly is cross margined.Thus the exposure of the entire firm needs to be taken into consideration. If a reversal in the fortunes of JCP, or Canadian Pacific depletes the capital of his firm, his prime broker may force him to trim his risk in HLF and as discussed, once the hype dies down and it's only trading 1.5 million shares a day, that could take some doing.  Personally I don't think this is likely to happen any time soon but it is a possibility and it is an issue that Icahn does not face. Icahn has the money, and it's his money.

So where does that leave us? Basically it leaves us in a waiting game between Ackman and Icahn, something totally different than the exciting clash of wills that is being portrayed in the press. Whether HLF is a pyramid scheme or not is only cosmetically the central issue. For Ackman to win it is necessary condition that HLF is a pyramid scheme but it is not a sufficient condition. Either the company must be investigated and destroyed by the authorities or they have to be destroyed by the economics of being a pyramid. And one of those things has to happen before 1.) someone decides to initiate a tender or partial tender offer. 2.) either losses in HLF or elsehwere or redemptions from his fund force Ackman to close the position. Since none of these events is likely to happen in the near term, by far the most likely outcome is that the company continues to operate as it has for the preceding 30 years, and the stock grinds higher albeit with a lot of volatility as all the weak hands piggybacking Ackman and Icahn are shaken out with each new announcement of positive or negative news.

So what's Icahns game in all this? I'll tell you. Icahn doesn't need to actually cause Ackman to be forced out, he just needs to be there when it happens. You see, if and when Ackman goes to the wall, for whatever reason, it will not be possible for him to close out his position in the open market. It's simply too big and the market is too thin. He's going to have to negotiate a private transaction with someone who can give him the shares he needs and he'll have to pay whatever price that guy wants. Icahn wants to be that guy. Doing off market transactions in size with a highly motivated counter-party is what made Icahn famous back in the 1980s. I'll tell you what though, you don't want long HLF when that happens because once the drama is over, the stock will crater the next day. The retail daytraders may help Icahn run up the stock, but for the same reasons other hedge fund managers will hesitate to get involved in a squeeze, they won't be part of the payoff. In the meantime Icahn gets to buy a large stake in a company that is growing at double digit rates for about a 9 PE and when Ackman needs him, he knows how to find him.

Time to tighten the chin strap on the helmet folks: the Eurozone endgame is underway

So today was the biggest stock market rally in months and there were a lot of good reasons for it. Though the ECB left rates unchanged there was some hinting that in the event that things got worse that there could be some additional easing at the next meeting. Since virtually all the data coming out of Europe is negative this seems like a lock. Then there was speculation that the Fed itself might ease sparking a big rally in gold but when the Beige Book came out better than expected this afternoon gold fell off but the rally kept on. Indeed, the strongest part of the rally was in the final 15 mintues when the market exploded higher on strong volume. If you ask me the most powerful thing behind the rally today was the Reuters story about the EU preparing a package for the Spanish banks.

Now while there has been a lot of talk about Greece and the Greek restructuring and the new elections on June 17^th which may result in the election of parties unfriendly to the austerity regime being elected and taking Greece out of the Eurozone, ground zero for the Euro-crisis as of now is the Spanish banking system. First of all, by far the most likely outcome is that the Greeks elect people who will maintain the agreements that have kept the country solvent. Even in the event that they don't most of the private sector creditors of Greece have already taken all the losses they are going to take in the event of a Greek default/Euro exit. The only people who will be hit by a default now are the ECB, the IMF and the EFSF all of which are ultimately backed by the Eurozone sovereigns or the world at large. As far as Greece goes the pain is over. The worst thing that would happen is that it would trigger contagion and maybe force Ireland and Portugal out as well but this is not too likely and in any case would probably not be fatal to the Euro project.

The same can not be said of the collapse of the Spanish banking system. Unlike the Greece and Portugal, Spain is a major economy in Europe and the Spanish banking system, at least at the top end, operates in the pan-European market and has close relationships with the other major banks in the Eurozone. As far as I am concerned the solvency issues in the Spanish banking system are by far the most important thing facing the Eurozone and this is because they are so large that if it becomes necessary for there to be a capital injection into the Spanish banking system the Spanish state is simply not large enough to do it. To give you a sense of what is involved the top two banks in Spain have balance sheets totally $2.45 trillion. Spanish GDP is $1.4 trillion. That is to say the top five banks in Spain have balance sheets about five times the size of the entire economy of Spain. It is estimated that the real estate losses on the balance sheets of the Spanish banking system amount to something on the order of $300 billion. That is a BIG BIG hole in the balance sheet of the financial system. Another thing to remember about Spain, and the whole of Europe for that matter, is that there is no such thing as the FDIC. If your bank goes under because it got smoked lending money to Brits to buy vacation homes in Marbella guess what fraction of your deposits are insured: zero. Yep, if your bank folds you get nothing. This means that once it dawn on people in Spain that there is this big hole in the financial system you will have an old school run on the banking system and someone is going to have to step in there and sort things out. The trouble is, the Spanish government isn't big enough to do it.

Now thanks to the magic of leverage and fractional reserve banking the total amount of equity that would have to be injected into the banking system to maintain its solvency is something more along the lines of $40-$80 billion but given that Spain is already borrowing at 600 basis points over Germany just to fund its regular deficit I think it is safe to say that there is no way in hell that it will be able to tap the capital markets for something that size in the event that they need to do so. Especially if the triggering event is a Greek or Portugese default which will cause a general abandonment of Eurozone sovereign paper for a while. So, like it or not, Spain is going to need outside help and the fact that some Eurocrats rang up Reuters and told them that they were hard at work on contingencies seems to have calmed the markets fear that the worst case scenario is off the table.

That said, personally I think this is just beginning. Spain has not asked for help, and the EU has made no official announcement. This is simply and off the record discussion that the EU is making plans to help Spain in the event that Spain needs the help. What will now commence is a very intricate dance whereby Spain will move in the direction of taking the aid. It helps that the EU seems to not want to make aid to the Spanish banking system contingent on additional reforms or on a generalize EU banking union but the Spanish government will still be reluctant to accept outside assistance if it can possibly avoid doing so. As a result it will be up to the markets to compel the Spanish to do so and I think the markets will probably oblige. So while today was a great day, I think there will be some more excitement to come.

That excitement will start tomorrow when the Spain tries to borrow $1-$2 billion in a debt auction. This will be interesting because it's very likely that today's announcement was driven by the Spanish claim on Tuesday that they were being shut out of the capital markets. Personally I'm not sure what will happen tomorrow. If the auction goes terribly will the markets assume that the Spain is going over a cliff and sell off or will they think that a rescue is now certain and rally. If the auction goes well will the markets assume that everything is OK and rally or will they think that the stage has been set for more wrangling between Spain and Germany and sell off. I really can't say. All I can say is that this is neither the beginning of the end nor the end of the beginning. It's just the beginning.  

The Facebook IPO: An orgy of game theory in which everyone is screwed

So, I did my best to ignore the Facebook IPO during the frenzy which led up to the actual issuance of the shares. Sure I love Facebook, I'm on it all day. You're probably reading this through a link I posted to it. The start of my career in earnest was marked by Netscape, the first mind-blowing IPO of the internet boom. I went on to make my first career trading equity volatility in the telecom and media sectors during the first internet mania and collapse. I went on in my career to build infrastructure that supported the largest IPO in the history of the Middle East so I know what the IPO process looks like from the inside. Still, I have ignored the Facebook IPO and this is because, now that I know in excruciating detail how the entire process works, it disgusts me.

So now the inevitable has happened. The IPO process smashed into the hopes of the investors like a freight train and clipped them for 18% of their investment in the first week and 30% in the first two. It's hard to exaggerate just how big a fiasco this is. Over $4 billion of investor funds are up in flames and since this was meant to be “the peoples stock” with a massive 25% allocation to retail, mom and pop investors have been smoked to the tune tune of over $1 billion. Ouch, that will leave a mark. Indeed there have been a slew of articles talking about how the Facebook IPO has cooled the IPO market for other companies in the pipeline.

Now the recriminations begin. The journalistic community and the tort bar have both been beating the bushes to find the villains behind this who can be excoriated to drive page views or vilified and then shaken down for cash. This is entirely natural but I think it does a disservice to the public because it seeks to explain the outcome in terms of personalities, which granted are very interesting, but it allows the narrative to ignore the complexities of the IPO process itself. I think this is a disservice because in this case what has happened is not that some villains seized control of the process, indeed while some dubious decisions were made I'm quite certain that no laws were broken. No no, the problem here is not that some villains manipulated the process, the villain IS the process.

The important thing to keep in mind that this story is not about what Facebook is actually worth in terms of its balance sheet or income statement. No human being could possibly tell you that. Indeed, everyone with access to the US equity markets voting with their dollars for the past two weeks can't come to an agreement within $4 billion dollars on any given day. There have been stories about how some analysts lowered their estimates but didn't tell clients because of the quiet period and the implication is that some people got advanced notice and trimmed their bids. Let me assure you that anyone with privileged access to Wall Street research could remember the '99-2000 era and knew full well that the pricing and trading of Facebook was going to have nothing whatsoever to do with what the Wall Street analysts though 2013 revenues were going to be. The real value of Facebook has nothing to do with its revenues per user, or its compound annual growth rate, or any other measurable statistic. Everyone in the game recognizes that Facebook is a one off, a business that no one fully understands other than to know that it is huge with a ton of potential. Facebook is a dream of a company and the price of a dream is easy to calculate: it is worth what people are willing to pay for it. No more. No less.

Now I realize, dear reader, that this may seem manifestly unhelpful but behind what seems a free market tautology are the more disturbing questions about the Facebook IPO and therein the black magic lies: Who came up with the the IPO price and how did they do it?

The process by which an IPO is priced is called a “book-building.” Bookbuilding is a slow motion, mediated auction with several stages. The first is a filing with the SEC announcing the intention to list, and giving the fundamental details of the company and the offering as prescribed by law. Then there is the road-show where the bankers and the management travel around the country meeting with potential investors, answering their questions and feeling them out for their interest in the deal. It's kind of like dating where the company and its potential investors meet each other, tell jokes, buy each other dinner, and decide whether to take their relationship to the next level. Then begins the formal book building. The bankers have made a back of the envelope calculation of the company and come up with a range. In the case of Facebook that range was $29-$34. Then they invite people to submit orders to them.

There are several answers to the question “who.” First there are the potential investors who at the highest level can be broken down into retail and institutional investors. Usually retail investors are not invited to submit bids, their decision is generally a binary one: are they in or out at the price whatever it may be. The people who determine the price are the institutional investors. These in turn can be broken down into “hedge funds” and “real money” who are mutual funds and the big pension funds and insurance company funds. These institutional investors decide how much they want to participate in the IPO and then submit bids with a maximum price and for a specific amount of shares. These bids are received by second half the the “who:” the Equity Capital Markets (ECM) teams at the banks in the IPO syndicate who then manage the how: the “book build.”

As I have said a book-build is a mediated auction. By “mediated” I mean that the ECM teams, the “auctioneers” if you will, have sole discretion in the outcome of the auction both in terms of what the final price is and in terms of which investors get how many shares. An unmediated auction is what you might see at Sothebys recently when “The Scream” was auctioned off. The bidders turn up at a set date and time, and then they bid against one another and the highest bidder wins. In a book build the ECM teams collect all the bids from all the market participants and then they alone decide at their own discretion what the final price will be and which of the bidders will get how many shares, indeed this is what the company that hired them to conduct the IPO is paying them for. This process is highly opaque but I will try to illuminate it for you.

In business, as in life, always remember that people respond to incentives. If you can discern the incentive system in which someone perceives himself to operate you may as well have read his mind. So what are the ECM guys trying to achieve? They have several objectives. First of all they want the IPO to be a success and a successful IPO is one in which both the company and the investors are happy. This is important because if they shortchange the company they might have a hard time attracting future IPOs and if the investors aren't happy they might have a hard time selling future IPOs. That is, the ECM guys want to stay in business.

Beneath that they have some conflicting incentives with regard to the investors they select. In general they want the stock to pop a little on the first day to make the investors happy but not so much that the company feels as though it has left a lot of money on the table. To achieve this the ECM guys try to manage which investors get how many shares. They try to give large allocations to “real money” investors who will be in for the long term and small or zero allocations to “flippers” that is hedge funds who are mostly investing in order to ride the one day pop and then flip the shares. Within this there is also a certain quid pro quo wherein large clients of the syndicate member who pay a lot of fees and borrow a lot of funds and therefore pay a lot of interest will receive favorable treatment come allocation time relative to smaller clients and new clients had better be convincing that they intend to expand the relationship with the bank into other areas. So in sum, at the strategic level the ECM team needs to balance the price between the company and the investors in order to stay in the IPO game and on the allocation side they want to have the right mix of investors to support the price and they want to reward their high fee paying clients.

How about on the investor side? Basically there are two kinds of investors the “real money” guys like pension funds and insurance companies who are longer term in their outlook and who generally rely on the constant contributions from employees or policyholders to generate the funds they manage. Then there are the, mutual funds and hedge funds that have to compete with one another for investor assets to manage. “Real money” accounts are generally more patient investors and are mandated to match assets to future liabilities. Thus they tend to be more risk averse so they are more sensitive to price in IPOs. If they think the price is rich, they'll hold back and if they think the price is fair they'll participate to a greater extent. They have a lot of influence over most IPOs because the ECM guys think they're unlikely to flip the shares but because they are so sensitive to price they are less influential in a deal like Facebook. 

The incentive structure for the funds that have to compete for investor assets are much more complex. First of all remember how the managers are compensated. Generally mutual fund managers are paid a percentage of assets under management and hedge funds are paid a percentage of assets under management plus a share of the profits of the fund. This means that for both of hedge and mutual funds a primary driver for compensation is to have as many assets under management as possible and, for the hedge fund managers, if they can hit home runs while they have a lot of assets under management they can become dynastically wealthy. Next remember how they compete with one another for those assets, through a combination of risk and return, they want the highest return for the lowest risk possible and they need to produce better returns at lower risk than their competitors.

Now think about what this means for the incentive system in which the fund managers operate. IPOs, properly priced, are almost a sure thing investment, so everyone has an incentive to be involved. What's more some of the checks on the “real money” funds don't operate on the “fast money” funds. Remember that they are judged relative to their peers, so if everyone gets into the IPO and it performs poorly then the fund managers are no worse off, but if their competitors get in and they don't and the IPO turns out to be a massive win they are behind from both a performance perspective and a volatility perspective. So if it looks like there might be a pretty good IPO coming down the pipe a lot of fund managers will feel as if they must participate and therefore they are likely to be pretty aggressive in trying to get into them and to get as large an allocation as possible. It goes without saying that they are likely to be much more aggressive than the "real money" accounts in such a case. 

So this brings us to the Facebook IPO which has some unique features of its own. First of all is the nature of the company. It is a unique and possibly the most widely known company on the face of the Earth at the time of its listing. Given its spectacular growth, its short operating history, and the fact that is in a business which practically only existed as long as it has mean that arriving at a valuation based on comparables or history is virtually impossible. This means there are not a lot of solid benchmarks for analysts and investors to anchor their valuations to and that makes the mediated auction even more influential in determining price. Also it relaxes the constriction on the ECM team to get the price right. Since the IPO is so much different from all other IPOs an error one way or the other won't necessarily harm the future IPO business of the lead underwriter as other firms might consider this particular IPO to be a one-off.

If the constraints on the ECM team are relaxed a little on the valuation side of things they become massively more intense on the allocation side. For something like this anyone who is benchmarked against other technology funds ABSOLUTELY MUST participate in the IPO. If it turns into a huge home run and they are not in, their investors will wonder why. Did they just not have enough influence with the syndicate to get an allocation? Were they not smart enough to know that it would be a huge hit? How could that be? It's Facebook for crying out loud! On the other hand, since everyone has to be in, if the deal turns out to be a dud then all their competitors are smoked as well so they're not worse off on a relative basis. The thing is they have to get into the deal and they have to get a meaningful allocation. And this is where the game theory orgy takes over.

So let's say you want to get a large allocation in a mediated auction. How do you do that? Well, you can try to make sure you are the highest bid. So when Morgan Stanley announces the range is $29 to $34 you might want to be toward the top of that. Of course this is Facebook so you can probably guess that there will be plenty of people willing to pay $34 just to make sure that they're in the game, so you might submit a bid above the range. Actually, the syndicate will go you one better. They'll allow you to submit something called a “no limit” bid that means you will match the highest bid there is no matter what it is. Some nutcase is bidding $70 a share? You're with him. Of course you're assuming that whoever is the highest bid is less crazy than you, not always a safe assumption in this game and in any case you think the ECM guys won't price it too high lest it fall, also not a safe assumption. In essence,  it is so important to you to get an allocation of shares that you're willing to abdicate your influence over the price to marginally increase the chances that you get an allocation. Given how important it is for the competitive position of the various funds I'm sure a great many did precisely this. But it's not enough to get an allocation, you need to get a meaningful allocation. Lets' say for example that you submit a no limit bid for 100,000 shares and the IPO is oversubscribed many times, you might come away with 7,500 shares. That's nothing! You may as well not have been in the game. So if you want 100,000 shares, you might submit an order to 750,000 shares. Then, when the bankers go through their spreadsheets and decide who gets what now you might just get a decent sized allocation. And you know you won't get the full allocation because you know that the deal is sure as hell going to be massively oversubscribed.

Well so this is what happened. There the ECM guys are sitting in their conference room receiving bids all day long for weeks in front of the IPO. They are literally deluged with bids, a lot of them through the original price range. So many in fact that they raise the price range to $34-$38. Then they are deluged with “no limit bids.” So many that they can fill the whole offer at $38. Then they're also swamped with the sheer size of the share requests such that the IPO is “many many” times oversubscribed. And that's not all, not only are you overwhelmed with by the high price and the massive size you are absolutely swamped by requests from every client service person in the firm to look after their “very important clients.” It's hard to exaggerate the pressure the ECM team is under in the final days of the book-build to make everyone happy. And that's what the guys at Morgan Stanley tried to do.

They raised the target range from up to $34-$38 to make the company happy and in the end they priced it a the top of that range at $38. They almost certainly had so many no limit bids that they could have priced it even higher, I'm sure they thought they were leaving something on the table for the investors. They probably thought it would go to $45 or something on the first day just when they saw the demand. Indeed, even after pushing up the range they were still so overwhelmed with demand that they grew the offering size by 25% this enabled them to give their clients larger allocations and make all the whiney salespeople whine a little more quietly. I'm sure that it seemed all was well.

Alas, it was not so. Now imagine the position of our hypothetical hedge fund manager who, when the range was $29-34 submits a “no limit” bid for 750,000 shares thinking he'll get maybe 100,000. Well, now that they've grown the offer and, if he's done a lot of whining, he's probably wound up with 250,000 shares at $38. Hey now! That might be a little too many shares at far too high a price, but let's see how it trades on the open. Well, it trades up a little but there are these problems at NASDAQ and it starts trading off, what is he going to do? He's going to sell! And that is what has been happening, the crazy people who wanted as much as they could get at any price two weeks ago are getting shaken out and in their stampede for the exits they are crushing the living daylights out of the stock.

And that in a very long nutshell is what happened. There is no single villain or even group of villains. The nature of the incentive system in which fund managers operate compels them to bid with extreme aggression for access to an IPO of this kind. The very aggression with which they bid relaxes the incentives to constrain the valuation that operate on the ECM team and pushes them in the direction of allocating more shares to the institutional investors than they actually want which triggers a massive wave of selling when the post IPO demand fails to match up with the pre-IPO demand. Of course the Mom and Pop retail investors who just wanted to own a piece of Facebook have no idea how this all happens and most of them will probably hold onto their shares in the hope that things will turn up someday.

Meanwhile, as of todays close they've lost $1,450,000,000. Sorry guys, welcome to the big time.