Boy it doesn’t suck to be a banker.

Henry Blodget|Aug. 18, 2012,  9:41 AM

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

And this latest one is a beauty.

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

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

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

But that was only the beginning.

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

How did the bankers make this second bonanza?

By shorting Facebook’s stock.

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

Seriously!

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

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

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

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

Through something called the “overallotment option.”

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

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

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

And if the stock drops after the IPO?

Well, then the bank really cashes in.

Because then the bank makes money from:

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

And that’s just what happened with Facebook.

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

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

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

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

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

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

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

Read more: http://www.businessinsider.com/facebooks-bankers-shorting-facebooks-stock-2012-8#ixzz247Cbz0li