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Initial Public Offerings

By James H. Nolt

Two weeks ago I introduced the idea that it is sometimes strategic for capitalists to avoid equilibrium prices. Since all the claims textbook economics makes about the fairness, efficiency, and stability of markets depend on trades occurring at equilibrium, this activity confounds those fundamental premises.

Textbooks teach so many misconceptions it is a challenge to select the worst offenses, but certainly anything involving money and credit is high on my list. There are various ways that credit can be provided. However, rather than introducing the real variety, textbooks create a stylized myth of banking in order to develop a tame image of a wildly diverse financial system. Economics should be more like biology, which highlights the diversity of life rather than assuming that life always takes one of a few simplistic idealized forms.

I will explain two frequent and lucrative circumstances when financial capitalists prefer disequilibrium pricing to equilibrium pricing, when prices are determined by the balance of supply and demand: initial public offerings (IPOs) and speculation when it is combined within pricing power. Both are largely ignored by textbook economics since they violate free market and equilibrium assumptions.

IPOs are the principal means by which governments and large firms raise new funds from the public. Most new issues of stocks and bonds use the IPO method. There are other possible means, such as the auctions that are now typical of U.S. government bond issues, but few creditors have the power to demand auctions. The investment banks that create most securities (stocks and bonds) prefer IPOs.

IPOs illustrate the hierarchy of power within finance. They start with an issuer who wants to borrow using bonds or add to existing capital by issuing new stock. The chief financial officer of the issuer meets with an investment bank, which is called the underwriter, to structure the IPO. Its job is to decide how to raise the funds required and the issue price. The underwriter proposes this to the issuer, who can accept it or possibly negotiate modifications to the deal.

Once the issuer and underwriter sign the deal, the underwriter prints up the new securities and begins to market them. Some may be offered directly to favored clients of the underwriter. Most are typically divided among a number of brokers who will sell them to the public initially (hence initial public offering). The broker begins “dialing for dollars,” calling up their clients to sell the new securities.

The underwriter makes its money immediately if the IPO is successful. Success is defined as placing all the shares or bonds. Because the prices are decided by the investment bank (not a market), they guarantee their initial profit. For example, an underwriter of new Argentine government bonds might offer the Argentine government $9,200 for bonds obligating Argentina to pay a face value of $10,000 in 10 years plus a fixed interest rate of $500 per year (5 percent). The shorthand notation of such a price is just 92, meaning 92 percent of the face value of the bond. The underwriter, who is a monopolist as regards any particular security, may now decide to offer certain quantities of bonds to various brokers and favored clients at 93. As soon as these are all placed, the investment bank has earned its fee of about 1 percent of the total value of the issue. This is the standard way underwriters and brokers earn fees during IPOs. The underwriter is then ready to do the next deal with another issuer.

Often the underwriter has specified an IPO price for the brokers to make sure they offer the same price to all of their clients, extending the underwriter’s monopoly power. If that price is 94, then brokers make an additional 1 percent instant profit on all the bonds they sell. This is called the primary market for securities, but it is really more of a deal than a market, since the IPO price is only available to those who get the initial call from the broker and only in quantities offered by the broker.

The underwriter maintains their monopoly pricing power during IPOs because they do not aim for an equilibrium price, but a price a little below the expected market equilibrium. This is well documented in the empirical finance literature, but rarely mentioned in textbooks since it contradicts their core free market assumptions. Continuing the example, the underwriter might expect that public bond markets would be willing to buy 5 percent 10-year Argentine bonds at 95, since it can observe that similar bonds are selling at that price currently. It often has very excellent knowledge of what the market price should be because secondary bond markets (reselling of bonds previously issued) are so extensive worldwide. Thus underpricing is not an error, but a strategic choice to gain the monopoly power to set the terms of the deal and to create excess demand for the new security with a lower-than-market price.

The underwriter aims at a deal that “sells itself” in two ways: (1) the investment bank gains a reputation of doing successful deals, i.e., underpricing IPOs; and (2) brokers and customers can see that the price offered is below market, so they can anticipate instant profits on the deal. There is seldom any question that the brokers will take whatever number of bonds the underwriter offers them and that most of the customers called by the broker will snap up whatever share of the IPO is offered. Customers will make profits the same day too if they buy from the broker at 94 and the price quickly raises to 95 as secondary market trading takes off and finally there is a real market allowing everyone to buy freely.

This is why there is no real market for credit. Credit is allocated privately through negotiated deals, i.e., IPOs. The public “credit” markets are not markets for credit at all, but for secondary trading of already issued securities. The only time anything resembling a free market occurs, the credit has already been allocated via the pyramid of power known as the IPO.

This method of allocating credit also contributes to centralizing wealth. Since it is easier to call one rich person rather than 100 small investors, IPOs rarely reach down to the small investor. These instant profits are available only to the large investors who are at the top of brokers’ lists of who to call. If they can sell an entire IPO share with only a few calls, their money is made more quickly. Top brokers also attract and keep rich clients (including institutional investors and corporations) as they gain a reputation of offering their “most juicy” IPO deals to their biggest clients first. Competition for the richest clients drives brokers to favor them.

Meanwhile, fans of competition might argue that fee margins like this will be squeezed since issuers have a choice of underwriters. If J.P. Morgan offers only 92, perhaps Goldman Sachs will offer 92.5 and win the business instead. This does sometimes happen, but it is often restrained by underwriters cooperating as a cartel, which is known in the financial business as a syndicate or consortium. More on this next week, along with an explanation of how financial speculators depend on disequilibrium pricing.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University. 

[Photo courtesy of ProducerMatthew]

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