Asymmetrical Information

From the desk of Jane Galt:

Big day in business news

A jury has limited the payout of the biggest single insurer on the World Trade Center site, to $877m for one incident. Larry Silverstein, the owner, had been seeking a double payment, arguing that the two planes constituted two separate insurable events. This ruling will probably limit his potential payout to $4.5 billion, rather than the $9 billion he's been seeking. It's not only big news for the insurance business--it could have a big impact on the site reconstruction.

Both Mr. Silverstein and the Port Authority of New York and New Jersey vowed to move forward with the rebuilding process regardless of the outcome of the trial. Mr. Silverstein has already begun work on the first of five towers proposed for the site. There is also $2 billion in federal funds and insurance proceeds available for the reconstruction of the transit center at the site. Rebuilding officials expect to raise the money for the memorial and two cultural buildings from private donations and federal funds.

"Of course we are disappointed in the outcome," said Joseph J. Seymour, executive director of the Port Authority. "However, Silverstein Properties is moving forward with construction of the Freedom Tower. In addition, federal funding to build the World Trade Center transportation hub designed by Santiago Calatrava has already been set aside." A spokeswoman for Gov. George E. Pataki released this statement: "We will move forward with the rebuilding. Nothing will stop us from keeping our commitment to the heroes we lost on that day."

But with the estimated cost of rebuilding the trade center at $9 billion, there are doubts about how soon, or even if, the four other office buildings at the site will be built.

Meanwhile, Frank Quattrone, former head of Technology investment banking at CS First Boston, has been convicted of two counts of obstructing justice and one charge of witness-tampering.

Of course, that's not really what he was guilty of--that's just what they could prove he was guilty of:

In his heyday, Mr Quattrone was arguably the most powerful investment banker in the dotcom world, shepherding both Amazon.com and Netscape to market. However, the role of investment banks in flotations later came under scrutiny. If banks were being paid fat fees—of up to 7% of the funds raised—to bring their clients to market, then why were the share prices shooting up, sometimes by several hundred percent, on the first day, leaving “on the table” millions of dollars that might otherwise have gone to the issuing company’s coffers?

The answer, regulators believed, lay in a practice known as “spinning”. This involved investment banks reserving shares in popular IPOs for favoured clients, their friends and families in return for more business. CSFB was one of the banks investigated; two years ago, it paid $100m to settle charges without any admission of liability.

Prosecutors initially suspected the bank of having received kickbacks—in the form of high commissions from hedge-fund clients—in return for such allocations. However, such charges were never brought. In the end, Mr Quattrone was charged with an attempted cover-up rather than any underlying offence.

I will leave it as an excercise for the reader to determine whether convicting people of covering up a crime that they (so far as the law is concerend) didn't commit is a step forward or backward for American justice. I will only point out that these sorts of convictions are distressingly common among our more famous securities fraud trials--don't we have any evidence on any of 'em?

Speaking of CSFB, for those who don't know, they're the lead bank on Google's IPO. Google is planning to do its IPO via Dutch auction, rather than the traditional mechanism of letting their investment banker set a price. This has apparently produced some angry reactions from the bankers who thus cannot use their price-setting ability to enrich themselves, and their favourite clients, at the expense of the company and/or the new shareholders:

So there you had Google coming out rightfully declaring that any incremental value generated by investors belongs to Google, at the same time as the broker dealer mechanism was busy trying to steer basic equity trading business through its desk. I believe that Google's decision to set its offering price through a retail auction mechanism has the potential of destroying a traditional profit center of wall street. Most hedge funds and mutual funds of a certain size think nothing of paying each bulge bracket firm millions of dollars each year in commission fees. As we have reviewed previously, traditional equity research, access to management and trade execution have become commodities in the wake of Spitzer, Reg FD and Technology respectively. The last bastion of hope for wall street has remained capital commitment and access to hot issues. I will leave aside the former concern and focus on the relationship between institutional investors and hot issues.

Wall Street has cut back their coverage of equities in order to rationalize their cost structures (no more investment banking to pay for the analysts) at the same time that investors have begun to self-regulate their position vis a vis the safe harbor qualification for their trading commissions. Increasingly, commission dollars are becoming more accountable. This is similar to the recent evolution of online advertising from destination web sites and branded banners to pay for click pricing. If new technologies enable increased accountability, such markets will indeed become more accountable. This is what is happening in the brokerage industry, as the powerful meme of transparency has become a consistent menace to bundled commissions and opaque pricing.

Google's IPO is above all a capital performance. Its offering memo describes a set of rules that at once promise zero short term accountability on behalf of management while at the same time promise unparalleled tick-by-tick efficiency in terms of equity pricing.

On Friday, Tina and I got together with some friends for dinner. One of the husbands works for CSFB and I congratulated him on the coup of being named the lead on the Google IPO. Whereas I expected a little gloating, instead he bit his tongue and complained about the greed of Google and how little money CSFB was going to make (including its not insignificant banking fees). I think the point he was trying to make was that by going the way of the auction, that Google was trying to take every single penny off the table that they can. Seeing his genuine anger, I didn't have the heart to remind him that this was a good thin[g] overall, namely that companies were going to start to benefit fully from the intersection of buyers and sellers of their stock, not the marketmakers per se.

Instead what I saw was the end of a certain kind of investment banking innocence. No, the outsized commissions are not your divine right. No, you can't control the allocation of underpriced shares to your best clients. Yes, you will be paid, but it will be in fees like those paid to lawyers, consultants or accountants. Profiting from outsized bid-ask spreads will need to be replaced by a different type of value. I am not sure Wall Street has figured out what it will do if Google's auction model proves to become the rule rather than the exception.[More importantly, what are all my business school classmates, who have now spent tens of thousands of dollars on an MBA, and 3+ years of 100-hour weeks running comps in a well-upholstered rat cage, going to do if the gravy train is pulled out of service just as they have taken their seat? --ed.]

It is interesting to note that the lone vocal holdout of the Google offering has been Goldman Sachs, who was rumored to express concern about the company's auction format. This from a firm that perhaps more than any other benefits from proprietary trading desks. Perhaps this is the next stage of conflict, between the democratization of hot issues and the entrenched commitment of the bulge bracket to commit more and more capital behind their trades.

Long time readers of this blog know that I think that investment banking fees, which run 7% of every IPO, bear little resemblance to value added, and are a classic example of how regulatory capture and the principal-agent problem of corporate executives can collide to produce undeserved wealth for those lucky enough to be employed at their intersection. (Though please, don't tell my business school classmates I said that.) The moral indignation of investment bankers at those nasty old companies trying to maximise value for the buyers and sellers in the transaction, rather than the so richly deserving middleman who has lent his name to this enterprise, thus fills me with a sort of righteous hilarity.

And for a great piece about what the shareholders can expect from all this--namely, to be afflicted with the Winner's Curse--we look to longtime AI favourite James Miller.

Posted by Jane Galt at May 4, 2004 02:54 PM | TrackBack | Technorati inbound links