Showing posts with label LinkedIn. Show all posts
Showing posts with label LinkedIn. Show all posts

Tuesday, May 24, 2011

Stopping the Next Bubble

Over the last couple of months my colleague has been writing about why the rich are different. That is, how they can make money in ways that are impossible for mere mortals based on their connections and preexisting -- often inherited -- wealth.

In a recent column, Joe Nocera gives a great example of one of those ways that Mark mentioned: stock IPOs. Nocera wrote about LinkedIn's recent IPO:

[LinkedIn] had hired Morgan Stanley and Bank of America’s Merrill Lynch division to manage the I.P.O. process. After gauging market demand — which is what they’re paid to do — the investment bankers priced the shares at $45. The 7.84 million shares it sold raised $352 million for the company. For this, the bankers were paid 7 percent of the deal as their fee.

For a small company with less than $16 million in profits last year, $352 million in the bank sounds pretty wonderful, doesn’t it? But it really wasn’t wonderful at all. When LinkedIn’s shares started trading on the New York Stock Exchange, they opened not at $45, or anywhere near it. The opening price was $83 a share, some 84 percent higher than the I.P.O. price. By the time the clock had struck noon, the stock had vaulted to more than $120 a share, before settling down to $94.25 at the market’s close. The first-day gain was close to 110 percent.

Who was able to buy those shares at $45 and immediately turn around and sell them at $120? The rich and the powerful favored customers of Morgan Stanley and Merrill Lynch. If you had $10,000 or $20,000 you wanted to invest in a block of LinkedIn stock you would have been out of luck--those brokers won't even consider giving you access to an IPO.

They actually have rules that supposedly protect small investors with insufficient assets from participating in such offerings because they are "risky." I know this because my wife and I have been in on IPOs in the past, and we had to be vetted in order to participate. It's all about who you know and how much money you spend with the broker.

This really calls into question the purpose and even the utility of the stock market. Ostensibly stock exists in order for companies to attract investors so that they can get money to grow their business and recoup their original investment costs.

But LinkedIn didn't make anywhere near as much money as some of the people who bought their stock for $45 and immediately flipped it, some for as much as three times what they paid for it. The people who do all the actual work are getting stiffed.

Once a share is sold the company never sees another nickel from it. Too often shareholders are only interested in driving the price up so that they can sell it: they don't give a whit about what the company is doing, or whether it is really viable. Shareholders often demand CEOs do things just to raise the stock price, even though they harm the ability of the company to do its work (like the ever-popular ritual laying off the employees). They just want to cash out as soon as possible to flip the next IPO.

For that reason stock market profits should be taxed at regular rates -- not the ultra-low capital gains rate -- unless you're selling IPO stock more than a year after you bought it. Buying stock from someone who just bought it from another guy is not a real investment--it's just flipping. However, income from dividends and bond interest really are investments and should get long-term capital gains treatment.

The worst thing about the LinkedIn deal is that this kind of stock trading causes bubbles, like the tech bubble that burst in the late nineties. Is LinkedIn stock worth anywhere near $94 or $120 a share? Of course not. Just like Yahoo was never worth what people paid for it, and most of the other tech stocks that traders ran the price up on in order to flip them. Google is another stock that's overvalued, but Google at least has some substance behind all the hype: its search engine business is legit and the Android operating system has become the foundation for millions of cell phones and tablets.

These days the bulk of stock trades are made by computers that make decisions based on minuscule fluctuations on the scale of microseconds. This computer trading was the cause of last year's flash crash.

Computer trading has a lot in common with the "quantitative analysis" that brought us the credit default swaps and other crazy investment vehicles that tanked the economy in 2008. These schemes use mathematics and computer programming to take responsibility, human decision making and common sense out of the equation in order to make money ever faster out of thin air.

That's why a transaction fee should be levied on every stock trade. Republicans in Congress are complaining about high taxes and are threatening to cut funding to the very regulatory agencies that should have stopped the banks' foolhardy investment vehicles. These agencies were already understaffed during the Bush administration; cutting back on them now would be a colossal error.

A transaction fee would be the best way to put the expense of regulation on the companies that are most likely to cause the next crash, as well as put a damper on the riskiest and most egregious financial transactions.

High-speed computer trading has the potential to bring the entire world economy crashing down in an outright depression. This is one technological innovation best nipped in the bud before it gets out of control.