Banks get $100M for “stabilizing” Facebook’s IPO; uh, where was the stabilization?

The big investment banks that orchestrated Facebook’s public offering last week divvied up a pool of $100 million for actions they took to “stabilize” the Facebook stock after the company’s IPO.

This is a remarkable payment, considering that the Facebook stock wasn’t stabilized at all.

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Instead, it has fallen like a rock since the company went public in mid-May, and the company is worth only half of what it was when it went public.

The result — many small investors have been badly burned — could be that the IPO process gets further hard scrutiny.

Some investors may balk at participating in future IPOs. In fact, I’d argue we may want to look at the Open IPO process that Google helped evangelize in 2004, which arguably offers a much more even playing field.

Let’s step back and explain what is going on.

News of the Facebook bank profit distribution was reported by the WSJ on Friday, and has since been making the rounds in other reports elaborating on the process.

Here’s how it unfolded. The banks, led by the lead underwriter of the IPO, Morgan Stanley, earned this extra profit through a process known as “stabilization.” It is a standard procedure in IPO.

Under this stabilization process, Facebook agreed to let underwriter banks sell about 15 percent more shares in an IPO than they actually owned. This sale happened the night before a stock begins trading. The reason for this is because the company wanted the banks to be able to buy back IPO shares quickly in case shares fell after the IPO. By getting these speical shares, banks can move especially quickly, because they don’t have to buy them first.

Usually this technique works. If the shares fall slightly after the IPO, banks can step in quickly to prop them up.

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But the problem with the Facebook story is two-fold. First, the Facebook stock experienced lower than expected demand from investors, and so the downward pressure was immense. The banks were thus forced to give up their support on the first day. The stock has since cratered, as you can see from the chart above. So while there was no effective stabilization at work, the banks still got their $100 million profit for having at least tried.

Second, the outcome sends a clear message about Facebook’s responsibility for the mess. If the banks are really being paid for having “stabilized” the stock, well, it means the banks did their job according to the letter of their agreement. They can wipe their hands of responsibility for the subsequent decline. The conclusion: Blame Facebook for the disaster. It just bungled the stock price it set for itself when it told the banks “go.” It’s not the banks’ fault.

Of course, the irony is that bankers are making money hand over fist: The $100 million comes in addition to the $176 million in fees they already made from the IPO — even as regular investors lost about $8 billion since the IPO.

In fact, there’s no way the bankers could lose. As the WSJ explains:

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If investors are selling the stock after the IPO launches, pushing the price lower, bankers can step in and buy shares at the IPO price in an attempt to keep it from falling below its issue price. This also serves to cover their short positions. If a short position remains on their books and the stock keeps falling—which was the case with Facebook on subsequent trading days—the underwriters can continue to cover their short positions by buying back shares at prices below the IPO price, netting a profit.

There is no risk to the banks in this effort. If the stock only trades up, the short position is covered when banks exercise what is known as an overallotment option, buying more shares from the newly public company at the IPO price. The banks don’t lose money, and the new public company makes more money when the overallotment is exercised.

In Facebook’s case, the stock managed to close less than 1% above its IPO price on May 18. After that day, however, it began to drop, which is when bankers were able to move in and cover their short positions at a profit.

As the results emerge from the recent string of Internet IPOs — from Facebook, to Zynga, Groupon and even LinkedIn — I can’t help but feel that the cynicism about the IPO process that already existed among investors will continue to grow. If so, it threatens to hurt the entire tech ecosystem. It was already hard enough to go public. If the IPO process gets shunned by investors for being rigged, companies are left with only the acquisition route. But with fewer options, companies will get sub-optimal exits.

So maybe it’s time to pull out that other, more radical Open IPO process (otherwise known as the “Dutch Auction”) for another look. That’s the process that Google nobly pushed when it went public in 2004. The process forces the company to bargain more with the wider community of investors over the starting price. Granted, Google still recruited some big banks to manage the process. But it was a nod in a more democratic direction.

Had it been held more accountable to a larger group of investors (not just the big institutions), Facebook may not have bungled things so badly. So far, though, the big investment banks have disliked the Open IPO process for that very reason: It lessens their power. And IPO companies have been fearful of pissing off the big banks, because those banks owned the distribution channels to large institutional investors. But if the crowdfunding trend continues to gather steam, and if the right online technique can be found to engage institutional investors more efficiently (hell, most investors are already using the Web for investing; why can’t someone create a system that better bypasses the banks?), this could get interesting. We could see another big disruption in the finance space, which can only be a good thing.