Hype Sells in Investing

Yesterday, the Zurich based International Capital Market Association (ICMA) disclosed that it has been investigating a well know investment bank selling tactic: hype.  I know that you are thinking something along the lines of: “I had already come to accept that hype was a part of the game – this is not news.”  You would be correct.

However, the ICMA is focusing on European bond sale where the big investment houses of the world are complaining that investment banks, when selling the sovereign debt of troubled European countries, have over-hyped the amount of interest.  Why is this important?

What is little known to non-finance industry insiders is that from initial public offerings (IPOs) to sovereign debt sales, that the high pressure sales tactics faced by the retail investor from brokers, are also faced by institutional investors from institutional sales people (i.e. high falutin’ brokers).  Because supply of bond issues is limited, interested buyers almost never get their preferred alotment of bonds when buying.  Instead, buyers typically get less than they had wanted.

So prospective buyers try to get an indication of market wide interest from the investment bank/underwriter.  In knowing the interest, oftentimes buyers will overstate their own interest – in my experience by 2-3x – so that when the total market allocation of a new bond issue is completed by the underwriter, the buyer will have gotten something close to his/her interest.

The ICMA is investigating many complaints by big buyers of European sovereign debt who have said that recent low credit rating issues have been over hyped, even by financial market standards.  Folks, its stories like this that make the financial markets look to outsiders like the “game is rigged.”  This whole system of deceit permeates financial industry culture and this is just another manifestation of it.  The sad part of it is that big institutional investors still feel the need to participate in the charade.

Why do sophisticated investors get taken in by hype?

One reason, the rational reason, is that institutional investors know that by “aiding” an investment bank by buying an unattractive issue that when an attractive issue comes along the investment bank is more likely to give the buyer a favorable allotment.  Sort of a “I scratched your back, now you scratch my back” arrangement.  Woe to the little investors in the big institutional investment vehicle, like a mutual fund, who is stuck with these non-investment savvy, political-type of decisions.

Another reason, the irrational reason, is that institutional investors are often possessed of tremendous intelligence, but very little wisdom.  That is, just like many people they never evolve past the junior high school mentality that when something is hyped it must be worth owning.  Therefore, the big institutional investors often covet something only when it is hyped.  This is further evidence of something that I have written about before: Wall Street is a cult.

Who is the beneficiary of this hype?  Oftentimes it is just the investment bank itself.  The way the primary issuance market works is that most investment banks pay the issuer of the debt or equity a price that is supposed to be only slightly below market value.  In turn, the underwriter sells the issue at a markup to the investment community.  But the more hype, the greater the markup.  The result is that the issuer ends up selling more of the issue than they needed to in order to raise money and the buyers of the issue have an issue that is overvalued and therefore more risky.

Sad but true, this practice goes on every single day and is just another reason why it is easy to be a critic of capitalism at the same time that I am a supporter of capitalism.  My criticism is that this practice is silly.  My proposal for correcting the situation is to require underwriters to maintain a live, electronic update accessible via the Internet of the actual underwriting process.  [By the way, this will never happen because the investment banks mostly benefit by the lack of markets transparency.]

By having a more transparent market the market will work better for sellers of issues and buyers of issues.

If a seller can see the actual number of orders and the bids associated with those orders then they get a clear indication of interest.  If the interest is higher than expected then they can raise the price of the issue, but decrease the number of securities in the total issue.

Yet, if the interest is lower (the big fear for the seller) then they also get a clear indication to get their financial house in order.  After all, the only reason most investors would decline a new issue is if they don’t like how the issuer is managing the state (think: Greece) or the business.  However, this is also valuable information.

If a buyer can see the actual number of orders and the bids associated with those orders then they also get a clear indication of interest.  If the interest is higher than expected, and they still covet the issue, then they can raise their bid for the issue without getting cut out of the deal (think: a Facebook IPO).

Yet, if the interest is lower then the buyer can lower their bid and thus, not waste the capital of their investors.  Or if the issue is a total turkey they can avoid it all together.

Most of the financial community would probably label this whole segment of the investment experience as falling in an ethical gray area.  For me personally it is just another example of behavior tolerated only because in a sea of unethical behaviors and structures it is minor in comparison.  Another way of putting it is: when your day to day experience is immersion in a sea of unethical behavior you become anesthetized to the minor violations taking place around you.

Jason