Facebook, JP Morgan Chase and a failure to learn lessons
It was revealing to see Facebook’s stock market debut flopping in the same week as JP Morgan Chase announced gigantic trading losses in late May. Both showed that planet finance is as out of control as ever and has learned absolutely no lessons from the financial crises of the 2000s.
Facebook’s debut on Wall Street was overpriced in the great tradition of the technology bubble, which burst in the early 2000s leaving some investors, not only funds but also ordinary people, seriously out of pocket. Just as in those days, its flotation price took into account sales rather than profits.
JP Morgan Chase recalled the bad old days of the financial and banking crisis of 2008, when banks were rescued with taxpayers’ money because they were too big to fail. It emerged the bank had clocked up mega trading losses on obscure financial instruments that hardly anyone understands, in trades which apparently escaped its internal controls for managing risk.
Yet unless the lessons of these crises are learnt, financial markets will go on building castles in the air, leaving others to pick up the pieces and suffer the damage when these virtual structures fall to earth.
First, Facebook. Back in the heady days before the technology bubble burst, embryonic Web-based businesses floated their shares on stock markets at prices calculated in relation to their sales, number of users or, in some cases, even potential users. This provided a road to riches for the founders of such companies and a highway to fat commissions for the banks arranging the IPOs.
But those who bought stock in such flotations soon discovered a basic rule: what shareholders actually get is a share of a company’s net profit, the amount left after all other financial claims have been deducted.
Sales and user numbers may help to understand a company’s potential, but they are no guide to whether a share price is a realistic reflection of this potential over a meaningful period of time.
It wasn’t just start-ups. AOL and Time Warner merged at a value that surprised many media watchers at the time. Then there was the spectacular rise and fall of Vivendi under Jean-Marie Messier.
Messier took Vivendi from boring utility to technological leader for the age of convergence, buying up businesses and using operating profit as a gauge of the company’s dynamism. But this was financed by a mountain of debt, and Vivendi nearly went bankrupt. This might have been noticed earlier if anyone had looked at net profit.
This is why the time-honoured way to gauge whether a company’s share price is cheap or expensive for its business is to divide its net profit by the number of shares it has. This measure is called the price-earnings ratio, and it requires no more than primary school-level maths to work it out.
In the case of Facebook, shares were sold at $38 each, although its earnings per share in 2011 were just $0.43. The sale valued the company at $104 billion, over 100 times 2011 profits of $1 billion. Is it conceivable the company could multiply its profits by so much? How long would that take, how could it be done?
Facebook is not the only culprit. In the decade since the technology bubble burst, a multitude of web-based businesses have continued to come to market at share prices based on a multiple of their sales. Some have been successful, meaning their shares now trade significantly higher than when they were floated, so those who bought shares at the time have made money. But most have not.
Next, JP Morgan Chase, which, coincidentally, was one of the banks advising Facebook for its IPO. While one part was involved in overvaluing Facebook stock, another part was losing billions on trading obscure insurance contracts and derivatives, the sort of financial instrument you need a doctorate in mathematics to understand.
What is not coincidental, however, is the repeating of history because lessons have not been drawn.
Four years ago the world teetered on the brink of financial melt-down because banks everywhere had bought securities containing derivatives of American sub-prime housing loans, which had been sliced up and repackaged so often that no one knew exactly where they were.
When the American real estate bubble burst their value imploded, and so, by implication, did the value of the securities within which they were packaged. That meant the banks that owned these securities no longer had assets worth enough to counterbalance their lending.
So what began as relatively local investment decision, to sell on high-risk sub-prime loans, almost brought the world’s financial system crashing down. That is why it is a good idea to be nervous about banks not controlling the risks taken under their roofs, like JP Morgan Chase.
And the fall-out from that time goes on. When Bank of America bought Merrill Lynch in 2008, the bank’s top executives knew the broker was loaded with huge mortgage losses, but shareholders were not told, according to documents filed for a court case on the deal in New York in early June.
Another case, that of France’s Société Générale, was also back in court at the beginning of June. The bank blamed a rogue trader for losses of €5 billion in 2008 from off-the-books trades, but the trader, Jérome Kerviel, argued that the bank’s hierarchy knew what he was doing all along.
The irony is that it would actually be far more of an indictment of Société Générale if its management were totally unaware of Kerviel’s trades, as the bank claims, than if it were complicit in them, because that would mean its risk controls were ineffective.
Key questions of who knew what, and why risk management procedures at some of the world’s top banks should fail exactly when they are most needed, are still unanswered.
What Facebook’s IPO and JP Morgan Chase’s trading losses have in common is a financial system that acknowledges no responsibility other than to itself, so cannot learn the lessons of its own excesses. But society can learn the lessons, and should impose them on the banks.
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