Why Can't California Find Any Underwriters Who Haven't Repeatedly Defrauded It?

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Matt Taibbi wrote today about this Bloomberg story describing how JPMorgan's munis business is booming despite maybe screwing a few muni clients over the years here and there. You can read Taibbi for a rundown of the shenanigans but his basic question is why, after said shenanigans, does JPMorgan still dominate muni finance? His answer is sort of unconvincing:

The news about Chase and Bank of America continuing to dominate a market they’ve already admitted to feloniously rigging says a lot about the state of modern finance.

Sure. But what does it say?

Bloomberg offered a telling quote from a state official justifying the decision to continue to do business with these criminal banks:

“I haven’t found an investment bank that hasn’t had some problem in the last three years,” California Treasurer Bill Lockyer said in a telephone interview. “We do business with them all. I think they provide good service. I think they’ve been highly ethical with us.”

This is coming from an official whose state, California, has seen multiple bid-rigging cases in recent years, from Riverside to San Mateo to Sacramento to Los Angeles to Santa Barbara, for starters. So a quote like that is pretty sad. It tells you that the system works fine for state officials and banks -- and no one is representing the people who actually lose out.

Erm ... it doesn't really. Maybe evil Bill Lockyer is in the pocket of giant banks who are screwing The People, or maybe he's an idiot, or maybe he's, y'know, basically right about the whole providing-good-service thing. Hard to tell from that quote. Here is what seems to be the real reason, per Bloomberg, that California stood by its JPMorgan:

In August 2009, after California closed a $24 billion budget deficit, JPMorgan loaned the state $1.5 billion so it could pay IOU’s issued during a cash crisis. The loan helped keep the state funded until September, when it could issue $8.8 billion in short-term debt.

Last month, JPMorgan loaned California $500 million for four months at 0.2 percent so the most-populous U.S. state could pay bills after tax collections trailed budgeted amounts. Barclays, which acquired Lehman’s investment banking and capital markets operations, also lent the state $500 million, charging a lower interest-rate than other banks, Lockyer said.

JPMorgan and Barclays also co-managed a $1.9 billion refinancing for the state. Lockyer said that the favorable terms of the short-term loan “was one of the considerations” for hiring the two banks to handle the refinancing.

There are loads of similar anecdotes in the piece, like the lead-off story where JPM loaned Philadelphia $275mm for two years to essentially bridge it to a bond offering two years later because Philly's finances were too screwed up to support a public deal. There again, the loan bought JPM the underwriting business. That's not corruption or conflicts between state officials and their states, that's just the state rewarding its business relationships. It is good for municipalities to have access to credit from banks with big balance sheets. They like it. So they pay for it, apparently in the form of capital markets business. There are weird legal concerns about tying lending to capital markets business! But those are basically antitrust-y concerns; from a conflicts perspective paying banks underwriting fees in exchange for cheap lending is a plausibly sensible trade.

Elsewhere somefolksaretalking about whether the IPO market serves growing technology companies, inspired by the JOBS Act, which seems to be going places. Here is a view from Epicurean Dealmaker that I mostly subscribe to though I suppose I'm a former bulge bracket ECM banker so maybe I'm biased:

Public financial markets — and the institutional investors who dominate them — have become too large to be an effective source of late-stage growth equity capital for most companies. The “round lot” (sorry, minimum size) for an effective IPO nowadays is at least $75 million dollars. But very few fast-growing companies ever need that much money to grow their business. ... Part of the problem lies with the current structure of the investment banking industry. Too many potential underwriters are just too large to consider run-of-the-mill, pissant IPOs to be worth their time and attention. To paraphrase 1980s supermodel Linda Evangelista, bulge bracket banks like Goldman Sachs, JP Morgan, and Bank of America Merrill Lynch just won’t get out of bed in the morning for less than a $300 million offering. They can’t even pay their defense counsels’ retainers with the commissions earned from such business. And for various reasons, smaller investment banks which could make a decent living off such fare are relatively few and far between.

You might wonder about the reasons for that last bit. I'd offhand posit two. One, investment banking clients like the services that big banks can provide, where "services" means "balance sheet," and so are more likely to give their IPO business to bulge bracket banks. (Thus, Facebook is getting a loan it wants from banks and rewarding them by giving them the underwriting business on an IPO it doesn't want.) And two, you may think that Goldman is all vampire-y and muppet-stomping, but they are a famous name, and institutional investors are more likely to say "hmm the last Goldman IPO did well for me so I'll buy the next one" than they are to say "well, I've never heard of this tiny boutique, but they sure seem ethical." (They might also prefer to buy the Goldman IPO if Goldman is providing them prime brokerage, liquidity, etc., so there's a balance sheet issue there too.) The barriers to entry are not trivial. There's this kind of sweet paper about how bulge bracket banks get better deals for their clients in mergers, for selected sorts of mergers, suggesting that both skill but also connections at the big banks are better than at the little banks, and I suspect that what's true in M&A is true in capital markets work as well. Bigness begets success begets bigness.

Maybe JPMorgan's continuing success with California despite maybe bid-rigging a bit in half a dozen localities says something about the state of modern finance, but it's probably not just that like California state officials are dumb or bribed. A stereotype that I picked up at some point in my travels is that the US has a very capital-markets-based financial system, while other advanced economies tend to be more bank-based. Part of what it means to be a capital markets based financial system, I guess, is to have an investment banking function that is really separate from bank financing: to have a financial system where the guys who intermediate between public securities buyers and municipal or corporate issuers are different from the guys who provide financing directly to those municipalities and corporates. Back in the olden days that was more or less the case; with the repeal of Glass-Steagall it became less so; with the bank-holding-company-ification of Goldman and Morgan Stanley it really broke down, though maybe the de-BHC-ification of Deutsche Bank is a step in the other direction, I dunno.

But the fact that municipalities are turning for financing to the same banks who they're suing for ripping them off on the last financing does suggest that something is up. And I'd bet that it's something pretty simple: that those are the banks who have the money.

Gangster Banks Keep Winning Public Business. Why? [RS]
JPMorgan Claims No. 1 for Government Debt After Jefferson County [Bloomberg]
Size Matters [TED]

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Facebook Will Take Free Money From Banks But Don't Expect It To Show Any Gratitude

The Wall Street Journal today discovered that universal banks that lend money to companies for cheap tend to want investment banking business in return for that lending and I guess that's a scandal: As the market for technology IPOs revs up and the biggest banks seek to capitalize on the size of their balance sheets, the practice of selecting underwriters that also provided loans is coming under focus, spurred by Facebook's IPO process. Critics of the practice say the choices aren't accidental and reflect the "you-scratch-my-back-I-scratch-yours" way that Wall Street works. Bankers, for their part, say they aren't allowed to make loans on the condition that they receive other business, but borrowers can use the loans as a factor in choosing underwriters. Some bankers say that lending is just one of the many services they offer companies. At Facebook, the credit line played a role in the batting order for underwriters, said a banker who worked on an underwriting pitch to the company. When I was young and naive and pitching for underwriting business against banks that did lots of lending, I always thought that banks "aren't allowed to make loans on the condition that they receive other business, but borrowers can use the loans as a factor in choosing underwriters" thing was ripe for a scandal. I still sort of think that: I just do not believe that no client coverage banker has ever said "we'll be in your credit facility but only if you promise us underwriting or M&A business." (Some people agree with me!) And, as the Journal notes, that would be a criminal violation of the antitrust laws, which is unspeakably weird but there you go. But if you ask a banker who has been carefully and recently briefed on anti-tying regulations, he will probably tell you something like "we don't demand underwriting business to provide a loan. Companies demand loans to get underwriting business." And, as the Journal says, that's not illegal.