How Wall Street Loses by Fixing Prices

There's a headline on Bloomberg News today that's bound to ruffle the feathers of the Sarbanes-Oxley antagonists out there: "IPO Fees in Europe Catch Wall Street for the First Time Since WWII."

Tighter regulations here in the U.S. are driving companies to list their shares in markets overseas, or so the free-market argument goes.

The article notes that so far this year, banks in Europe have made $1.1 billion in I.P.O. fees, while their American counterparts have earned $1.4 billion. That gap has narrowed considerably from 2002, when U.S. banks earned five times as much as the European made in underwriting fees.

But before joining the bandwagon to Capitol Hill to ease the legislation passed in the wake of Enron and WorldCom, there's another figure worth noting: The Europeans, in exchange for $1.1 billion, have helped their clients raise 78 percent more money than the U.S. banks have for $1.4 billion.

Why the discrepancy? Price-fixing, of course.

The average underwriting fee in the U.S. has held steady at 6.7 percent since 2002, while Europeans charge about 3.2 percent, Bloomberg reports. In fact, most I.P.O.'s for the last two decades here in the U.S. have cost issuing companies about the same price: 7 percent.

Apparently the competition from overseas hasn't gotten so bad for Wall Street that it will consider competing on price. The simplest supply and demand pricing equation taught in introductory economics courses seems to still be lost on investment bankers.

University of Florida finance professor Jay Ritter has examined this so-called "seven percent solution" among U.S. investment banks at great length.

In this chart, Ritter compares the number of issuers between 1985 and 2006 that paid exactly 7 percent, below 7 percent, and above 7 percent.

It's clear that sometime around 1988, major investment banks decided to compete on service rather than price.

This phenomenon was well recorded during the Internet boom, when investment banks were flooded with fees while astronomical first-day trading pops meant that companies could have raised more money than the banks had them believe.

Indeed, Ritter's chart shows a single blip in the last decade: in 2001, the number of "below 7 percent" offerings rose considerably. Alas, it didn't last.

In 1999, when a banker named Bill Hambrecht introduced a new kind of pricing system for stock offerings, called a "Dutch auction," there was the hope that Wall Street would finally have to budge on price.

In exchange for a 4 percent fee, Hambrecht's bank would let buyers decide the price of a stock offering. But eight years later, the only established company to use the system is still Google, and the promises the Dutch auction made have been long forgotten.

Hambrecht, still hoping for a revolution, continues to underwrite small offerings.

Meanwhile, Wall Street banks continue to ponder their future by taking aim at the regulators instead of their own policies. The Financial Times reports today that New York governor Eliot Spitzer has organized a panel of investment banking C.E.O.s, consumer groups, and regulators to figure out how New York can remain competitive with London.

Perhaps they can save some time and head over to an Econ 101 lecture at N.Y.U.

by Megan Barnett