PIPE shorting and Professor Hanson’s head

Thanks to the awesome editing of Monica Anderson, the Moldbug-Hanson video is up at Vimeo—so you can compare it with my report.

Some have said that the debate was actually won by Professor Friedman. Cannot one imagine him with a green lightsaber? One can, can’t one? And others have expressed surprise that I don’t actually wear a black cloak or have facial tattoos, and in some ways could even be mistaken for a normal person. The better to seduce you with, young rebels. It is your destiny!

Best of all, the video is timely. For there’s a new development in the conflict. I believe I may finally be able to claim Professor Hanson’s dried head for my mantel.

Briefly, I’ve spotted an actual decision market which is actually manipulated—precisely as my sinister theories predict.

If this be so, my attack is not just deductive and philosophical, but also inductive and scientific. In short: it severs the neck, at the third cervical vertebra. The seconds ice the thing, trim it lightly, and DHL it to my taxidermist—Oxford Street’s best man. Like cryonics, only different! And Professor Hanson must complete his career with whatever neural matter the stump retains. I believe he has tenure, so this should cause him no undue difficulty.

Of course, the Professor still has an out. Since any such chicanery is illegal—American financial markets not being the free-market utopia some fancy—it is too much to expect undisputed evidence of decision-market manipulation. His spinal tissue will find no other point to quibble on. It can always quibble on this one. Indeed, I expect it to.

For instance, the defendants in cases such as Berlacher could be entirely innocent of any manipulative intent. They might have profited just by coincidence. It looks bad, however. As the prosecutors wrote:

Berlacher involved the same familiar fact pattern as the earlier cases: an investor purchased shares in a PIPE transaction and simultaneously sold short an equivalent number of shares in the open market.

“Familiar fact pattern.” Of course, it’s just an allegation. But worse—we see not only mere Federal prosecutions, but genuine, verifiable rumors. For instance, widely-disrespected financial journalist “Tyler Durden” writes:

Think of it as a PIPE investor who shorts stock of a company he/she knows will give out stock at a discount to market, a practice since banned by the SEC but being done rampantly to this very day.

Again, we cannot expect anyone to actually admit to this behavior. But as a student of history, I’m going to say: smoke, fire. There is clearly something going on here. What the hell is it? And how do my sinister theories (actually more, um, dexter) predict it?

PIPE stands for Private Investment in Public Equity. In a PIPE deal, a publicly-traded company sells a large number of shares not in the usual way, by conducting an open secondary offering (not just dumping the shares on the market, but close to it), but by selling a large block of shares to a single investor or syndicate thereof—generally, private equity.

There is nothing intrinsically wrong with this. However, one common PIPE structure has an interesting wrinkle which turns the market for this stock into a decision market. This decision market is chronically manipulated, which is at least one of the reasons that PIPE deals suck.

In practice, PIPEs are generally restricted to companies in a dire financial position. The investors who buy into them are notorious bloodsucking leech bastards—squid who feed on vampire squid. PIPE is strictly Mos Eisley finance. Not mobbed-up, but close. Just the sort of subterranean scum-market in which we’d expect to see systematic manipulation.

The way this structure works is: dolphin in dire straits comes to predatory squid. Dolphin in dire straits says: “Hello, predatory squid! I have a big problem. I need 20 million fish.”

Predatory squid says: “Hello, my juicy little dolphin! I can solve this problem. I have 20 million fish for you. I’ll give you 20 million fish right now, in exchange for something you can print at no cost—your own stock. What is it now, April? Whatever your stock price is on June 1, I’ll take 20 million fish of it.”

That sounds good to the dolphin. His stock is trading at 10, and there are 10 million shares outstanding. To save his whole dolphin pod from starvation, he accepts a mere 20% dilution.

But mysteriously, dolphin stock begins to sink. By June 1, it is down to 2 fish per share. The squid ends up with 51% of the pod. Since that’s enough to do anything you want with anything, he has all the dolphins canned and sold as cat food, maximizing the return on his investment. Property rights and free-market economics!

Not that this is the government’s fault, of course. It’s the dolphin’s fault. He never should have gotten involved with a squid-eating squid. Since he did, he needed the government to protect him. Alas, it doesn’t always do such a good job of that. More regulation is needed, comrades! Not.

But what did the dolphin do, exactly? What was his mistake? He created a decision market. Normally, the market in dolphin stock is just a prediction market. The stock price matters, but abstractly. It does not matter directly and mechanically. It does not have profitable side effects. It does not create a conflicting incentive, which overpowers the market’s predictive signal.

For the whole month of May, dolphin stock is a decision market. The decision is: what price does the squid pay for its shares? The number of shares it gets for its 20 million fish, hence the percentage of the dolphin’s ass it gets, is the inverse of the stock price on June 1. A very real and palpable decision! And a profitable one. For the squid’s gain, of course, is the dolphin’s loss.

The squid has a clear incentive to manipulate the market. During May, he profits automatically if dolphin stock goes down. He has a non-predictive incentive to short. As one expert writes:

Hence, structured PIPEs lacking floors or caps are pejoratively labeled “death spirals” or “toxic converts,” because investors in these deals may be tempted to push down the issuer’s stock price through short sales, circulating false negative rumors, etc., so that their structured PIPEs become convertible into a controlling stake of the issuer.

This incentive may contradict the squid’s own predictions for the performance of dolphin stock. If he has any. He’s a squid, after all. He’s not investing in dolphin because he loves dolphins. Squid love nothing. They have neither heart nor brains. They are certainly not in any way cerebral. They eat, that’s all. Actual market prediction—not their cup of blood.

But, since the profit from X should exceed any losses he may expect from Y, our squid expects to eat. He expects to eat so well that he engages in this foul, predatory behavior—despite its obviously unethical and SEC-attracting nature. He’s a squid. He plays the game.

Now, let’s look at how Professor Hanson’s theories describe this situation. To Professor Hanson, our squid-eating squid—who, by shorting, is investing non-predictively for ulterior motive—is in fact a sheep. His behavior is not predatory, but imprudent.

And why? Because the squid will not succeed in depressing the dolphin market. Rather, by investing non-predictively, he is making a wrong bet. Or at least, a bet with (according to the squid’s own predictions) negative expected value. Here the Professor and I agree.

Because this bet has negative expected value, there must be an equal and opposite counter-bet with positive expected value. In Professor Hanson’s universe, this will attract wolves—expert speculators, who can smell inefficiency the way a professor smells grants. The wolves home in on the counter-bet and devour the squid/sheep, quite incidentally restoring the dolphin market to its original and inevitable state of Platonic efficiency.

Here is where we disagree. I believe this scenario is plausible. Professor Hanson considers it (so far as I can tell) inevitable—at least, in a large public market.

Do PIPE deals attract wolves? Will speculators, hoping to detect (note that in Professor Hanson’s spherical-cow models, positions and even motivations are visible) the inefficiencies of manipulation, buy dolphin in May? They might well. There is certainly nothing stopping them. Nor—as with the squid themselves—would we know if they did. Real markets are opaque.

For manipulation to be entirely precluded, however, the wolf counterattack must be inevitable— and of equal magnitude to the squid feeding frenzy. The latter is indeed finite, if only because there is a finite amount of dolphin! And the former potentially includes all players in the market—but only potentially. Potentially is not actually.

If this wolf army was inevitable, squid would not profit routinely from PIPE shorting—which would not be, in Mr. “Durden’s” colorful phrase, “rampant.” Hence, Professor Hanson has claimed that there is no such thing as a coelacanth, and I have dumped one in his inbox. The ball is in his court! But frankly, I’m already wondering where I’ll put that moose head.

For the wolves to attack the squid and save the day, there need to be heavy wolves in the dolphin market, and they need to smell (squid) blood. They must be able to detect the fact that dolphin stock (remember, this is a weak, vulnerable company to begin with) should not be falling in May, and hence deduce the presence of a bet with positive expected value.

In other words, a large amount of money needs to be sitting behind a large amount of certainty. And the bigger the squid (the larger X, our ulterior motive), the larger and more confident the wolves must be. As we’ve seen, even with a small, simple, bounded X, wolf activity is not apparent. At least, it’s not apparent to the Berlachers of the world.

Instead, the Berlachers of the world follow the “familiar fact pattern” of selling short roughly the same number of shares they expect to acquire when the deal closes. Professor Hanson’s hypothetical wolves aside, any market can be manipulated downward by artificially increasing the supply of shares, which is what short-selling does.

In an ordinary market, this is not a way to produce expected profit, because to actually collect profits the manipulator must bury the corpse. He must cover his shorts by buying them back on the market. Which drives the price back up, erasing the expected profits. The Berlacher-squid, however, need not buy the shares on the market—he gets them straight off the dolphin’s ass. Far from burying the corpse, he eats it.

Now, I remind you of the devil the Professor wanted to bridle with this weak rein. He wanted to make arbitrary sovereign decisions with his “futarchy.” He wanted to control the government this way. As a student of history, I can tell you that history is just about the biggest, wackiest, least predictable thing there is—and history is the story of governments.

In short, Professor Hanson claims to draw out Leviathan with a hook. Wilt thou play with him, as with a bird? No, Professor, thou shalt not. Thou shalt be learning to eat through thy pharynx.

At least, in the game of squid versus dolphin that is a PIPE structure, the ulterior motive (X) is both bounded and well-described. The decision market is just setting a stock price. No one besides squid and dolphin have any incentive to intervene in the game—and the most the squid can win is, well, the entire dolphin. X, in short, is under control. Still Y, though potentially infinite, appears actually, empirically insufficient to dominate it. One white raven, delivered.

Sovereign decisions have no such mild X. Who has an incentive to gank the market in, say, war? Who doesn’t? Obviously, if America is fighting Hitler, and Hitler can intervene in the decision market that decides whether America should surrender—to Hitler—well, a man like Hitler’s not going to say no to that, is he?

Quite the contrary. Hitler will bet the whole Reichsbank—then put on leverage! American surrender, after all, is a Pascal’s bet for Hitler. So, in a sovereign state controlled by decision market, we all suffer the fate of the poor dolphins, and are made into cat food by Hitler.

This is the future that Professor Hanson wanted, for you and your children! This is his “futarchy.” Hitler—cat food. Cat food—Hitler. Picture it, America. That red lightsaber is looking better and better, isn’t it?