Morgan Stanley made money on Facebook share drop

May 24, 2012, 2:00 PM UTC

FORTUNE — Here’s another example of how on Wall Street for the big banks it’s heads they win, tails they win.

Even as Facebook’s shares dropped, causing losses for regular investors, Morgan and other underwriters of the company’s IPO likely racked up big profits trading the social media company’s shares. In fact, Morgan Stanley and the other banks who were selling Facebook shares to the public were positioned to make more money the lower Facebook’s shares went.

“We think Morgan has done pretty well on the deal,” says a person at a bank that was one of Facebook’s other underwriters. “Reputation of the bank aside, Facebook hasn’t been a bad trade for Morgan.”

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IPO experts say what Morgan and Facebook’s other underwriters likely did is a common, though little understood outside of IPO circles, practice on Wall Street. The trading itself doesn’t appear to have broken any rules. It was even disclosed in Facebook’s prospectus. Nonetheless, the fact that Morgan profited as Facebook’s stock sank raises more questions for the bank at a time when it’s facing increasing scrutiny for how it handled the IPO. Regulators are looking into whether analysts at Morgan and other underwriters warned some clients but not others about problems at Facebook shortly before the IPO. Investors are suing as well.

Here’s how Morgan (MS) likely booked a profit on Facebook’s fall: Investment bankers typically sell 15% more shares in an IPO than they actually have. For Facebook (FB), the difference was about 63 million shares. How can they do that? Included in every IPO deal is an agreement that gives underwriters the ability to buy more stock from the company at a slight discount to the IPO price. So if the price rises after the offering, the underwriters can buy the shares from the company that they have promised to other investors, but don’t actually have, and book a small profit. That’s what typically happens.

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But, as we all know, that’s not what happened in Facebook’s IPO. The stock dropped. As a result, the underwriters were able to pick up shares they didn’t have in the market, rather than buying them from the company, at lower and lower prices. In effect, the underwriters were short the stock. And like all short trades, the lower the price you buy the stock back at, the more profit you make. Morgan, as the lead underwriter on the deal, sold the majority of Facebook’s shares, so it booked the majority of the trading profit.

How much did Morgan make? From the outside, it’s impossible to know. Facebook’s shares hit $31 on Tuesday. If Morgan and the other underwriters bought back every share they had sold at that price, the Wall Street banks would have pocketed nearly $450 million. And that’s on top of the roughly $170 million they split in underwriting fees on the deal. Much of those fees went to Morgan as well. But it’s likely they didn’t make nearly that much. Many have speculated that Morgan and the other underwriters bought shares on Friday at $38, Facebook’s IPO price, to support the stock. Those purchases were losers and would have cut into their trading profits. And it’s likely Morgan and the others tried to continue to support the stock as it slipped further, buying back shares constantly as the stock dropped. A person close to the deal puts the trading profits at $100 million, still a big payday.

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To anyone outside of Wall Street, this whole arrangement seems like a giant conflict of interest. Just days before the IPO, Morgan agreed to allow Facebook to sell more shares than it originally proposed. Morgan also set the IPO price higher than originally expected. That, in part, set the stock up for the fall, creating the trading gains for Morgan. Wall Street, of course, doesn’t see it that way. In fact, Facebook’s own prospectus says that the underwriters “may sell more shares than they are obligated to purchase under the underwriting agreement, creating a short position.”

Regulators don’t seem particularly concerned with the practice either. Walter Van Dorn, a partner at law firm SNR Denton who spent seven years at the Securities and Exchange Commission in part monitoring IPOs, says that the practice of over allotment in IPOs was well-known. “The SEC doesn’t see it as a conflict of interest,” says Van Dorn. Indeed, it’s unlikely that Morgan was rooting for Facebook’s stock to drop. The deal has likely been a big hit to the reputation of its tech banking team, which had generated huge fees for the firm.

Still, what’s clear is that there is a lot that’s not understood about the way Wall Street sells shares to the public. Even among Wall Streeters, the fact that underwriters can profit from IPO stock drops is not widely known. The Facebook deal is shedding some light on the process, and hopefully dispelling the myth that IPOs are the last guaranteed way to make a quick buck on Wall Street. That’s long overdue.