Did JPMorgan Chase (JPM) make a Faustian bargain by paying $2 per Bear Stearns share? And was the decision to buy the world’s most storied investment bank predicated in the belief that a good proportion of the $41.5 billion of Level 3 assets acquired from Bear Stearns will, with the passage of time, transition to Level 1 status?
There is little doubt that all assets levels (as per Fair Value Measurements defined under SFAS No. 157) contained in the balance sheets of the bailout targets have deteriorated since the last accounting quarter. The $115 billion market-capitalization number for JP Morgan today can be deemed a decisive overvaluation. As more data in early 2009 confirms the key underlying trends (down) governing asset valuations, JP Morgan’s share price should work its way to $15; Friday’s closing price ($30.94) represents a bargain for short sellers.
The “finger-in-the-dyke” strategy adopted by Ben Bernanke and Hank Paulson is firmly grounded in the belief that if you keep the financial and insurance sectors running (on life-support) long enough, even serious flaws within those sectors will be corrected. Therefore, the fundamental thrust of any bailout or rescue must be the avoidance, at all costs, of systemic risks. A late night (March 13, 2008) review of Bear’s books convinced the Fed Governor and the Treasury Secretary that failure (bankruptcy) was simply not an option; that Bear was “too interconnected to fail”. For instance, Bear’s credit default swap portfolio alone revealed an astounding 5,000 counterparties.
As John Cassidy (The New Yorker, December 1, 2008) explains in his insightful review of the tempestuous days of September and October, JPMorgan’s “knockdown price of two dollars a share” was the end the result of intense and “torturous” negotiations after the Fed agreed to take on Bear’s $29 billion portfolio of subprime securities, not a consequence of any comprehensive valuation of Bear’s Level 2 and Level 3 assets; while Level 2 assets are valued through observable or unobservable inputs that are corroborated by market data, Level 3 assets cannot be corroborated by market data.
Most disturbingly, based on his investigations, Mr. Cassidy suggests that many of the decision-makers involved in the Bear buyout were not entirely familiar with the dynamics of credit default swaps, collateralized debt obligations and complex structured products. So it is fair to assume that the Bear and JPMorgan merger did not adequately incorporate either the potential risk of depreciating Level 3 assets wiping out the latter’s earnings well into 2010, or the hefty loss provisions demanded by Level 2 assets in the light of rating downgrades and defaults in the US corporate matrix.
Thus far, there has been no disclosure concerning Bear’s 5,000 counterparties. For that matter, the true extent of counterparty exposure (on foreign exchange, interest rate and credit derivatives) in the financial statements of American International Group (AIG), Citigroup (C) and Goldman Sachs (GS) has also remained a closely guarded secret. But regardless of the counterparties, the post-September widening of spreads in the CDX investment-grade and high-yield indexes generally spells trouble for Level 2 and Level 3 assets and for the credibility of capital-adequacy and solvency ratios over the next few months.
As far as JPMorgan is concerned, its ability to sustain anything close to its last quarter income of $527 million ($0.11 per share) during the course of 2009 will be further impaired by the delinquency allowances required by its regular banking business, which now also includes the business of Washington Mutual.
Disclosure: Author holds short positions in C, GS, JPM