The Bear Stearns Saga and the Fed's Dilemna

Bear Stearns (BSC) covered the airwaves all of Friday, with its 'significantly deteriorated' liquidity position and the early morning announcement of a NY Fed-JPMC liquidity support package. The Fed has gone a step further now after its 200bn TSLF announced the past week. It is now taking a direct risk on MBS-heavy instruments that it will bank on as collateral for the indirect funding to Bear Stearns. It's indeed a daring step, considering the state of the debt markets. However, nothing short of this would have helped either: BSC going bust would have caused irreparable damage to the financial world and probably have caused a market freeze. Despite the Fed-JPMC intervention, apparently some capital market players found the liquidity situation so demanding that they couldn't even borrow money on Treasuries. How much more worse could it get?

Now that a significant part of market confidence over the short term depends on how the BSC saga unfolds, it is important to have a view on this story.

BSC's 9bn+ revenues in 2006 came from a mix which included 4+bn from fixed income, 2+ bn from equities trading & research, 1+bn investment banking underwriting and advisory, 1+ bn from global clearing services/prime brokerage and another 0.5bn each from private client services & asset management. The most seriously affected portion of the business is obviously the fixed income division, which is heavily exposed to residential MBS (including a good component of securitized ARMs). Most of its securities and fund loans to hedge fund providers would probably be significantly impaired in terms of liquidity. It has over USD 350+bn in assets/liabilities riding on a shareholder capital of just over USD 12bn. This leverage of over 32:1, with about 15+bn of its debt maturing in the next four quarters, exacerbates the short-to-medium term liquidity position. However, its prime brokerage infrastructure, equities trading & research depth and private client advisory business would still command good value despite current market conditions. Considering that the Friday EOD stock price of 30/share is just about 1/3rd of its 85/share+ book value, there's probably still enough value in this stock considering that there's still good potential in divisions that account for over 50% of its revenue stream. However, with its over-leveraged balance sheet, true value depends a lot on mark-to-market valuation of its huge MBS and CDO portfolios.

BSC would definitely have enough willing suitors, though valuation range is an unknown factor at this point. JP Morgan (JPM), being BSC's clearing and settlement service provider, would be in the best position to judge the true value of its debt portfolio. It is probably for the same reason that JPM was the conduit for the Fed-sponsored bailout package, architected between Lazard, NY Fed and JPM Thursday night. Interestingly, NY Times already mentions JC Flowers and RBS as being potential suitors too. There is already talk of some kind of a long-term deal in the next 48-72 hours. However, my personal feeling is that this might eventually take longer to play out. Most likely the key players would want BSC to regain some confidence with its pre-poned Monday earnings conference. If Alan Schwartz and Sam Molinaro are able to manage the call focusing on key fundamental strengths of their global equities & prime brokerage business, and also articulate clear short-term and long-term revival strategies, we should see some revival of market confidence in Bear. To draw a comparison, E*trade's (ETFC) Jarrett Lilien did a reasonably good job at this, focusing on fundamentals strengths of their trading platform. If the Monday call pans out well, we could see some rebound in the stock, followed by a possible long-term deal announcement over the next 3-4 weeks.

The whole BSC development poses an even more tough situation for the Fed ahead of this week's FOMC meeting. Its 200bn package together with sustained inflation would have given it enough reason to avoid a major (50 bps+) rate cut; but the situation has now changed back to panic mode. I would now reduce my bets on a 50bps or lower rate cut, unless Monday turns out to be unusually good for the market. This Fed has been reacting to market pressures so far and it is difficult to imagine them taking a longer-term balanced (inflation vs growth) in this post-Friday market situation.

Disclosure: None

Comments

[prescient11]

The problem with BSC is that their survival requires other entities to deal with them, which they will no longer do, especially since they were downgraded. Thus, a deal appears almost essential by Monday a.m. ETFC is in a much stronger position as they are not leveraged (thus they can work through problems over time) and have a money making brokerage to support the bank, will have over a $1B cushion IN CASH above the well-capitalized levels (stronger than Citibank's) and now have the backing of Citadel - a hedge fund so strong that they are also mentioned as a possible purchaser of all or part of BSC. Unfortunately, BSC has no such backer, is leveraged to the hilt, and now has been severely downgraded impeding their attempts to get back on track quickly.

[prescient11]

In other words, BSC will be gone Monday and Etrade will survive and thrive for a long time coming, it's practically assured that Etrade is more than fine. The problem is leverage and liquidity. BSC has too much of the former and not the latter. Mr. Lillien had a much better story to tell - i.e., they make a ton of money on the retail brokerage, they have absolutely no subprime or CDO exposure, and the Citadel backing makes it clear that they are flush with cash.

Unfortunately, BSC does not have such a story to tell.

CNBC is already reporting that JPM is making the deal.

www.cnbc.com/id/236589...

[Maniac inMotion]

Any deal JPM would get would likely by at a very steep discount.

The buy won't consider current revenue streams, it's all about the losses JPM will swallow from taking BSC under its wing. And the losses incurred by MBS exposure may likely be partially tax-deductible if JPM works it right with government begging JPM to do so.

Companies buy other companies at a premium when they see a synergy. There's no synergy here. It's less a takeover and more a takeunder. A JPM/BSC acquisition is less about winning synergies and more about keeping global financial markets from needing a defibrillator.

CLEAR! :$

[Maniac inMotion]

Woooooooooooooow... news just out JPM buys BSC @ $2/share per the WSJ. And BSC closed Friday @ $30. Wooooooooooow, talk about payday for those BSC puts.

[the finalhorseman]

i wonder if benny and the jets have a stake in jp? or maybe they want jp to be the new united states treasury? something doth not smell correct here, besides a bunch of rotten fish in denmark