What's In Store for Bear on Monday?

Includes: BSC, JPM
by: Steve Waldman

On Friday, Alea's J.C. Kommer pointed us to an SEC press release about Bear Stearns:

According to the information supplied to the SEC by Bear Stearns as of Tuesday, March 11, the holding company had a substantial capital cushion. In addition, as of March 11, the firm had over $17 billion in cash and unencumbered liquid assets.

Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns' excess liquidity rapidly eroded.

The title of JC's post was "Bear Raid".

That's not just a pun on the troubled firm's name. "Bear raid" is a term of art for a well-known, usually illegal, strategy. Suppose you know the positions of a heavily leveraged, capital-constrained player, and you'd like to have its assets on the cheap. Rather than trying to buy those assets, sell them short to drive down their prices. At the same time, start rumors that their current owner is insolvent. Soon the target starts getting margin calls it cannot meet, and is forced to liquidate its portfolio to satisfy creditors. This puts even more pressure on the already depressed prices of its holdings. Buy up the dying target's portfolio, along with the assets you sold short, for a song. Ka-ching!

Cassandra offered some wonderful musings on this kind of strategy in connection with the now quaint Amaranth meltdown.

It's unlikely that Bear's little liquidity problem last week was anybody's secret plot. There is quite enough spontaneous, organic panic in the market to explain how a teensy little rumor might spiral into a life-threatening crisis for a firm with an overstretched and uncertain balance sheet.

But, in light of the circumstances, I was troubled to read this CNBC story (via Calculated Risk):

The discussions indicate that potential bidders for Bear have been narrowed to [J.C. Flowers and JPMorgan Chase], although other last minute contenders could still weigh in... time has become a major issue for the investment bank... S&P lowered its long-term counterparty credit rating on Bear to "BBB" from "A," and it placed long-and short term ratings on credit watch with negative implications... Because of that S&P downgrade, bankers have now come to the conclusion that a deal must be done by Monday morning because no one on the street will trade or lend to Bear Stearns, which is rated a notch above junk bond levels... If there's no deal Bear Stearns will have to file for bankruptcy, executives said.

A quick sale, on its face, is an attractive option. It's a "market solution". Bear stockholders wouldn't be completely wiped out, and Bear's counterparties would be relieved to have a stronger player on the other side of their deals.

But a quick sale is likely to be a fire sale, and it's impossible for a transaction of this complexity to be adequately vetted in 72 hours. With all the world trying to get a deal done, whoever "buys" Bear might end up getting the firm's good assets cheaply without fully assuming Bear's potentially unknowable liabilities. (Recall the uncertainty still surrounding Bank of America's purchase of Countrywide.) In the very worst case, to make the crisis go away, the Fed might be asked to backstop some or all of Bear's obligations while a "buyer" cherrypicks the assets.

Viewed as a one-shot affair, this might seem like the best that can be done in a bad situation. But, alas, there are always those unanticipated consequences to consider. Bear Stearns probably was not the victim of an intentional bear raid. But, set the right precedent and the next bank to fall very well could be.

Bear Stearns has already been nationalized all but in name. Executives hinting that the firm will file for bankruptcy unless an immediate sale is arranged are playing a game of chicken with the Federal Reserve, trying to get paid now for stock that may be much worse than worthless when all the books are tallied. They suppose they have leverage, since the Fed has made clear that an abrupt bankruptcy would be too harmful to permit (probably because of Bear's role as a derivative counterparty, see Michael Shedlock).

Suppose that Monday morning, Ben Bernanke is presented with a deal, under which a buyer gets Bear assets on the cheap, Bear stockholders get paid out, and the Fed (implicitly or explicitly) bears residual risk. If the Fed doesn't approve, executives say, Bear will file for bankruptcy. Dr. Bernanke will then have an unappetizing choice. He can say yes, and hope that there aren't any more rumors out there about any other firms. Or he can say no, and make it very clear that if Bear Stearns files for bankruptcy despite the Fed's continuing provision of liquidity, he will do everything in his power to hold Bear executives personally responsible for the crisis that results.

A man who by all accounts is a very nice guy may be forced to play some very hard ball.