JPMorgan Stole My Thunder by Buying Bear Stearns

How quickly value can evaporate these days. On Friday, Bear Stearns (BSC) closed at $30, down from $57 the night before. I spent the weekend working up an article on why investors should still avoid it despite an apparently low price relative to book value. Before I could publish it (not that it would have done any good), JPMorgan said it will buy Bear Stearns.

JPMorgan Chase & Co (JPM) said on Sunday it would buy stricken rival Bear Stearns for just $2 a share in an all-stock deal valuing the fifth largest investment bank at about $236 million.

How could a stock go from $57 to $2 in two trading days, all the while having a book value above $80? I can’t say, exactly. But here’s what I was planning to say on the assumption that the stock would still be $30:

Many value investors look for stocks trading at prices below the company’s book value per share. Such stocks are often undervalued.

After Bear Stearns’ shellacking on Friday, the stock closed at $30. Yet on the conference call, Bear Stearns CEO said its book value “fundamentally” is still in the mid-$80 range. Does that mean value investors should step in?

I don’t think so. Taking a look at the 10K the company filed in January, I found it quite easy to make most of that $11.8 billion book value disappear.

To start with, there is $950 million recorded as “goodwill & intangible assets.” Subtracting this out leaves a tangible book value of $10.8 billion, or $82 per share.

Next, Bear’s balance sheet includes, in “other assets,” $5.2 billion in “financial instruments that are valued using models or other valuation methodologies.” Most of the total is “comprised of financial instruments whose fair value is estimated based on internally developed models or methodologies utilizing significant inputs that are generally less readily observable.”

Given that the credit issues have really just started to flow through the system, I’d want to be conservative about the value of these instruments. For the sake of argument, I’m assuming they are really only worth half their book value. Admittedly, I’m just making a guess. But then again, so is Bear Stearns.

If I take $2.6 billion off the value of these instruments, the tangible book value is reduced to $8.2 billion, or $60.22 per share.

Bear also reported $33.5 billion in “assets of variable interest entities and mortgage loan special purpose entities.” These were the loans it was unable to move off of its balance sheet. Of this amount, Bear says its maximum loss is nearly $3 billion. For conservatism, I’ll assume that maximum loss gets realized. That cuts the tangible book value to $38.

Finally, as of November 30, 2007, the company had notional/contract amounts of approximately $13.40 trillion of derivative financial instruments, of which $1.85 trillion and $1.25 trillion, respectively, were listed futures and option contracts. These amounts are not fully reflected on the balance sheet.

It’s likely that many of these derivative instruments offset each other, reducing the total exposure that Bear faces. But without being able to see the underlying contracts, investors are unable to make that judgment. Since the tangible book value is less than a tenth of one percent of the notional value of these contracts, it isn’t hard to imagine the contracts changing in value sufficiently to wipe out the remaining tangible book value.

While there may be a buyout of Bear Stearns, it would be made by sophisticated investors with full access to the company’s financial information. These investors are in a position to determine a value for Bear Stearns.

I, on the other hand, am not. And if I can’t make a reasonable estimate of the company’s value, I’m going to stay away.

Disclosure: The author has no positions in the companies mentioned.