More Questions Than Answers on Bear

I've just read through last night's conference call (.pdf) on J.P. Morgan's purchase of Bear. Overall, I've many more questions than answers:

1. Sure, executives always talk up their deals. But really, this sounds like a fantastic coup for J.P. Morgan. They get Bear, which as a going concern was worth roughly $10B not long ago, for next to nothing. According to JPM execs, Bear was being candid when it insisted its books were fundamentally sound, and the crisis was just a liquidity issue. Much of the risk JPM might not have been comfortable with has been laid off on the Fed. jck at Alea notes that the markets, skittish about financials though they may be, have rewarded JPM with roughly $11B in excess market capitalization today. The market clearly views the deal as a windfall for J.P. Morgan. If a Fed-guaranteed Bear was a $10 billion bill just waiting for someone to pick up off the floor, why were there no so few bidders this weekend for the firm? Why was J.P. Morgan able to name its price? Alternatively, why didn't the Fed itself purchase the firm for $2 a ticket and then negotiate at leisure a value-maximizing sale for the benefit of taxpayers?

2. Why were Bear's shares worth $30 Friday at 4 p.m. and close to $0 by Saturday evening? (Charlie Gasparino announced on Saturday that the firm would likely file for bankruptcy if a deal wasn't done over the weekend.) Pointing to rating agency downgrades isn't helpful. S&P and Moody's have clearly tempered their pace of downgrading the monoline insurers and some AAA structured credits in order to mitigate systemic risk. I think it implausible that they would have downgraded Bear so quickly without some consultations. After all, as of Friday, Bear was perfectly liquid (thanks to the Fed's special credit line), and it's overall position looks to have been pretty solid. Somehow, something happened over a period of 24 hours that changed Bear from a slightly tarnished name that yet sell itself for a decent price to an urgently distressed asset. I've yet to hear a convincing account of how that went down. (Lawyers have already been called to look into this, and JPM has set aside funds for litigation.)

3. The Fed is financing, and bearing the downside risk, on roughly $30B of Bear assets. About $20B of those are mortgage-backed securities, the rest are unaccounted for. Many of us — perhaps reasonably, perhaps hysterically — view Bear's derivative portfolio rather than its mortgage-backed securities as the greatest concentration of risk. Is it possible (and I am asking here, I really don't know!) that an "in-the-money" derivatives portfolio could be viewed as an asset, and pledged to the Fed? After all, synthetic credits include CDS positions, and we wouldn't be surprised to learn that the Fed accepts highly-rated synthetic bonds as collateral. Very specifically, is the Fed's downside risk on the $30B it has financed limited to $30B (the Fed gets stuck with worthless assets), or has it assumed a role as a guarantor of assets that could become outright liabilities under adverse conditions? I do not think this is likely, it would be too radical, too weird. But it would be nice to have explicit assurance that the portfolio whose losses the Fed has taken responsibility for includes only "limited liability" securities.

4. In my previous post, I feared that Bear execs would use the threat of a destabilizing bankruptcy to try to extract an undue payout to shareholders. Now that the deal is done, and it is Bear shareholders who seem to be shafted, Andrew Clavell asks very pointedly why Bear did not use its bargaining power at least a bit more effectively. Why couldn't Bear hold out for $4 per share instead of $2? Just how hard ball did J.P. Morgan and/or the Fed end up playing? Andrew points out that the option value of a share in bankrupt Bear might be more than the $2 consolation prize on offer. Why should Bear shareholders accept this deal (they must vote to approve it)? The possibility that Bear shareholders would not approve the deal was the risk Morgan executives seemed least capable of addressing during the conference call. They think shareholders will approve, but things will clearly get complicated if they don't.

I want to reiterate, I think the outcome of all this is better than it could have been. I feel some sympathy for Bear stockholders, since fundamentally the firm may have been no less sound than its competitors. But managing liquidity risk was the Bear's responsibility, and it failed to do so. From a "moral hazard" perspective, I'm glad an important player was allowed very publicly to fail. However, any salutary effect on incentives may be counterbalanced by the new funding facility for investment banks, which looks like a commitment by the Fed to bail-out any other firm in similar straits. I'm also a bit uncomfortable with J.P. Morgan's windfall, which isn't really a "market outcome", and strikes me as a massive case of "private the gain, socialize the risk".

I'm glad the Fed removed any incentive to try to bring down other firms via "bear raids". But, as a correspondent of Yves Smith points out, investment banks may be safe, but hedge funds are suddenly vulnerable. I'd guess that the Fed is privately suggesting aggressive margin calls on hedge funds would be unwise right now. The Fed's bully pulpit is in good shape, as a firm excluded from the Fed's new liquidity facility would be one whisper campaign away from roadkill. The impaled carcass of a bear sits at the gate of Dr. Bernanke's castle as a reminder to all of the price of being disliked.

Comments

[ajwooley@gm...:]

Because the Fed and JPM want to defy years of economic theory.

2008 Mar 17 04:56 PM

[AlexS:]

Bear shareholders will only be paid $2. However, by the time you add in all the lawsuits that will fly you get to about $30 a share which was the value on Friday. So it's not really a windfall for JPM. Easy come easy go.

2008 Mar 17 05:30 PM

[cfish:]

I doubt that JPM made a good deal on this. The fact that JPM checked the books and the Bears Building valuation is 1Billion tells me that the book was way worse then we all can imagine. All JPM did was "guestimate" how much more loss it will take for assuming Bears debt.

2008 Mar 17 06:28 PM

[Egg:]

According to a Jim Rogers quote I read, Bear Stearns execs would have had to give back a billion plus in bonuses paid out in January if they had filed for bankruptcy.

If it's true, it would help explain the rationale for the take-under. If it's true, it will also be used against BSC in all the civil suits JPM is expecting.

Regardless, the whole thing really stinks...and I can't envision any shareholders (at least if they voted today) voting for the merger.

2008 Mar 17 06:57 PM

[User 5045:]

From TheDeal.com

Indeed, J.P. Morgan's CFO, Michael Cavanagh, indicated in a conference call Sunday that the bank is building a $6 billion "cushion" for transaction costs, which includes litigation, severance payments, integration and deleveraging. Taken with the share-payments to Bear shareholders, that gives the broker-dealer a market value of about $44 a share, or $5.2 billion, according to Jefferies & Co. analyst Andy Baker.

That number is still much lower than the $84 a share in book value that Bear reported at the end of November.

2008 Mar 17 07:35 PM

[DougM:]

1. Why was J.P. Morgan able to name its price?
A: The only firm available to buy BSC that has the balance sheet strength and liquidity from the fed. Other possible buyers either can't borrow from the fed or are banks with balance sheet troubles of their own.

2. Why were Bear's shares worth $30 Friday at 4 p.m. and close to $0 by Saturday evening?
A: Because bankruptcy appears to have been the only other alternative, as their liquidity was exhausted. The new liquidity facility from the fed arrived too late for BSC. It might have collapsed Friday if not for the liquidity infusion channelled through JPM. As to the price, who knows? Wishful thinking on the part of shareholders as to the actual value of the company? But without any other buyers, JPM could effectively name its price.

3. Is it possible (and I am asking here, I really don't know!) that an "in-the-money" derivatives portfolio could be viewed as an asset, and pledged to the Fed?
A: Many people think it's already a stretch that the fed is accepting MBS as collateral. Clearly the fed got involved here to avoid a cascade failure of the shadow banking system's derivatives pyramid, so I could forgive them from steering clear of that mess on their own balance sheet.

4. Why should Bear shareholders accept this deal (they must vote to approve it)?
A: You're right, BSC could have threatened to "go nuclear" and trigger the derivatives panic, as a means for trying to get a better price for the buyout. Then again, executives might have been worried about the lawsuits and possible criminal prosecution that might await them along that path. It will be interesting to see if large stockholders want to play at that kind of brinksmanship.

2008 Mar 17 08:36 PM

[GKM:]

So is opening the discount window to brokers a carte blanche for those brokers to go and take the near worthless debt to the Fed to exchange for t-bills so they can go and lever up a bunch of trades which probably equate to long oil short financials (since that is what is working)?

2008 Mar 17 11:14 PM

[chanakya:]

Equity owners have to bear the risk of an inefficient operation.. Obviously JPM knows more than it can reveal at this stage given the implications it will have on the broader market and some gentle cajoilng from the Fed. But as the vote comes nearer, you can expect tit bits on how bad the situation was and why a prolonged bankruptcy will not help the shareholders. It must have been quite a dilemma for the Fed on how to intervene in the situation, but the key factors would have been a (i)strong credit standing for the acquirer--they wd have to rule out a situation where the acquirer could not digest BS(ii) an indication that while the Fed will provide a line of credit, equity owners will ultimately pay(iii) err on the side of orderly transition even though it might disadvantage a few in the short term
Actually, the Fed may make some gains in the process.. who knows!
All in all a very decisive action indeed..these are learning times for policy formulators across the world.. learn while you drive

2008 Mar 18 02:08 AM