Why Bear for $5 May Make Sense

Submitted on Wednesday, March 19

By all accounts, JPMorgan (JPM) has all the leverage to complete its proposed acquisition of Bear Stearns (BSC) for $2.00 per share. Actually, since it is a stock deal and JPMorgan shares have risen since the announcement, the acquisition price is now $2.40 per share.

Still, for a deal likely to be made at $2.40 per share, why would anyone be willing to pay $5.00 per share for the stock today? One answer that keeps getting bandied about is that bondholders are buying the stock in order to vote for the deal, as it is worth losing some money on the stock to preserve the value of the bonds.

That argument makes some sense, but I believe it doesn’t tell the whole story. It is possible for the bondholders to not only preserve the value of their bonds, but to lose very little on the stock in the process.

While the stock has been getting all the news, options on Bear Stearns have seen enormous trading volume. I think the bondholders are buying the stock, but hedging their bets by creating synthetic short positions.

A synthetic short consists of writing a call option and buying a put. Here’s how I think a bondholder can be playing this:

• Buy 100 shares for $5
• Write an October $5 call option for 2.10 (bid price as I write this)
• Buy an October $5 put for $2.45 (ask price as I write this)

Net cost for this transaction is $5.00 + 2.45 - 2.10 = $5.35. At expiration, it will be worth $5.00 no matter where the stock is trading. So, for $0.35 per share, or $35 for every $500 of exposure, the bondholders can buy the right to vote on the deal.

Given that the bonds were trading at $700 per $1,000 face value on Friday, and are worth $1,000 when backed by JPMorgan, it is pretty simple math. For every $1,000 of bond exposure, you can pay $70 to vote in favor of a deal that is worth $300 to you.

What’s more, since there was so much more debt than equity, only a small fraction of the bondholders need to make this bet to gain an overwhelming majority of the equity votes. Or, each bondholder could insure a smaller portion of their value.

Taking that into consideration, paying $5.00 for the stock starts to make sense.

Provided, that is, you already own the bonds.

Disclosure: None

Comments

[Derek Dizhi...:]

If the $2 deal went through, 420 instutional clients will take a hit because there are that many holding Bear Stern's stocks at at least $80 to $100/share. If the deal went through, all 420 institutions will take a hit (assumed they holds 250,000 shares of Bear Stern at $80/share), we are talking about $40 millions in red on their balance sheet. Those include Morgan Stanley, Vanguard, Janus Capital Management, and many other funds each holding at least 655,000 shares at $80/shares at least. Morgan Stanley by Dec 7, 2007 still holds 6,500,000 shares at $80/share, equals about $500 millions. If it went through by $2 deal, it will be $13 millions in return for $500 millions in cost to Morgan Stanley. But this is only one company, just think, when this $2 deal went through, by the end of the year, it will reflect on all 420 institutions balance sheet with a hit of $40 millions, and how do funds operate, they have to increase asset value (NAV) and returen to attract new investors. When they take the hit, it will mean lower NAV, and most investors will not stay around to wait for the drop in their investment, the investors will redempt, the funds will run out of cash, and instead they will have to sell off the fund's portfolio at a discount to come up with the cash for investors redemptions. When all 420 institutions or funds are all selling at the same time, all stocks will be down, and possibly lead to a market crash as well, and when the US market is not stable, the worldwide market will be affected as well. It is a ripple effect which will affect every single household whether they own the stock or not (because when the stocks are down a lot, some companies will start to lay off people as well). As of today, there are 2 pending class action lawsuits filed against Bear Stern's for the $2 deal. And New York City Comptroller Thompson also has filed another investigation because City retirement fund has $10 millions in Bear Stern's stocks. Joseph Lewis (the largest single shareholder of Bear Stern) already said he will fight the deal. If the $2 deal went through, it will be like setting a TB in the US and by the end of the year, it will pop. We need to protect our investments and our jobs too. While all the online stock watchers are talking about bondholders are buying BSC in order to make sure the $2 deal went through. But when the entire stock market are hit, what makes you think a lone bank JP morgan Chase can survive the worldwide drop? Both Senate and House already initiated an investigation on this $2 deal. It is the truth I am telling and it is just like the "Next" where I can already see what will happen at the end of the year. May God The Father protect us all...

2008 Mar 20 10:09 AM

[User 166164:]

Two things about it:
1. The institutional investors have 77% ownership and thus the bondholders can't buy too much. The employees 30% portion of that 77% is mostly restricted to be non-voting. So the Bondholders don't have much to trade on.

2. The deal is for a 20% "option" to buy at $2.00. Sure that gives them some control of the board, but the other 80% of the stock is not priced at $2.00 and the market price could go up form there.

On another note, if this was a DONE DEAL, then why has the Fed allowed trading to continue. In a DONE DEAL, the trading would be suspended.

On another note, there were some Blog replies that made the point of the legality of this. The fed window was closed, so did they have the authority to do this. I think that's a stretch to try to sue the government anyway.

My killer question in all of this is the 80% not being purchased by JPM. Is it like Chrysler Stock at $3.00 or is the price somehow fixed at $2.00? I think it is market priced and that makes this another Chrysler deal.

2008 Mar 20 10:24 AM

[mrmarket:]

you'd think JPM would be out buying up Bear debt right now. Push it up near par. Regardless of whatever trades bondholders have put on in order to vote on the deal, if they can sell their bonds close to par today, they'll take it.

2008 Mar 20 11:28 AM

[cwydavi:]

So, is it not a good idea to buy the stock now at $5? If I buy now at $5, about today's price, then will I possible lose when JPM buys at $2? Im new to this. I appreciate any advice. Thank you!

2008 Mar 20 05:29 PM

[User 165900:]

Well done. I agree 100%.

2008 Mar 20 07:25 PM

[Reinko:]

To Derek Dizhi Huang:

Very informal, of course every household will be hit via this one way or the other. Wait for the rest of this year, much more beatings will be there.

To User 166164: If you can go short on stock you do not have in your portfolio your 77% of stock holded by institutinal stuff argument does not make much sense. In this financial environment elephants can fly...

To the author of this article: smart calculations, but do they bear fruit?

At last: Why is nobody reporting on the fact that the Bear bank had about 13 trillion in derivate contracts? Why should they need an entire US GDP size postition in this?
For a long time I am studying the absurd position of derivatives at the International Bank for Settlements from Basel.

It is very simple: The positions are so huge that no one will pay the stuff reported over there and 13 trillion is just peanuts I can tell you...

Yes it is peanuts, an entire US GDP is just peanuts over there!

2008 Mar 20 07:31 PM

[zenalgorithm:]

So the bondholders only have to write options for about 30-40% of the float to virtually ensure the sell to JP.
The float is 115,810,000 shares.

So they have to write puts and calls for at least 40 million shares? Completely unrealistic... What is the daily volume on the total # of options for BSC?

My guess is that the government is going to have to somehow force BSC into some sort of bankruptcy if the resistant shareholders hold their ground. If I were a BSC shareholder, I wouldn't settle for a weenie $2...might as well force the bondholders and banks to compromise a better offer.

IMO, the government is going to have to force a quick bankruptcy to end all the potential litigation quickly.

2008 Mar 21 01:09 AM