On Sunday, March 16th, 2008, JP Morgan (JPM) along with the Federal Reserve (Fed), announced that JP Morgan would be purchasing Bear Stearns (BSC) - which was once valued at $160 per share - for $2 per share. This deal was brokered by the Federal Reserve as a last ditch effort to save the ailing Bear Stearns from an imminent bankruptcy filing.
If we look at the details of this buyout, we see that the Fed provided $30 billion in non-recourse funds to Bear Stearns, via JP Morgan and the discount window the Fed provides them. This move was seen as necessary in providing liquidity as hedge funds and other Bear Stearns account holders rushed to the venerable investment bank demanding their money. Bear Stearns, being leveraged over 30 to 1, did not have sufficiently liquidity to deal with this "run on the bank" and therefore had no other choice but to take the deal.
While it is true that Bear Stearns shareholders still have the ability to vote on the takeover, it is widely believed that the only possibility, other than the $2 per share deal, is bankruptcy. JP Morgan all but assured the deal would go through as planned by including several poison pill provisions into the deal:
- If the deal does not go through and another bidder emerges, JP Morgan retains the right to buy 20% of Bear Stearns for $2 per share
- JP Morgan retains the right to purchase the Bear Stearns headquarters for roughly 20% less than its value
In addition to this, the Fed is providing $30 billion to Bear Stearns through JP Morgan and has already told JP Morgan that this debt is non-recourse, that is, JP Morgan is not responsible for up to $30 billion worth of bad assets that Bear Stearns has. I doubt other banks would receive such a wonderful offer to use our tax dollars for a bailout from the Fed.
This is very interesting when you look at the numbers. If JP Morgan is willing to buy Bear Stearns for $240 million even after the Fed takes the first $30 billion hit, it must value Bear Stearns at roughly -$29.76 billion.
I think that number is slightly exaggerated, as JP Morgan is certainly making this deal because they expect to earn some hefty returns on their $240 million investment. Let's say JP Morgan wants to gain 1000% on the transaction, valuing Bear Stearns, after the $30 billion safety net, at $2.4 billion. That seems reasonable. JP Morgan could certainly get away with buying Bear Stearns for 10% of its true worth; they certainly had the leverage in the negotiations.
Okay, so if you subscribe to the thought that Bear Stearns losses will not exceed $30 billion, then JP Morgan values Bear Stearns at roughly -$27.6 billion ($2.4 billion minus $30 billion in bad assets). What does this mean for Lehman Brothers (LEH), Goldman Sachs (GS) and Merrill Lynch (MER)?
If this analysis is even remotely accurate, and I believe it's not outlandish, then the other investment banks are in for a world of hurt, as are their investors.
In the interest of full disclosure, the author of this article owns put options in Lehman Brothers (LEH).