Thoughts on the Bear Stearns/JPMorgan Deal

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).

Comments

[User 167134]

Whatever. You act as if those mortgages have no value. They may be impaired but are worth >0.

Top tier traunches are less risky than people are giving them credit. Bottom traunches are junk but not all classes are. I wish I could get into the hedge fund that buys these assets up at pennies on the dollar.

Keep spreading fear to get your puts in the money!

[Ryan]

If they're worth more than 0, which I also tend to believe, it doesn't change the fact that JP Morgan values Bear Stearns far below what it once was worth. That's a fact. Put aside what everyone tells you in the media, and that fact is what you're left with.

JP Morgan can value things far better than we can.

[Research123]

LOL...JPM can steal a company better than anyone else can!

[BalanceSheetChecker(BSC)]

Here is my theory: Bear Stearns is worth a whole lot more than its current price but an irrational run on the bank (as short-term panics tend to be) put it and the whole financial system at risk. The Fed's role is to promote stability in the financial system which meant it had to do something. And fast. Now put yourself in the Fed's shoes. It didn't want Bear Stearns to go under. Period. And in the panic of the moment there was no way anyone was going to step up and pay a full price for Bear. What do you do? You don't really want to give Bear away to JPMorgan, or anyone else for that matter because that would imply that the system is/was in fact unstable and just giving it away to someone would put it in a comprimised position (as evidenced by all the inquiries/lawsuits/etc... the deal now faces). Everything I have read about this deal seems like the Fed came up with the perfect solution - Have JPMorgan offer to buy/backstop Bear for an absurdly undervalued price with some help from the Fed ($30 billion support that was incredulously only offered to JPMorgan?!). The less people in on this fix of a deal the better. As we have seen this has provided the needed stability/confidence for Bear to contunue operations as normally as possible under the circumstances, which is job A-1 for the Fed. Also at the ridiculously low price it ensures the deal never actually goes through because shareholders would never vote for it. (Even a week later the volume of shares trading hands well above offer price shows that nobody actually thinks this deal will go through). Finally the deal was structured so that it doesn't make sense for anyone else to make a run at Bear AND the whole process is forced to drag on for at least a year through a re-votes mechanism, giving the markets plenty of time to calm down. I must say, the Fed came up with a brilliant solution to such a tricky situation! A company with over 80 consecutive years of profitability (how many firms can say that?) gets to stay in business rather than being forced to sell itself out in an irrational panic. Sharholders will keep voting down the absurdly low offer (which, if the rumors are true, the Fed forced to be low-balled for this very purpose) and no one will be foolish enough to give JPMorgan 20% of the firm by making a counter-bid within the next year. In time this crazy JPMorgan offer will expire and it will again be business as usual for Bear (and more reasonable valuations will return for its shares). The value of Bear coming out of this will depend on how much Bear employees let JPMorgan meddle/sabotage their company while JPMorgan waits for their rejected offers to expire. Bear may lose some of its value as fair-weather employees panic and jump ship before this sorts itself out, but long-term employees that keep the faith in the value of their firm, their shares, and the financial system should come through just fine in the end (or at least much better than they are now!) There is, of course, the option on Bear's building which it will presumably have to buy back from JPMorgan next year for $400 million-or-so, but such is the cost for surviving a panic (and JPMorgan's fee for it's troubles).

[Tie D]

To the posters above. No one said the mortgage backed securities are worthless, they just aren't worth the money that they are being used as collateral against. This is what people mean when they talk about liquidity crisis. Here is an example of someone who is late in the run on the bank:

Bear Customer: I heard that your firm might be in trouble, can I please withdraw my 10 million dollars?
Bear Employee: The thing about that is we didn't actually hold onto your deposit. We invested it in these mortgage backed thingamajiggys, and about 20,000 other customers beat you to the window, so we ran out of cash. Would you like some CDOs instead?
Bear Customer: WTF am I supposed to do with this? I can't get anything for it.
Bear Employee: Well, if you look on the message boards, people will point out that they aren't completely worthless, they are just worth less than they were.
Bear Customer: Well how many do I get?
Bear Employee: Well, thats the thing...since we don't know what they are worth, we can't determine that. Also, we don't probably don't have enough for everyone.
Bear Customer: Well, where can I get face value for it?
Bear Employee: If we knew that, we would be able to liquidate it, and give you your money. Have a nice day!

[khinsaaa]

brilliant, you!! CHeck this out, your take reminded me immediately...

docs.google.com/TeamPr...

You should go work for SNL

[ekor]

If the sovergn wealth funds can get 11-12% on their bailout dollars, why can't the US taxpayers? I can appreciate the necessity to contain the tsunami like ripple effect of allowing these "too big to fail" institutions collapsing, but their future earnings should be directed at paying back Joe Taxpayer, & not fat bonuses to themselves for their over leveraged, gross mismanagement.

[BalanceSheetChecker(BSC)]

To Tie D,

That's where the Fed's job is to step up and provide liquidity. It's called "lender of last resort". Reasonable conservative accounting provides a value that the Fed will honor in times like these.

Anyhow, since this was originally posted JPMorgan was forced to raise their bid because the plan I described above was seen through. When it became too obvious the Fed didn't actually want the deal to go through they had to renegotiate on the fly to keep up the charade. The current offer on the table has been structured to be much more convincing but if I had to bet I'd say the deal still won't go through, but it will probably be halted due to legal challenges (how many holes are baked into this thing?!) rather than the more obvious shareholder vote. Just my theory.

[BalanceSheetChecker(BSC)]

Less than two hours after the last post the headline reads: "U.S. Pension Plans in Michigan Considering Seeking Restraining Order to Block JPMorgan Takeover of Bear Stearns".