JP Morgan Increases Fed-Backed Bid for Bear

Last Monday, the news swirling around the stock market was JP Morgan’s (JPM) $2 per share bid to buy Bear Stearns (BSC). Bear – at the time the fifth largest U.S. Investment Bank -- astoundingly was being sold for about $240 million, far less than the value of its Manhattan headquarters building (approximately $1.5 billion). Further sweetening the deal for JP Morgan was the Fed’s pledge of $30 billion against some of a Bear’s most illiquid mortgage backed securities.

It was a momentous act by the NY Fed and reminiscent of the bailout of Long-Term Capital Management [LTCM] ten years ago. LTCM had made highly leveraged bets on bond convergences and collapsed during the Asian currency crisis. Fortunately, when the dust settled, the Fed’s emergency intervention staved off panic and LTCM’s risky bond positions were eventually liquidated by other holders at a slight profit. As an interesting side note, Bear Stearns CEO Jimmy Cayne was invited to take part in those bail-out negotiations, but reputedly indignantly stormed out of the meeting without committing Bear to the rescue effort.

Bear Stearns executives were hard at work again this weekend, in an attempt to appease shareholders who were extremely upset with last weekend’s fire-sale price of $2 per share. Bear Stearns stock traded up a bit last week based on market speculation that a better offer for the company was possible. Reports yesterday morning suggest that a deal reached over the weekend will increase JP Morgan’s bid to $10 per share. While this is an improvement, it may still find resistance from Bear shareholders who remember the shares were worth $170 in early 2007. Sadly, this may be as good a deal as Bear will find, as its highly leveraged portfolio of risky mortgage backed assets is virtually illiquid as a result of the ongoing credit crunch. Bear is left with the stark choice of taking an unpalatable deal or going bankrupt.

The NY Fed will still play a crucial role in the new deal with one slight adjustment. In the prior deal, it agreed to be responsible for up to $30 billion in losses for financing Bear Stearns’ illiquid assets. Now, JP Morgan will bear responsibility for the first $1 billion in losses and the Fed will cover the next $29 billion. Clearly, the Fed’s commitment was a key mechanism to move JP Morgan to action, Fed backing was necessary in order for JP Morgan to take on the risks associated with Bears’ substantial and risky mortgage backed assets.

Time will tell if this deal will leave the Fed covering a huge portion of Bear Stearns’ losses, but they have certainly taken much of the vulnerability away from JP Morgan. Is this really a substantial improvement over just letting Bear Stearns go bankrupt and sorting out the pieces afterward? The Fed is sending a message to financial firms that are “too big to fail” that if you ride a bubble too long, do not worry because there is a fairly good chance you will be bailed out. This increases the moral hazard in the future that aggressive speculation and poor risk management practices will likely cause a recurrence of the same circumstances which led Bear Stearns astray.

Disclosure: None