JPMorgan, Bear Stearns: More Smoke from Wall Street

Yesterday, JP Morgan (JPM) CEO Jamie Dimon made a few statements that I just couldn’t let slip past my propaganda radar.

First, when asked about the current credit crisis, he stated that he felt it “appears to be three-quarters over.” I’m not sure how he can conclude that, given the enormous leverage banks still have, as well as hundreds of billions of sub-prime, ARMs, and Alt-A mortgages set to expire over the next 2-3 years. Certainly, while much of the fate of sub-primes will be resolved by 2009, there are many other problems brewing. Remember, the bond insurers are still a mess, and municipalities nationwide are just beginning to feel the effects of drastically reduced property tax revenues. Without some big backing from the banks, I can’t see how the bond insurers will be able to pony up adequate funds when certain munis go in default.

I have little doubt that over the next two years, many cities that will default on their debt. I expect to see huge defaults in certain municipal bonds from Detroit and Cleveland and most likely several other cities before it’s all said and done. This could easily expand into a statewide problem. California has already declared a state of fiscal emergency due to an expected deficit of around $20 billion over the next 12-15 months. That’s California. Can you imagine the potential problems faced by states like Ohio, Michigan, Illinois, and Pennsylvania?

If you haven’t already looked at some short strategies for munis, I’d say now is a good time to be doing so – just when the powers that be it are starting to spread the myth of a recovery in the credit crisis. Maybe Dimon is being honest about the credit crisis – for his bank. But in no way is the end near for the others.

I suppose when you are the recipient of an $18 billion gift from the Fed (i.e. Bear Stearns (BSC)) with virtually no risk of a net loss, it’s natural to start feeling good. The fact is that Bear Stearns was NOT bailed out by the Fed. A bailout would have meant that the Fed opened its printing presses to Bear. In fact, I would say that the JPM deal with the Fed will go down as one of the biggest heists in U.S. financial history.

Why do I say this? Well, first consider that, after the Fed issued $30 billion to help deal with potential liabilities at Bear Stearns, it stated that JP Morgan would only be exposed to a maximum of $1 billion in losses. So if JP Morgan loses the remaining $29 billion, they are free and clear. Taxpayers will be stuck holding the bill.

How can Dimon claim his bank is taking on “an awful lot of risk” with Bear Stearns when the Fed (taxpayers) are the ones taking almost all of the risk? In my view, after you factor in the Fed’s $29 billion guarantee combined with the ownership of all of Bear Stearns’ assets, there’s absolutely no net risk. In fact, I’d categorize this deal as a certain gain for JPM; most likely a huge gain. As the top player in hedge funds (in terms of assets), Bear has the world’s most highly coveted prime brokerage and clearing units. I would value these two units at around $18 billion combined.

In addition, Bears’ small group of elite brokers (a few hundred) are some of the most productive in all of Wall Street. When I was there, about 50% of them did at least $20 million in revenues annually (based on what I was told for whatever that’s worth; and by the way, I was in the other 50%). As a bonus, JPM gets to hand pick the best from what is already known as a very talented group of employees. Throw in another $2 billion for the value of the Bear employees they retain plus Bear’s $1 billion state-of-the-art headquarters in NYC. While JP Morgan might have to spend around $2 to $3 billion for restructuring charges (including employee retention bonuses, etc.) they stand to gain big from the deal with virtually no risk.

After trimming down Bear, I would estimate the total value of to be around $18 billion net for JPM, conservatively. All of that and Dimon refuses to give BSC shareholders a more generous buyout. (JPMorgan Chase CEO: Recession is just beginning). "I want to make it perfectly clear: Mission not accomplished," Dimon said. He warned investors that while he still believes the deal was a good decision, "we are bearing an awful lot of risk" by taking on Bear Stearns' assets.

Ask yourself why it was that after Bear’s liquidity crisis, the Fed announced it would extend needed cash to any other investment bank but didn’t include Bear Stearns. That, my friends is a bailout for the other Wall Street banks, if in fact they need one.

If you always wondered who the kingpin was of the Federal Reserve banking system, the JPM-Bear taxpayer-funded charade should at least point towards JPM. So why wouldn’t the Fed extend this protection (normally reserved for commercial banks) to Bear as well? Who knows for sure?

Here’s my best guess - I’d imagine that the Fed has not forgotten the refusal of Bear Stearns to participate in the bailout of LTCM a decade earlier. While several other banks declined to help, Bear was the only major player that refused. Oh, and don’t confuse Dimon’s $1 billion 2nd quarter gains from the Bear takeover with any expected future gains as a result of selectively peeling Bear Stearns’ assets. I would expect JPM to gain tremendously down the road. (JPMorgan CEO sees $1 billion gain from Bear deal).

Furthermore, Dimon stated,:

We don't know if it's going to be mild or severe…We're thinking there's a third of a chance that it's going to be pretty bad ... closer to the 1982 recession than the very mild recessions we had in 2001 and 1990.

I’d say that’s a very optimistic forecast. In my opinion (for whatever it’s worth), there is a 90% chance of a recession similar to 1982 and a 70% chance it will be worse. Without the printing presses of the Fed, my estimates would be 100%.

In conclusion, while I feel Dimon has understated the credit crisis and overstated the riskiness of assuming Bear Stearns’ assets, I will give him credit in at least starting to acknowledge a good possibility of a very severe recession. But at this point, that should be fairly obvious to even the media hams who continue to deny reality. I would expect JP Morgan to clean up very nicely on this deal, albeit down the road.

Would I buy the stock? Not on your life! Not only is it overvalued in my opinion – and with a nice premium already attached due to the Bear deal - but banks are the last equities I would be buying now, given both the credit and market risk that remains.

The estimates made in terms of restructuring charges and valuation of Bear Stearns’ prime brokerage, clearing house units, and the value from employee retention are my own rough estimates, but they are not backed by any official numbers. If anyone has seen any Wall Street research that addresses estimated restructuring charges and valuations of Bear’s prime brokerage and clearing units, I’d appreciate if you let me know.

Disclosure: As of the submission of the article, Mike did not own any of the stocks or bonds (long or short) mentioned.

Comments

[trw88:]

Typical gloom and doomer. Writes first without looking at data - just makes things up to fit his scenario.

.Pennsylvania is and has been running a deficit.

ydr.inyork.com/ci_9106...

2008 May 13 07:39 AM

[trw88:]

I would take jamie Dimon's assessment before this guy's any day. Very sloppy piece.


Typical gloom and doomer. Writes first without looking at data - just makes things up to fit his scenario. For example. Pennsylvania is and has been running a deficit. No clue.

ydr.inyork.com/ci_9106...

2008 May 13 07:41 AM

[trw88:]

Make that a surplus in PA. Sorry, firsat time comment and had some editing issues with the form.

2008 May 13 07:43 AM

[mdm402:]

Wondering where you got that Bear's PB business was tops in assets. Everything I'm aware of, and I've been close to that business for eight years, puts MS first, GS second, and Bear a fading third, and that was before a lot of clients got skittish about Bear's stability. Before I left GS in February, they were picking up lots of balances from Bear clients looking to hedge.
I'd also say BNY Pershing and Goldman Sachs Execution & Clearing (the old SLK) have much stronger clearing franchises. Jamie Dimon clearly wants to be in these businesses, and Bear was the best asset for sale, but it certainly isn't best of breed.

2008 May 13 08:32 AM

[Russia is v...:]

Wow, what a negative article. I thought JPM assumed several hundred billion in liability in the BSC takeover. The $30bil mentioned above was the excess JPM could not handle.

2008 May 13 09:56 AM

[User 192159:]

I found the article quite interesting. The credit crisis is far from over and it has long reaching tenacles in the economy. More surpises down the road for the financials and that will be a reality.

2008 May 13 11:07 AM

[helplessobs...:]

It ain't over till its over! There is much more to come from the BSC story. Joe Lewis and others will get something big from the Fed and the taxpayers.

2008 May 13 11:36 AM

[jackooo:]

Mike Stathis
Great article. You say it like i see it.

2008 May 13 01:42 PM

[User 68127:]

Jamie Dimon wouldn't have any incentive to lie. Would he? Would he?

2008 May 13 03:39 PM

[fxtrader07:]

odds are pretty good that jpm eliminated a lot of bad exposure by simply taking over the counterparty to it (i.e. the winning bettor of the trades). Bear stearns was NOt really insolvent - but it got under a vicious attack from a handful of hedge fund and naked short sellers who were trying to drag the entire market down. if you can succeed in igniting a run - any bank will collapse. ANY! even the healthiest (which bear of course was not) so even though i believe that jpm got a very sweet deal here, i can understand and defend the fed's action in this particular case.
@trw88: there is a reason why this time the gloomers and doomers might be nearer to the truth than anyone else - and than anytime before...

2008 May 13 06:42 PM

[jimmy46:]

You sound like you think the Fed should have bailed out BS.
Why?

Someone has to fail to prevent moral hazard becoming
even more prevalent.

I'd like to see a few more failures so players would
be more careful in the future.

2008 May 14 01:01 AM

[Mike Stathis:]

fxtrader, you are missing the point behind the inequity of the situation, which raises suspicions as to what's going on at the Fed.

jimmy46, not true at all. I'm saying you have to treat all banks fairly. I think there should be no bailouts. Read my previous artcles and you will see.

2008 May 14 02:41 AM

[Jake Berzon:]

The reason that Bear Stearns didn't get rescued through an open credit window is because it was too far gone at that point and arranging a shotgun wedding with JPMorgan - Chase was the least expensive, most efficient, quick and sure way to return confidence and prevent a disaster. The Fed really impressed me with this one.

2008 May 24 03:07 AM

[Bababooie:]

Mike,
Noticed on your bio: "Prior to Apex Advisors, Mike worked at UBS and Bear Stearns, focusing on asset management and merchant banking."

Thank you for your insite. I have an affinity for my past employers as well. Unfortunatly, the Sub-prime loan issue was just a matter of musical chairs. The group at BSC are superior in their financial prowess, but politics won out!

2008 Jul 01 02:05 PM