Bear Stearns Bondholders Win Big

| About: ELEMENTS Ben (BSC)
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A couple of weeks ago, Barron's had an article evaluating the equity value of BSC. They indicated that the building itself is worth around $12 per share, plus the value from their other business, such as prime brokerage service, wealth management, investment banking, etc. It adds up to at least $20. But the article failed to mention that besides equity holders, there are also bondholders who have different priorities and incentives than shareholders.

There have been some rumors that JPM was actually willing to pay around $15 instead of the initial $2 at their first proposal. But the Fed and Treasury Dept had some other concerns. First of all, they didn't want this to be viewed as a bailout since the public would say the government sides with Wall St. With a $2 fire sale with BSC equity almost totally wiped out, government can point out to the public that BSC gets punished severely and doesn't get any compensation and rescue for all the bad things they have done wrong. Secondly, there is speculation that government wants to penalize BSC for being the only large investment bank that did not participate in the bailout of LTCM back in 1998. Now with JPM raising the price to $10 with almost 40% of shares secured, this deal will most likely go through with bondholders' help, with shareholders against the buyout having little chance to succeed.

The biggest win in this deal is actually the BSC bondholders. At Yahoo Finance, it shows up to last quarter (Nov 2007) BSC has long term debt of $131B and short term debt of $157B. These two numbers look extremely high to me, probably due to consolidation with their other BSC affiliated business. So I decided to go directly to BSC's own website to look at their 10K as linked here.

The debt numbers look much better. At page 43, it shows $66B in long term debt and about $9B in unsecured short term debt. If anyone knows the reason of such big difference between Yahoo Finance and BSC 10K, please let me know.

JPM's buyout really makes no material difference to shareholders. With employees owning 1/3 of the company at much high costs, maybe over $100 at 3 digits, getting $10 back vs. $0 doesn't make big difference at all. However, there is a huge difference for bondholders. In bankruptcy court, usually the trade counterparties received the highest seniority on BSC assets, then if anything left, it goes to the next tier of secured long term bond holders, then to the next tier of unsecured short term debt holders.

BSC equity will definitely get wiped out, likely most of the $9 unsecured short term debt holders. Depending on the value of the assets and trade partners' claims, the $66B long term bondholders will likely take a big loss and years to recoup their money, or turn into shareholders of a new BSC company if it emerges from bankruptcy (the nice BSC building along with any business left will go to them, not the shareholders as Barron's suggested). Thanks to the buyout, suddenly BSC bondholders who hold deeply discounted junk bonds get a freebie, now their bonds are back to investment grade guaranteed by JPM with little default risk unless JPM goes under water, which is unlikely.

Also the unconventional $30B "non-recourse loan" to JPM from Fed and Treasury helps bondholders even before this JPM buyout was announced, since this $30B loan is secured only by the shaky BSC mortgage debt which is worth almost nothing. This time, it is JPM getting the freebie. What is a "non-recourse loan"? It gives JPM incentive but no liability to buy BSC. If the collateralized mortgage debt goes to zero, homeowners will go into foreclosure, lose their homes,  and the Fed and Treasury will lose money or actually taxpayers like us will lose money. But not JPM, since the debt is non-recourse and JPM is not liable. More importantly BSC bondholders will not only not lose money, but also get $30B cash as backup from the Federal government. With the buyout, they are at the same time being lifted from junk to investment grade, with holding bond claims to BSC upgraded to holding claims to JPM which is a much bigger and solid bank. So they get double coverage.

In general, both JPM and the government in this buyout really upgrade BSC bondholders but severely penalize equity holders. This is probably part of the reason why BSC was trading much higher than $2 last week, since bondholders want to buy shares to get the voting rights to make sure that this deal will go through, at the expense of shareholders and us taxpayers. Right now, for BSC bondholders, the only risk is that this buyout deal might not go through.

Why is there such big disparity and inequity between the two classes of investors?