Monday, March 17, 2008

Bad News for Bear Shareholders is Good News for the Markets

(Felix Salmon) Two dollars per share is an astonishingly low price to pay for Bear Stearns: when I first saw it I honestly thought it was a misprint. If Bear is essentially worth nothing, that means other banks - Lehman seems to be the latest in the crosshairs - are also worth less than the market thought on Friday. But overall the rescue of Bear Stearns by JP Morgan is a good thing for the international financial system, and a good thing for the markets. Here's a bit of late-Sunday-night analysis to set you up for what's likely to be a very volatile Monday.

One of the more admirable things about Bear Stearns was always its strong culture of employee ownership. And one of the good things about being able to name your price is that you can buy a venerable investment bank for $2 a share. But, as Ken Houghton points out, the two great tastes don't necessarily go well together:

It's always been especially true at BSC that the assets walk out the door at the end of the day. The question now is how many of them will bother to walk in the door on Monday.

My guess is not all that many. JP Morgan on its conference call Sunday night talked about the costs of "retention for key people at Bear Stearns" - but more to the point the Bear Stearns bankers are now JP Morgan bankers, and JP Morgan has never been particularly stingy with its bonuses. The Bear Stearns bankers want this deal to go through, because it means they will continue to be employed. The alternative is bankruptcy and liquidation, which is much riskier for them - so they're likely to vote their shares in favor of the deal.

Institutional investors, too, are likely to be sanguine about this deal, they might not be happy, but they know that $2 is better than nothing. Individual investors might vote against - one individual who somehow managed to get through on the conference call was clearly unhappy and said he would do just that - but those individuals don't own enough of the stock to make much of a difference. The individuals who do have large shareholdings, like Joe Lewis, are likely to accept the deal and then, if they feel particularly aggrieved, litigate in its wake: an unspecified chunk of the $5 billion plus in closing costs that JP Morgan outlined in its presentation come under the general heading of "litigation".

One thing which was clear from the conference call is that JP Morgan seems to be taking Bear Stearns at its word when it comes to the $84 (ish) book value: CFO Michael Cavanagh said that he was "very comfortable with the levels at which Bear Stearns has marked its positions". The discount to book is a function of having to do a complex deal within the space of one weekend, as well as the difficulties of digesting a major investment bank during a period of extreme market volatility. Oh, and the fact that the chances of any other bidders coming along are remote.

And what about the $30 billion non-recourse Fed facility? It seems that this is a case of JP Morgan getting all of the upside (it's buying the equity at a price-to-book ratio of 2.4%, and a price-to-extra-future-earnings ratio of 0.24) while the Fed takes most of the downside. But even there JP Morgan said quite explicitly that the Fed facility is very much expected to be repaid in full, and that the reason for its existence was that they simply didn't want to have to dump tens of billions of dollars' worth of illiquid assets into this market as they delever Bear. "JP Morgan is perfectly comfortable with the assets that we're acquiring, but with the financing support of the Fed, the deleveraging will be a very orderly process," said Cavanagh.

The big risk with this deal is that the markets will take the price paid for Bear as a mark, and will sell off the other four investment banks accordingly. After all, if you strip out the value of the headquarters building, Bear's shareholders are essentially paying JP Morgan $1 billion to take the bank off their hands. If Bear's worth less than zero, is Lehman really worth $20 billion?

And that's why I'm not a huge fan of the cut in the Fed's primary credit rate, either: it seems panicky and prone to backfiring. What's more, if they're cutting the discount rate - and it seems that that's exactly what they're doing - they should say so, rather than just talking about a "primary credit rate" which no one's ever heard of. In any case, given that they were scheduled to cut the discount rate on Tuesday, did they really need to do that now, and make themselves seem even more jittery and panicky than they needed to?

In any case, the Fed is now lending money to investment banks - which it doesn't regulate - at exactly the same rate at which it lends to regulated commercial banks. While Jamie Dimon has shown himself to be decisive and opportunistic this weekend, Ben Bernanke looks increasingly like a schmuck who'll do anything Wall Street asks him to do.

General stock-market sentiment in the wake of this announcement seems bearish, but not catastrophic, with Asian markets down 2-3%. Certainly this is the kind of deal which only gets done when things are Really Really Bad, and there are a hell of a lot of stock prices right now which don't look Really Really Bad at all. Personally I think a nice down day for the Dow could be just the ticket, especially if it coincides with a little bit of spread tightening on the fixed-income side of things as traders start to pile into the moral hazard play. That would help bring stock prices into line with bond prices, and even possibly set the stage for a nice rally when the Fed cuts rates by 100bp on Tuesday.

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