Monday, March 24, 2008

Does Bear have JP Morgan over a barrel?

(Naked Capitalism) This is the nuttiest situation I can recall in some time in deal land, assuming the rumor in the New York Times is true. The Grey Lady reports that JPM is working to increase its offer for Bear from $2 (well, roughly $2 since it is a stock-for-stock deal) to $10.

Yes, Bear's stock price is trading above the JPM's offer price; that normally would produce pressure to sweeten terms. But this deal was about as far from normal as you can get. JPM has an option on Bear's headquarters building, an option to buy 19.9% of Bear's shares at the deal conversion price (admittedly, some limitations exist) and most important, it has the Fed's backing in the form of its $30 billion first loss position (in the form of a secured loan, with JPM permitted to pony up "illiquid securities" which reads like an invitation to let the Fed carry the worst non-derivatives positions JPM can find).

Why is JPM offering to pay more? The New York Times story suggests JPM is negotiating with Bear, the Fed is not keen to reopen the deal, and for good reason. There are already House and Senate hearing scheduled on the deal. The Fed can defend its role if Bear goes for a fire sale price (if the firm was toast, the shareholders should have been wiped out entirely as a condition of a government rescue, but the $2 price can be presented as an unfortunate necessity).

But JPM raising its offer makes the Fed look like a chump to have agreed to the initial backstop. That will vastly increase criticism of the deal. And if JPM knew enough to offer $10 a mere week later, why didn't it put that on the table last Sunday? This looks like JPM took advantage of the Fed (ie, Bear is not in as awful shape as JPM portrayed; the price still should have been $2 given the imminent bankruptcy, but with a smaller loan facility from the Fed).

The only thing I can fathom:
One, that the apparent economics of the deal will support JPM paying more (duh, but it needs to be said)

Two, someone has the 5 x 7 glossies. I can only presume that a Bear ally has information (perhaps about why the deal was advantageous to JPM in terms of how their positions would be netted and/or how badly JPM needed the deal to happen) that would be hugely embarrassing if released. A raise from $2 to $10 is huge and appears unwarranted for (from what I can tell, the stock didn't get above $8 this week and has traded mainly around $6. It closed the week just below that level). This price talk suggests JPM is panicked. The facts in the open say that Dimon ought to be able to stare this challenge down.

Three, as the NYT claims, there were contractual errors in the deal that require JPM to go back to Bear to get waivers, putting Bear management in the catbird seat. Eeek, but highly plausible given the haste with which the deal came together.

Although item three sounds persuasive, it does not seem sufficient to warrant as large an increase as is on the table. I suspect there are other embarrassing revelations that JPM is keen not to have come to light. But the fact it can (as well as may) increase its bid by such a large degree does not pass the smell test. It suggests it negotiated in bad faith with the Fed.

One other factor that the NYT article mentions is that customers are still reluctant to trade with Bear since they perceive the deal to be at risk. That no doubt makes the economics of the deal less attractive to JPM (there will be less revenues, hence either lower profits or greater losses, between the time of signing and closing than anticipated earlier). The longer the uncertainty, the greater the risk that trading accounts will shift their business entirely away from Bear. That does create an economic incentive to pay more. However, even if that factor alone were sufficient to justify the higher price, it will not go down well in the court of public opinion. Possible revenue losses between now and closing will go over the heads of most newspaper readers, and more important, most Congressmen.

The face saving reason justification would have been that Bear's management can sell 39.5% of the company without shareholder approval. Thus using the trumped-up excuse that the deal might not get done (baloney if there hadn't been a screw up), JPM can raise its offer to the upset shareholders and dispel the misguided uncertainty that the deal is at risk. Had the deal been done along the lines presented in public, a mere PR salvo should have been sufficient to clear any doubts up.

If JPM does increase the price beyond a token amount, like a dollar, expect there to be a firestorm of criticism of the Fed allowing a payout to a failed firm. Either JPM should buy Bear free and clear, with no government support, or the shareholders should be wiped out, or as close to that as the practical constraints allow. Bear really should have been nationalized, but there are reasons why the JPM route, although in theory less than ideal, was a necessary evil. It could be executed on a short timetable and kept the Fed from assuming operational control of an entity it did not know and certainly did not understand.

Improving the payout to Bear's shareholders is a terrible precedent and deserves to be lambasted.

And now we have the complicating factor of this leak. This makes Dimon (well, his own staff and attorneys) look bad, it may precipitate a backlash against Bear management (before they and the employees got sympathy in some quarters for their extreme fall in fortune) and it may also make it even harder for the Fed to back an increase in price for Bear (and it was already going to be hard). And this embarrassment will make it much harder for the Fed to do any more salvage operations, at least until any blowback from this development settles down.

Note I predicted that even with the Fed's first loss position in the deal, JPM would come to regret it. Increasing its exposure to the credit market mess, particularly to a firm that was heavily involved in the riskiest activities (lending to hedge funds, mortgage backed securities trading, writing protection on credit default swaps) so far before the end of the cycle will turn out to be a bad move. And at a higher price, even a modestly higher price makes the economics worse.

From the New York Times:
JPMorgan Chase was in talks on Sunday night for a deal that would quintuple its offer for Bear Stearns, the beleaguered investment bank, in an effort to pacify angry Bear shareholders, according to people involved in the negotiations.

The sweetened offer is intended to win over stockholders who vowed to fight the original fire-sale deal, struck only a week ago at the behest of the Federal Reserve and Treasury Department.

Under the terms being discussed, JPMorgan would pay $10 a share in stock for Bear, up from its initial offer of $2 a share — a figure that represented a mere one-fifteenth of Bear’s going market price.

The Fed, which must approve any new deal, was balking at the new offer price on Sunday night after several days of frantic, secret negotiations, these people said. As a result, it was still possible the renegotiated deal might be postponed or collapse entirely, said these people, who were granted anonymity because of their confidentiality agreements.

If the Fed were to reject the new proposal, it could set off a furor among shareholders of both firms that the government was preventing them from making a fair deal.

In an unusual move, Bear’s board was seeking to authorize the sale of 39.5 percent of the firm to JPMorgan in an effort to move closer to majority shareholder approval. Under state law in Delaware, where the companies are incorporated, a company can sell up to 40 percent without shareholder approval.

The renegotiation, which would set a sale price of more than $1 billion, comes after a tumultuous week on Wall Street and in Washington because of the near collapse of Bear and the hastily devised deal to save it.

While the initial agreement appeared to have defused the financial crisis of confidence that undid Bear, the initial terms of the deal — and the government’s controversial role in reaching them — drew criticism from those who say the takeover amounts to a government bailout of Bear, a firm at the center of the mortgage meltdown.

A new deal could raise even more questions about the Fed’s involvement in the negotiations. As part of the original deal, the Fed guaranteed to take on $30 billion of Bear’s most toxic assets. The central bank also directed JPMorgan to pay no more than $2 a share for Bear to assure that it would not appear that the Bear shareholders were being rescued, according to people involved in the negotiations.

In television interviews last week, the Treasury secretary, Henry M. Paulson Jr., who has been closely involved in the negotiations, sought to portray the agreement not as a rescue effort but as a way to provide stability for the entire financial markets.

“Let me say that the Bear Stearns situation has been very painful for the Bear Stearns shareholders,” Mr. Paulson said on Monday on the NBC “Today” show, referring to the $2 a share price. “So I don’t think that they think that they’ve been bailed out here.”

If the price is increased, however, some critics could have more ammunition to complain that taxpayers are helping to bail out a Wall Street firm that should be responsible for its own risky behavior. That is one reason the Fed was hesitant on Sunday night to approve the transaction at $10 a share, people briefed on the talks said....

Some shareholders could seek to file lawsuits to block the deal, claiming that the unusual board vote was an act of coercion.

JPMorgan was also in negotiations with the Fed on Sunday to assume the first $1 billion in losses on Bear assets before the Fed’s $30 billion cushion kicks in. However, the Fed may now be seeking to raise that number.

A major aim of a new agreement would be to provide assurances to investors who trade with Bear that it will continue to be open for business. Even with JPMorgan’s original agreement in place last week, some of Bear’s largest customers would not trade with it, still nervous that the deal might unravel.

JPMorgan and Bear were prompted to renegotiate after shareholders began threatening to block the deal and it emerged that several “mistakes” were included in the original, hastily written contract, according to people involved in the talks.

One sentence was “inadvertently included,” according to a person briefed on the talks, which requires JPMorgan to guarantee Bear’s trades even if shareholders voted down the deal. That provision could allow Bear’s shareholders to seek a higher bid while still forcing JPMorgan to honor its guarantee, these people said.

When the error was discovered, James Dimon, JPMorgan’s chief executive, who was described by one participant as “apoplectic,” began calling his lawyers at Wachtell, Lipton, Rosen & Katz to seek a way to have the sentence modified, these people said. Finger pointing over the mistakes in the contracts began as bankers blamed the lawyers and vice versa.

As it began to look more possible late last week that the deal might be struck down, JPMorgan approached Bear in earnest on Friday about renegotiating the sale price to guarantee its completion and brought the Federal Reserve into the talks as well, people involved in the negotiations said.

Mr. Dimon became increasingly desperate in recent days. He offered certain employees cash and stock incentives to stay on and made calls to his rival chief executives on Wall Street — John J. Mack at Morgan Stanley and John A. Thain at Merrill Lynch, among them — pleading with them not to recruit Bear employees during the transition.

Mr. Dimon had became convinced that the deal was in jeopardy after spending much of last week taking angry calls from Bear’s largest shareholders, including Mr. Lewis, these people said. Moreover, Mr. Dimon, who had indignantly told associates that he would “send Bear back into bankruptcy” if the deal was struck down, was persuaded by his advisers that he had less leverage than he thought, according to people briefed on the conversation. Such vindictive behavior, they told him, would turn into a legal and public relations nightmare.

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