Point Counter-point

Reader JPKK says:

JP Morgan Buys a Bear and the Fed Cleans Up the Woods

How did Bear Stearns (BSC) go from planning to report decent earnings for the current environment to being hours away from filing? It all comes down to keeping liquid in an illiquid market.

Last week starting late Wednesday and through Friday BSC experienced a run on the bank when several European banks stopped acting as Repo counter parties, this resulted in numerous institutions beginning to add a premium charge for anyone else who was going to use BSC as part of a transaction the institution was going to be a counter party in, which resulted in more counter party agreements being canceled, withdrawal of credit lines and Hedge funds who used BSC’s prime brokerage business drawing down their balances.

BSC had the weakest liquidity position of the major brokers and couldn’t raise cash fast enough and was rapidly approaching the point where counter parties would likely seize and fire sale collateral, which would have resulted in a massive unwind as others become forced sellers or faced margin calls due to mark to market. Probably the biggest fear of the Fed was what would happen from the massive forced unwind from hedge funds due to the size of BSC’s prime brokerage business.

So the Fed stepped in to try and insure an orderly liquidation rather than a meltdown and unwind that would have spilled over. JP Morgan and JC Flowers showed up, looked at the books JC walked away and JP told the Fed it needed to do something about $30B of assets that JP didn’t want, as no surprise to many apparently a Bear doesn’t just sh*t in the woods it also has a balance sheet for that.

So the agreement they came to was the Fed would take the $30B in assets at a 50% hair cut and make it non-recourse. So there isn’t a $30B bail out, the Fed gave JP a $15B loan for the assets, which was about the fair market value of the assets, for which only the Fed has downside, thus the max bail out is $15B and could end up being $0 in the end, the more probably max down side is a $9B bail out since the estimated fire sale/liquidation value of these assets was $6B. However, JP does have the option to pay off the loan and take the assets back in the future, meaning JP has all the upside on the assets as well.

As to the $2 price that many are claiming is a pittance, its essentially the equity holders being offered the option to collect the saving on legal costs from bankruptcy instead of going through bankruptcy and likely getting $0 down the road. If shareholders reject the deal we go back to fire sale of seized collateral that will in the end leave equity holders underwater.

But Bear’s building is worth $1.8B, and its free and clear…Well bear has $81B in unsecured debt outstanding, and in a bankruptcy proceeding a long list of counter parties and clients it would likely owe even more.

I think in the end this was the Fed doing a good job of ensuring the orderly functioning of financial markets instead of a massive meltdown on technical factors, while not truly bailing anyone out the Fed made sure BSC was liquidated in an orderly manner and offered some protection to the bank willing to take on the risk on short notice.

As to rumors and speculation about when Lehman(LEH) will following those seem to be greatly exaggerated, LEH is twice the size of BSC, has twice the liquidity as a percent, is significantly less dependent on Repo financing ($19B vs $74B outstanding) and has been a better risk manager. Also LEH has the new lending facility the Fed has extended to primary broker dealers to provide liquidity if it there is a run on the broker.


This one by Reader JPKK