More Bear! (Part One)

Well, today begins the three part story of Bear Stearns, as told by the WSJ. Deal Journal has a great summary post … A few thoughts:

1. It struck me that Bear wasn’t able to see the forst through the trees when it came to it’s strategy, specifically demonstrated with the “Chaos” trade. When one thinks about how these sorts of things can play out, especially in unprecedented times, how the decision to unwind these trades came about makes perfect sense. Someone puts on a unique trade and management asks them to justify it. Well, there’s a slide with four or five bullet points explaining why this trade should work (mostly qualitative/anecdotal). Also, there there’s a chart presented that shows a pretty bad history for the trade if it had been put on in the past. Indeed we can examine Mr. Schwartz’s history with the trade to see this:

For some of the assets, the market was frozen, Mr. Schwartz reasoned, so selling was out of the question. On others, he had mixed feelings. He didn’t want to unload tens of billions of dollars worth of valuable mortgages and related bonds at distressed prices, creating steeper losses.

…

The [hedge, called “the Chaos trade”] was a deeply pessimistic bet — essentially a method for making money if the mortgage and financial markets cratered. The traders bet that the ABX, a family of indexes made up of securities backed by subprime mortgages, would fall. They made similar moves on indexes tracking securities backed by commercial mortgages. Finally, they placed a series of bets that the stocks of major financial companies with exposure to mortgages … would decrease in value as well.

…

Faced with the fierce divide among his top executives, Mr. Schwartz, who was generally supportive of the chaos trade, decided to abandon it. He wanted specific pessimistic plays that would offset specific optimistic bets, rather than the broader hedges Mr. Marano had employed. Frustrated, Mr. Marano ordered the trades undone.

(emphasis mine).

Now, everything until the last part follows naturally. The last part (matching your hedges to your positions one-to-one) is fine, until you realize that it’s impossible to do this in a liquidity-challenged market. Also, with a massive re-pricing of risk, due to liquidity constraints, one should take a broader view. The CDO market drove demand in securitized products generally and mortgages specifically. Inventories in loans and bonds were sitting on firm’s balance sheets while credit concerns were coming to fruition. So, firms can’t sell risky products, which are losing value from a fundamental re-pricing, and, also, the lack of buying (overall liquidity) is causing a further, more broad technical re-pricing. That is the subtle point from above–why bet on “financial markets cratering” if you own mortgages and call that a hedge? Well, given the widespread ownership of these products, their credit impairment caused widespread credit concerns. With credit worthiness in doubt, liquidity became scarce. Scarce liquidity means less available money to buy these products, and leads to a technical problem with markets and drives prices lower (lower demand … easy, right?). Clearly this requires a deeper understanding of how interconnected markets are and exactly how they work together–potentially a leap of faith or a layer of complexity a firm wasn’t willing to bet on.

There was, however, evidence markets were behaving this way. Spread product was moving in lock step (directionally). LCDX (index of loans, generally made to high yield companies) was moving wider, corporate bonds had a secular widening, and mortgage product was impossible to trade, commanding a larger and larger liquidity premium… Also, LIBOR was rising and banks were finding it harder and harder to borrow. But, instead of using relatively liquid indices and stocks to bet on these “second order” effects, Mr. Schwartz started asking for specific bets that offset highly illiquid positions. Good luck. To ask for relevant hedges is logical, follows from first principles, seems safer, and wasn’t executable–easy for risk managers and executives to demand and impossible to do, leaving the problems unsolved. Keep in mind, too, that the stock market hedges could easily be unwound in the event they failed to be correlated to the loans they were hedging. Would the “specific” hedges that would, themselves, be highly illiquid? No chance. CMBX and ABX have been known to trade in markets that are 5-10 points, or percentage of notional value, and that’s for small size (5-10 million dollars). To hedge the size here … well, I can’t imagine the costs.

Just to review: They had toxic positions, hedged them, and then removed the hedges, but (from what I can tell) didn’t sell the positions (while trying to one-to-one hedge the). There’s something to be said for taking the hit you know about today instead of trying to call a bottom.

2. Regulators were having calls, as regular as daily, with Bear. From the article:

Bear Stearns’s … risk officers were meeting in the sixth-floor executive offices with staffers from the Securities and Exchange Commission. The regulators had traveled from Washington to make sure Bear Stearns had access to the day-to-day loans it needed to fund its trading operation. After scrutinizing the firm’s $400 billion balance sheet well into the afternoon, the regulators agreed to reconvene with Bear Stearns managers for daily briefings until the market crisis passed.

Now, uness Bear is different from ever other financial institution, when it’s regulators come knocking it’s unusual–everyone walks more straight and takes much more care when dealing with them. The reason is simple: there’s nothing to be gained when a regulator is pleased, the best thing that can come from making regulators happy is avoiding the situation where said regulators are unhappy and consequences arise. I wonder if, ever, in the history of Bear, regulators called in to check on their situation daily. This should have been a major warning sign and left employees involved extremely uncomfortable as it was going on.

3. Many sophisticated investors walked away from a deal with Bear.

• KKR walked away, and we never learn what their concerns were (Bear was focused on not crossing clients)
• Allianz SE’s Pacific Investment Management Co. (PIMCO) had discussions with Bear that “fell apart”
• Fortress discussed a merger with Bear (sounds similar to what I wrote about recently) that never went anywhere

Now, J.C. Flowers walked away because both sides had issues, so I don’t count them. Similarly, I don’t count the hiring of Lazard, and that effort failing to bearing fruit. I’m not sure why each of these potential transactions fizzled, but certainly it seems like a pattern that one can read into.

4. Two institutions with a major financial stake in Bear’s viability expressed concerns. One of these, PIMCO, unless I’m missing something glaring, had been in talks to acquire a stake in Bear and declined (second bullet point above). Maybe they knew something the rest of us didn’t, from their earlier talks and whatever due diligence they had performed? It would make sense, but would probably also be illegal. More likely? PIMCO was focused on Bear and extrapolated to the current market conditions. Perhaps, also, some unease exuded from the senior PIMCO ranks…

On a side note, what’s with the illustrations? Maybe this is going to be a chapter or section of a book? It reads that way almost… Newscorp swooping in to add a fresh (and awkward) feel to the WSJ? It was distracting to say the least. Of course Dealbreaker goes (almost scarily) deeper with this observation (as is their charge), and they have some amusing thoughts.

I can’t wait for part two!

Bear Stearns: Where We Are, Some Little Known Facts, and Opinions

Well, it looks like the dust has settled on the situation. My predictions have actually fared quite well–lawsuits, retention bonuses, brokers jumping ship, and some interesting rumblings about management seeking out new bidders.

Bloomberg even highlighted Jamie Dimon’s greenmail:

Dimon made the proposal to several hundred Bear Stearns senior managing directors at a meeting yesterday evening in the securities firm’s Manhattan headquarters, according to two people who attended. He said members of the group who are asked to stay after the acquisition is complete will get additional JPMorgan shares, according to the attendees, who asked not to be identified because the meeting was private.

Bear Stearns employees own about a third of its stock, with a large concentration in the hands of senior managing directors. Their support may help JPMorgan counter opposition from billionaire Joseph Lewis, who owns 8.4 percent of Bear Stearns and said yesterday he may seek an alternative to the bank’s proposed purchase.

“He’s basically bribing them for their votes,” said Richard Bove, an analyst at Punk Ziegel & Co., referring to Dimon’s presentation. “In this environment, there are no jobs on Wall Street, so he can bribe them by letting them keep their jobs and they’ll vote for him.”

Lots of people have opined on the merger terms and the possibilities for other bidders, and even some odd provisions that suggest no one knows the entire story yet. Everyone who reads my blog knows what I think on the obvious points. Here’s an interesting fact, too, that I haven’t seen elsewhere. From the Times Online:

A counter-offer for Bear Stearns would face a series of hurdles. Part of the JPMorgan Chase offer, which values Bear at $2 a share, includes the financial support of the Federal Reserve Bank of New York, which has underwritten $30 billion of the most toxic of Bear Stearns’s investments. The New York Fed also extended special financing to JPMorgan to cover the cost of Bear Stearns redundancies and impending litigation. Any new bidder would have to convince the central bank that it should transfer its underwriting to support a new offer.

(emphasis mine).

Wow. Talk about a sweet deal! I’m not sure what that sentence means, but I know I haven’t seen that anywhere else, so I remain skeptical, but it wouldn’t surprise me. So, with this heavy handed approach, here’s a question: Why does the Fed care so much about ensuring the specific deal they got JPM to ink goes through? In the above Deal Journal post, it’s made clear that the Fed wants this deal to go through. So, if there is another bidder out there, at a higher price, then why does it matter who gets Bear? Certainly the crisis they were talking about ha been avoided, no? Let’s examine the facts (from a myriad of sources):

• Bear Stearns had gotten a 28 day loan, via JPM, from the Fed.
• The Fed had decided toget Bear sold A.S.A.P., this left other bidders out, as reported by the media.
• The Fed decided to guarantee, essentially, $30 billion in assets on Bear’s balance sheet.
• The Fed has now decided to open up it’s discount window to securities firms, to avoid this situation in the future.

These actions seem inconsistent. Why would you force a securities firm to be bought, but then allow other to borrow at the discount window? Why would you make a 28 day loan, and then, with not much else changing, force another alternative? Why would you try to get JPM to accurately asses the value of Bear, and then, when they are unable to do so, both guarantee the most troublesome assets and allow JPM to lock in a very low bid price?

Now, I hate to be trite, but the taxpayers now own $30 billion dollars of stuff that is nearly impossible to value and, simultaneously, not going up in value (leaving only flat or down). JPM shareholders are getting roughly $1 billion in incremental earnings (I, obviously, would claim that when all is said and done that number will be lower, but that’s their number and we have no reason to believe that they don’t believe it to be accurate) for a fraction of the outlay in cash (and potentially not even the legal expenses, if indeed the above statement from The Times Online is true). And all the while, the Fed is standing guard over the gasping, bleeding body of Bear Stearns warding off further bidders? This isn’t the kind of intervention that I can honestly say sounds “above board.” To me, one either let’s Bear file for bankruptcy protection or they are bailed out–forcing a suitor onto them seems a bit weird.

Now begins the next chapter in this saga, exploring who profited from the demise of Bear and the source of the rumors that caused this whole mess.

Good News or Bad News First? (And Some Bear Links)

The good, for continuity. I spent about an hour chatting over IM with Felix Salmon and Equity Private (with a quick guest appearance by DealBreaker’s Bess Levin). It was quite an interesting time, to say the least!

The bad, now. They actually killed my post ideas. Yes, you heard me right, killed them dead. Well, it was a bit conspiratorial. I had conjectured that JPM’s option to purchase 20% of Bear at $2.00 and their “locking up” Bear’s building meant that they were happy to have someone else come in higher (earn the difference between the higher bid and $2 on 20% of Bear’s shares, and get the building). Alas, the fly in the ointment? Felix pointed out Section 6.9 of the merger agreement (Tidbit: Section 3.2 … “please provide”). I still believe that Bear’s advisory and Leveraged Finance business have value to, say, a P.E. buyer.

Well, even if it wasn’t likely, the markets must be assuming that a higher bid was likely, right? To that end, I had a post all ready! Bear closed at $5.91 today. If you assume that premium is due to a higher price, then there’s a 50/50 chance Bear get’s bought at $9.50 ($5.91 – $2.00 is approx 50% * ($9.50 – $2.00), essentially assuming the share price premium is a probability times a premium from a higher priced deal). I had all the numbers crunched. Alas, Felix has quashed that one too. I’m not 100% sure I buy the “debt holders are buying the stock” argument, but my other theories are all killed.

Unfortunately, then, I have no clever post. Although, here is one question answered.

Bear Stearns: Notes and Predictions

Wow. What a difference a day makes. Bear Stearns is now, apparently, being fire-sold for $2 a share to avoid being fire-sold for the values of it’s assets minus it’s liabilities.

I was reading the WSJ piece on the topic, and it seems like there was a lot of pressure applied by the Fed to ensure Bear got sold, with no regard for shareholders (the article states this, in essence). So counterparty risk is now secure. Great! But wouldn’t it have been better to run a real process and determine the value of the company? Wouldn’t it have been more valuable to not send the message that the “health of the financial markets” is more important than a firm’s sale occurring at their true equity value? (And aren’t both of those, taken together, a contradiction? Mis-valued assets was how this mess got started.)  So, let’s make some bold predictions! I don’t think they will all be right, but they are obviously all reasonable to me. I’ll show my hand and give the probability I ascribe to the prediction coming true, as well.

Prediction: Lots of shareholder lawsuits. K.K.R. was looking a bidding, so was J.C. Flowers, and the Fed says the deal needs to be done today, so they get crammed out. Who do you sue? Everybody of course! Hence JPM estimates $6b in costs for this transaction, first item listed–litigation. Probability: 100% (Bonus prediction: Someone notable from Bear joins in a lawsuit or files one themself! Probability: 50%)

Prediction: The price gets raised. A process wasn’t run, shareholders will demand more, and the Fed is taking $30 billion in risk. For $1 billion in accretion to earnings, and not even being in the first loss position on the toxic assets Bear is holding, why pay such a low price? This will become a problem for JPM. Keep in mind, this can be raised (the pruchase price) by having to pay out certain shareholders more than the bid price. For example, employees they wish to retain might have shares made whole at a higher level than the sale (you have 40k shares of BSC, you get $40 in JPM stock for each share if you stay, for example). Probability: 70%

Prediction: JPM will never see some of those assets add to their franchise. If the prime brokerage business really saw the kinds of outflows reported by the media (from Bear, that is) JPM could already be finding itself over-paying for that asset. And the mortgage and securitization business at Bear? Management for that business are at the top of that market in terms of knowledge and relationships–watch that business experience brain drain quickly. Probability: 70%

Prediction: Integration will be a nightmare. Culture clash will occur at many points in the process and within many businesses. JPM and Bear’s cultures aren’t compatible. Bear is a very raw environment and is very cut-throat. You’ll see this get ugly, fast. Big names on both sides will leave and power struggles will be common. Perhaps this is normal merger behavior, but it will be worse because the Bear employee have already been financially destroyed. You’ll see resentment for JPM from ex-Bear employees and silos form within the firm. It will be difficult to interact with certain parts of the firm depending on where you worked when JPM bought Bear. Ouch. Probability: 60%

Well, that’s it for now. I’m sure much more information will leak out as this deal develops. If this drags on or lots of game-changing information comes to light, I might revisit these later.