Sure, executives always talk up their deals. But really, this sounds like a fantastic coup for J.P. Morgan. They get Bear, which as a going concern was worth roughly $10B not long ago, for next to nothing. According to JPM execs, Bear was being candid when it insisted its books were fundamentally sound, and the crisis was just a liquidity issue. Much of the risk JPM might not have been comfortable with has been laid off on the Fed. jck at Alea notes that the markets, skittish about financials though they may be, have rewarded JPM with roughly $11B in excess market capitalization today. The market clearly views the deal as a windfall for J.P. Morgan. If a Fed-guaranteed Bear was a $10 billion bill just waiting for someone to pick up off the floor, why were there no so few bidders this weekend for the firm? Why was J.P. Morgan able to name its price? Alternatively, why didn't the Fed itself purchase the firm for $2 a ticket and then negotiate at leisure a value-maximizing sale for the benefit of taxpayers?
Why were Bear's shares worth $30 Friday at 4 p.m. and close to $0 by Saturday evening? (Charlie Gasparino announced on Saturday that the firm would likely file for bankruptcy if a deal wasn't done over the weekend.) Pointing to rating agency downgrades isn't helpful. S&P and Moody's have clearly tempered their pace of downgrading the monoline insurers and some AAA structured credits in order to mitigate systemic risk. I think it implausible that they would have downgraded Bear so quickly without some consultations. After all, as of Friday, Bear was perfectly liquid (thanks to the Fed's special credit line), and it's overall position looks to have been pretty solid. Somehow, something happened over a period of 24 hours that changed Bear from a slightly tarnished name that yet sell itself for a decent price to an urgently distressed asset. I've yet to hear a convincing account of how that went down. (Lawyers have already been called to look into this, and JPM has set aside funds for litigation.)
The Fed is financing, and bearing the downside risk, on roughly $30B of Bear assets. About $20B of those are mortgage-backed securities, the rest are unaccounted for. Many of us — perhaps reasonably, perhaps hysterically — view Bear's derivative portfolio rather than its mortgage-backed securities as the greatest concentration of risk. Is it possible (and I am asking here, I really don't know!) that an "in-the-money" derivatives portfolio could be viewed as an asset, and pledged to the Fed? After all, synthetic credits include CDS positions, and we wouldn't be surprised to learn that the Fed accepts highly-rated synthetic bonds as collateral. Very specifically, is the Fed's downside risk on the $30B it has financed limited to $30B (the Fed gets stuck with worthless assets), or has it assumed a role as a guarantor of assets that could become outright liabilities under adverse conditions? I do not think this is likely, it would be too radical, too weird. But it would be nice to have explicit assurance that the portfolio whose losses the Fed has taken responsibility for includes only "limited liability" securities.
In my previous post, I feared that Bear execs would use the threat of a destabilizing bankruptcy to try to extract an undue payout to shareholders. Now that the deal is done, and it is Bear shareholders who seem to be shafted, Andrew Clavell asks very pointedly why Bear did not use its bargaining power at least a bit more effectively. Why couldn't Bear hold out for $4 per share instead of $2? Just how hard ball did J.P. Morgan and/or the Fed end up playing? Andrew points out that the option value of a share in bankrupt Bear might be more than the $2 consolation prize on offer. Why should Bear shareholders accept this deal (they must vote to approve it)? The possibility that Bear shareholders would not approve the deal was the risk Morgan executives seemed least capable of addressing during the conference call. They think shareholders will approve, but things will clearly get complicated if they don't.
I want to reiterate, I think the outcome of all this is better than it could have been. I feel some sympathy for Bear stockholders, since fundamentally the firm may have been no less sound than its competitors. But managing liquidity risk was the Bear's responsibility, and it failed to do so. From a "moral hazard" perspective, I'm glad an important player was allowed very publicly to fail. However, any salutary effect on incentives may be counterbalanced by the new funding facility for investment banks, which looks like a commitment by the Fed to bail-out any other firm in similar straits. I'm also a bit uncomfortable with J.P. Morgan's windfall, which isn't really a "market outcome", and strikes me as a massive case of "private the gain, socialize the risk".
I'm glad the Fed removed any incentive to try to bring down other firms via "bear raids". But, as a correspondent of Yves Smith points out, investment banks may be safe, but hedge funds are suddenly vulnerable. I'd guess that the Fed is privately suggesting aggressive margin calls on hedge funds would be unwise right now. The Fed's bully pulpit is in good shape, as a firm excluded from the Fed's new liquidity facility would be one whisper campaign away from roadkill. The impaled carcass of a bear sits at the gate of Dr. Bernanke's castle as a reminder to all of the price of being disliked.
|Steve Randy Waldman — Monday March 17, 2008 at 3:23pm||permalink|