Monday, March 17, 2008

Did JPM get a good deal with Bear Stearns?

On the surface, it seems like JPM walked off with a great deal. As of the last reported period, ended November 30, 2007, Bear had $11.4bn in Equity and an asset base of $395bn. With 113mn shares outstanding (184 issued less 71 mn treasury shares) the company had almost exactly $100 book value per share and $349 in assets per share.

If we throw in an extra billion for the actual value of the Manhattan HQ, which was (probably generously) estimated at $8 per share, the company had $108 in equity/share. JPM must have stolen the company, right?

JPM was able to by the company for less than 2% of tangible book as of Nov 30. Not only that, they were able to get the Fed to pretty much guarantee the balance sheet, so there should be few write-downs, right? Couldn't the Fed have allowed Bear to work off its balance sheet problems and have allowed the company to go on, rather than let JP Morgan make a vulture killing?

I think we shall see that JPM got a decent price for the company but this might not be as good a as ideal t first appears. It is worth noting that several other players, including J. C. Flowers, who has made himself a billionaire by purchasing distressed banks, took a look and decided to walk. Perhaps they could not have gotten the Fed's guarantee. It is also worth noting that the folks who decided to sell were among the firm's largest shareholders and were among those who will feel the loss most personally as their equity and their options are essentially wiped out.

Bear was carrying massive leverage under which small losses would wipe out shareholder equity. Furthermore, its operating businesses were experiencing massive reductions in volumes and coupled with the growth of the balance sheet and the interest associated with it, Bear was going to find itself having difficulty meeting its fixed charges. This is a pernicious problem with banks - once under distress it becomes virtually impossible to do the additional business required to earn the money to repay the obligations. JPM itself wanted to make sure that it would have no goodwill writedowns that would raise speculation that its own balance sheet would become impaired. Thus, doing a business at a hefty discount to an uncertain book value was the only way to get this deal done.

We need to go deeper into the financials to understand why Bear could no longer continue as a going concern. Against a bankruptcy, $2/share doesn't seem so bad, actually. I believe there is every reason to believe that the actual book value of Bear is much lower than the annual report suggests.

First, let's look at the balance sheet. Like all banks, Bear uses generous amounts of leverage. Investment banks, in particular, use high leverage because they hold assets for very short periods of time - they underwrite securities, they do not hold them as investments.

High leverage is what enables banks to make good profits on small margins. For instance, if your assets are earning 1.1% (on total asset value), after interest payments, but you only own 10% of the assets with equity, you get to keep the full earnings, turning a 1.1% return into an 11% return.

But on the downside what it means is that you can be wiped out with a small loss.

Bear had this to say about Leverage in its own 2007 Annual Report (pg 52). You can find the entire report at the or get it here from Yahoo! Finance.

Balance sheet leverage measures are one approach to assessing the capital adequacy of a securities firm, such as the Company. Gross leverage equals total assets divided by stockholders' equity, inclusive of preferred and trust preferred equity. The Company views its trust preferred equity as a component of its equity capital base given the equity-like characteristics of the securities. The Company also receives rating agency equity credit for these securities. Net adjusted leverage equals net adjusted assets divided by tangible equity capital, which excludes goodwill and intangible assets from both the numerator and the denominator, as equity used to support goodwill and intangible assets is not available to support the balance of the Company's net assets. With respect to a comparative measure of financial risk and capital adequacy, the Company believes that the low-risk, collateralized nature of the items excluded in deriving net adjusted assets (see table) renders net adjusted leverage as the more relevant measure.

Bear argues that comparing the gross balance sheet to shareholder's equity (what I would consider normal) unfairly reflects the position of several assets that are cash or equivalent and which *could* be used to reduce borrowings. A fair point is that preferred stock, particularly in distress, should be considered equity capital because dividends can be suspended and because in this case the preferred is not redeemable at the option of the holder (thus Bear has no obligation to actually pay this debt. For our convenince Bear makes the adjustments to the balance sheet and summarized them in the follwing table.

As we can see, Bear's leverage rates increased from 25x, a not uncommon figure, to 33x. Even if we add the additional value of the real estate, we only bring the leverage down a bit. Adjusted, of course, this number becomes lower at around 19x. This was not simple misfortune on the part of this bank. Moreover, there is also this "nugget", also from pg 52 of the 2007 Annual Report:

Given the nature of the Company's market-making and customer-financing activity, the overall size of the balance sheet fluctuates from time to time. The Company's total assets at each quarter end are typically lower than would be observed on an average basis. ... At November 30, 2007, total assets of $395.4 billion were approximately 12.2% lower than the average of the month-end balances observed over the trailing 12-month period, while total assets at November 30, 2006 were approximately 0.5% higher than the average of month-end balances over the trailing 12-months prior.

So the actual leverage ratio during the year was even higher than is here represented.

It may be yet worse - another gem from the section on Off Balance Sheet Arrangements, on pg 61- "[the] Company reflects the fair value of its interests in QSPEs on its balance sheet but does not recognize the assets or liabilities of QSPEs". QSPEs are Special Purpose Entities which hold various mortgage backed paper. While the company may not have to repurchase the paper, (thus avoiding the need to consolidate the entity) we have no idea how much risk the company is really taking - what is the actual exposure here? Fine that the balance sheet reflects earnings or losses through 30 November, but what happened in December, January and Feburary as housing and the mortgage market continued to decline and foreclosures set post-war records?

Even without this exposure the high leverage ratios from on-balance sheet positions mean that a loss of somewhere bewteen 3-5% would be enough to wipe out the equity on the balance sheet. Considered under those terms, even JPM might not be buying much above actual value. Another way of saying that is that 3% of $400bn is a $12bn loss, against which Bear has equity of $11.4bn.

It was a systematic mismangement of the balance sheet. As recently as 2003 the balance sheet was half the size at $212bn. Not only did they allow asset volume to explode (while it was obvious that asset quality was declining), they failed to ensure that equity would even keep pace, because during the extremely difficult 2007 they still found cash to pay $172m in dividends AND repurchase $1.6bn in stock ! Had that money remained on the balance sheet, the company would have at least maintained its already high 25x leverage ratio affording it some extra cushion. Given the fact that the company was still buying back stock in October and November well after the crisis began in August, rather than shoring up the balance sheet it becomes clear that the company was simply out of control.

This might have been salvagable, were Bear capable of continuing to book high fees and unload some of the paper. But then we look at what is happening to revenue.

Fee income is suffering because of writedowns in the fixed income underwriting category. Revenue declined by 36% from over $9bn to under $6bn. Substantially all of that decline came from reversals in the fixed income segment, but as we entered 2008 it was clear that revenue from other key sources - serving as a prime broker to hedge funds, securities underwriting, merchant banking and the like were likely to decline further. Moreover, further writedowns in fixed income were a near certainty.

Income did even worse - declining by nearly 94% to a paltry $193mn. This meant that income before operations (including interest income) just covered fixed charges. Since this year is sure to result in worse top line development, it will no longer be possible to meet fixed charges. This could alone be a $2bn or 20% hit to equity with no prospect of "riding out the storm".

JPM, with its stronger balance sheet has a better chance of doing so. But in the end, there might not be much value left for JPM to acquire.

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