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 www.sec.gov 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.

What I was trying to say

In my last post was that the meltdown of Bear Stearns threatens the entire financial system. This was the reason that the Fed had to intervene to arrange the sale of Bear.

The reason that any element can bring down the system now is the interdependence of the players. The rise of structured finance, which enables risk to be sliced into various pieces and traded between banks, funds, insurance firms, investors, the government, corporations, farmers, travellers - in short, everyone - means that the failure of any large player inevitably weakens everyone else.

Derivatives essentially function like insurance - enabling the buyer to receive protection from specific risks (like having one's house burn down or having to make payments in currencies other than those in which a firm earns its revenue) at a cost - an insurance premium. Likewise, the seller function as an insurer, taking on that risk in return for consideration (the premium paid). If the seller decides to lay off some or all of that risk, they seek reinsurance, by assigning the contract (selling it) or by purchasing an offsetting position. This can be done for all or part of a position.

The problem is that as the risk becomes dispersed throughout the financial system, those at teh center, the investment banks and their large clients - hedge funds and insurance firms, and some corporations - find themselves counterparties to everyone. If one fails, the insurance that they have offered becomes worthless, forcing the insured to recognize a loss from an exposure they had believed to be hedged. Once that loss appears, equity of the counterparties can be quickly wiped out and more selling and liquidation ensues.

In a very real sense, what structured finance has done is not only spread the risk widely, it has meant that when any sector has a major problem the effects are impossible to isolate, because, at the end of the day, through the banks, everyone becomes a counterparty to everyone else, and failure at one bank is enough to bring down the system.

I point out that this is not news, though many seem to be surprised by it. In 1998, LTCM, having suffered a $5 billion loss, nearly had its equity wiped out and it stood to default on over $100bn in trades. The effect of the write-downs on the markets would have been huge.

Why does this happen? Well, insurance is based on estimates of what is likely to happen. Most of the time, it's a good bet for the insurance company. They reliably collect premiums that are more than adequate to offset small losses on in the position taken. However, sometimes really big events happen and when they do there is a surprising amount of correlation among assets, particularly financial assets and particularly among assets of similar classes. This means that if you regularly issue insurance against a specific type of default - all of your claims are likely to come at the same time. This would be OK, were it the case that the insurer had the assets in place and that those assets were sufficiently liquid to ensure that conversion to cash to pay claims didn't lead to greater imbalance and higher losses.

Virtually no firm, and certainly no investment bank, which operate with massive leverage, has the balance sheet necessary. It requires huge stores of cash - and cash is not a big earner. High returns on equity and the big bonuses that come with them aren't earned with cash. If you own 1/3rd of the company and live in a nice house in Omaha, you might not care that much about holding cash (especially if you operate with an underwriting profit, in which case the cash is free), but if you work in NYC and are competing to have your kids get in the most prestigious pre-school and you rely on annual performance bonsuses to pay for your lifestyle then you don't want lots of cash sitting around. You need to keep dealing and generating fees.

This is not to knock the investment banks. Generating fees is a very good idea, since those profits can be used to offset the loses (if you can continue operations).

But what I want to caution against is the belief that the risk models used to predict the insurance payoffs are good. Even Alan Greenspan, a fan of structured finance - and asset bubbles - admits that overreliance on models is a problem. This is because of the Rumsfeldian "unknown unknowns" which are impossible to model, no matter how good we get at modeling "known unknowns". Worse, the moments that the models will be most useless will be precisely those moments when insurance is most needed, that is during crises when traditional risk measures, such as Value-at-Risk (VaR) that depend on predicting the correlations among a series of risks, will break down.

I posted the first, unedited, and considerably less clear explanation, because I wanted to share my thoughts at the time. There has been evidence that my thinking on this was pretty good - the bank is selling for much less than its close on Friday (even I didn't think it would essentially go for liquidation value) and because I predicted more problems. The WSJ already hinted at problems at Lehman (though, thus far, it's speculation - on my part as well).

The Times of London is also insinuating that several leveraged hedge funds are near to collapse. This would also not surprise me. Leverage, so great on the way up is even more deadly on the way down. Long periods of being rewarded for taking increasing risks and getting paid less and less (but still getting paid) to take them inevitably leave one naked. And the tide is rushing out.

As an investor, I remain patiently on the sidelines. Right now, there is panic selling, knives are coming out and I'm not real interested in trying to catch it - never was that coordinated. The deleveraging that is underway will dramatically change the investing climate that we have come to know. It will truly be unlike anything we have seen in my lifetime.

Most of the old rules will be out of the window. I think there is still a great deal of reason to expect deflation and not inflation. As an investor, preparing oneself to thrive regardless of which scenario occurs is very tricky, but as always - the first rule is Hippocrates: "do no harm".

Why the Fed had to intervene to prop-up Bear Sterns

I wrote the article below yesterday afternoon and then decided to leave it for awhile so I could edit it. I didn't get a chance to get back online yesterday, and after waking up this morning discovered that the Fed had taken further action and that JPM had agreed to purchase BSC for $2 per share.

I have decided to post the unedited article - you will see that it takes something of a detour in paragraph 3, discussing derivates and counterparty risk - the driving force behind the Fed's unusual action to keep Bear afloat until it could be sold.

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Quick quiz – what is the biggest risk that an insured takes after purchasing insurance? Answer - That the insurer won’t be able to meet the obligation in the event of a major loss. When the insured is himself an insurer of other risks the potential for reverberations to lead to systematic failure are too large to ignore. The Fed saw the need to prevent the fifth largest investment bank from failing specifically because it saw that the failure of Bear would lead to a collapse of the structured finance market, a catastrophe that had to be averted at all costs. One can argue that the Fed managed to get a pretty good deal.

Bear Stearns had to be prevented from failure because it served as both a source of liquidity and lending to several dozen large hedge funds (in the form of a prime broker) and also found itself as the counterparty of several transactions (many with the same hedge funds). Had it gone under, its hedge funds would have found it difficult to process transactions and also to obtain adequate financing. Furthermore, many hedge fund positions – though winners – would have been effective losers, since the insurer (the counterparty) couldn’t actually make good on the contract. If this were to happen, these hedge funds, who are themselves counterparties to thousands of transactions would themselves no longer be viable counterparties and the contract failures would resound throughout the system, potentially rendering the entire structured finance/derivative markets inoperative.

To understand things a bit more clearly, let’s first review the primary uses for derivatives. Over the next days and weeks we will likely hear several pundits cry, either shrilly or smugly, that rampant speculation is the cause of the problem. Perhaps. Derivates, however, are at least as often used for hedging as for speculation. Derivates, such as forwards, futures, and swaps allow one party to “lock in” a price or an interest rate which allows them to focus on their business and not currency markets. Options, though more often discussed, function quite differently from most other derivatives. Exporters regularly use currency forwards to ensure that their transfer prices remain stable (avoiding the problems with either prices or margins jerking up and down in response to currency fluctuations). Farmers and ranchers use futures to ensure that at least some of their crops or herds will be sold at a price known in advance, protecting them from the influence of weather. In any of these cases it is possible that one would have made more money with an un-hedged position. (E.g. the farmer who agrees to sell soybeans at $3.00 a bushel may find that when he actually comes to deliver that the market would have paid $4. But he accepts this because it ensures that he doesn’t find himself trying to sell for $2, which might lead to bankruptcy).

In principle, the counterparty to the transaction is usually also be seeking to hedge. A meat producer or Ag firm also locks in a price and can therefore contract with its suppliers and be certain of a profit. In actual fact, however, the counterparty may simply be trying to make money as an insurer – either by exploiting price differentials in the market (hoping that the prices really is $4 and that they can purchase at $3 and sell for a profit) or by generating sufficient premium income from writing the contract to cover a small loss.

Generally these products work well. In fact, it can be argued that they reduce risk, since they provide for price negotiation over a long period. (Contrast that to the daily fluctuations possible in these markets – small increases or reductions of supply or demand can cause dramatic price changes – Marc Rich can tell you all about how to do it).

The problem is, derivatives often lead to small losses or small gains, punctuated by rare, but often extraordinary, gains or losses. Such risks are indeed popular with hedge funds and traders, since they can usually exploit small price “errors” and make stable and reliable profits. The problem is when things break down. Naturally, when one side experiences an extraordinary gain (which might be offsetting a large currency loss for instance), the counterparty is experiencing the large loss. If he hasn’t ensured adequate liquidity to write that check, he can often find himself illiquid, or even insolvent.

Regardless of the technical correctness of the models used by the “insuring” party, it is easy to see that many people who had purchased insurance might find themselves uninsured after all. This would lead to yet more chaos and likely more insurance failures (or more extraordinary events) putting yet more strain on the system and moving from the financial sector to the real economy as the breakdown began to affect the movement of commodities and other products.

Against such a dire outcome, the Federal Reserve has essentially left itself open to taking a small loss on Bear’s collateral. In return, it is able to charge JP Morgan the discount rate for the cash. Seems like a good deal –IF and it is a capital IF – this holds the line.

I am less certain that it will. There are many other companies who have been engaging in the same practices and the markets are likely to remain stressed. We have no idea what price BSC will actually fetch when the negotiations for sale are completed. The stock closed around $30, but if the company is in this bad shape it is unlikely that it will go for this price in a distressed sale. Given the poor management (decisions like trying to bail out its own funds stripping equity from the balance sheet) and high leverage there may be few tangible assets at all. Intangible assets may also have little value. The name Bear Stearns will be erased as it is now tainted. And who can say how long the bankers will be allowed to stay? Customer lists are worth something. In any event I suspect that we will hear something quite soon.

There will likely be more hedge fund failures and possibly another investment bank will find itself overextended. It is more likely to be one of the exclusive I-Banks (like Lehman Brothers) and not a money center bank, but Citi is having its problems, so who knows?

One thing is for certain, claims by those like Larry Kudlow that this credit crisis is near over are simply untrue.

Bear Stearns Bankruptcy?

Bear Stearns announced today that it would receive temporary (28 days) secured financing on an as needed basis for JP Morgan Chase and (indirectly) from the Federal Reserve.

The plan was announced as a response to a major liquidity crisis that has been ongoing since two hedge funds imploded in August. Bear remarked that

Bear Stearns has been the subject of a multitude of market rumors regarding our liquidity. We have tried to confront and dispel these rumors and parse fact from fiction. Nevertheless, amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated.

Furthermore, they announced that they are in talks with JPM regarding "permanent financing or other alternatives."

This unusual financing structure will see that:

Through its Discount Window, the Fed will provide non-recourse, back-to-back financing to JPMorgan Chase

Read both statements here.

This essentially turns JP Morgan into conduit. The collateral for the loans will come from Bear Stearns. Should Bear default and the collateral fail to satisfy the outstanding loan to JP Morgan the Fed will take the loss. The loan is "non-recourse" which means that the Fed cannot pursue assets of JP Morgan to satisfy the debt.

This unusual step has been taken because, as an investment bank Bear Stearns is not eligible to borrow from the Fed, whereas JP Morgan, a commercial bank, is a member of the Federal Reserve System and does have that right.

The problem is transforming from one of liquidity to one of solvency. Investment banks tend to have extremely high leverage, much higher than that of commercial banks, because I-Banks rarely hold investment assets for long periods. They underwrite and need keep assets on the books only until they have sold them to clients or other syndicate members. Commercial and retail banks, by comparison, tend to hold loan portfolios as investments and so use more "modest" 9:1 leverage (I-Banks are often 25:1).

Obviously, with such high leverage rates even small declines in asset prices can wipe out equity on thinly capitalized balance sheets. Merging Bear out of existence would reduce the leverage of the portfolio, by combining it with the much healthier balance sheet of JPM.

Temporary revolving credit such as the Fed is extending can solve liquidity problems, but it cannot solve a solvency crisis. Nor can it resolve the bigger problem for stand alone I-Banks that they need to be able to sell their paper to someone, at a premium, not simply trade it for cash.