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Bear Stearns' $2 Catastrophe

Posted: Mar 17, 2008 14:31 PM by Wayne Pinsent

Tickers in this Article: UBS, LEH, CFC, BAC, JPM, BSC

On Monday morning, the financial world awoke to stunning news of JPMorgan Chase & Co.'s (NYSE:JPM) takeover of Bear Stearns (NYSE:BSC). Well, the takeover was expected, but the $2-per-share buyout price was the stunning part.

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This marks the end of a precipitous fall for the nation's fifth largest investment bank, which traded at $160 less than a year ago. The news is a huge disappointment for Bear Stearns shareholders, and is taking down the shares of all the financials as worries spread, but, overall, the move will prevent the much bigger headache of a bankrupt Bear dumping its assets onto the market. Finally, the deal could be a steal for JPMorgan. (For background on Bear Stearns and the credit crunch, see Dissecting The Bear Stearns Hedge Fund Collapse and the Subprime Meltdown Feature.)

JPMorgan to the Rescue?
The JPMorgan buyout comes just days after an agreement was reached where JPMorgan and the NY Fed would bailout Bear Stearns with cheap loans by allowing JPMorgan to take Bear's collateral to the discount window. This was necessary after liquidity started to quickly dry up. The lending agreement, through a secured loan facility, gave JPMorgan the chance to scrutinize Bear's books and decide whether it wanted to buy the beleaguered broker-dealer. Evidently, JPMorgan liked what it saw.

When Bank of America (NYSE:BAC) made the decision to buy Countrywide Financial (NYSE:CFC), it had analysts looking over Countrywide's books for about a month. Yet, it took only two days to hack out the Bear Stearns deal. The pressure to get a deal done quickly was evident in other ways as well. Regulatory approval, which usually takes weeks at least, was received immediately after the deal was done. The Federal Reserve even agreed to take $30 billion of the risk to sweeten the negotiations.

Is Bear a Steal at $2?
Bear's stock plummeted to $30 on Friday, and many were expecting a buyout to be substantially lower, but it was surprising to see the fire-sale price of $2. JPMorgan is buying the Bear in an all-stock transaction, where Bear Stearns shareholders receive .05473 shares of JPMorgan stock for every share of Bear they own.

As of Friday's closing prices this values Bear Stearns at $2 per share or $236.2 million. At this price, Bear Stearns actually looks to have a negative valuation. The transaction gives JPMorgan ownership of Bear Stearns midtown Manhattan headquarters, which cost more than $280 million to build. Bear Stearns retains essential ownership of the building through a synthetic lease that helps save on taxes. By some estimates the building is worth easily two or three times the price tag JPMorgan is buying the whole company for.

Focusing on just that one piece of real estate, it looks as if JPMorgan is getting Bear at an incredible steal. It also implies that JPMorgan is taking on major liabilities from Bear, however the Fed is helping with the risk. It is covering the risk of $30 billion of Bear's riskiest assets through the special lending facility that had already been put in place. JPMorgan still assumes about $13 billion of risk in assets from Bear, but the management feels comfortable with the risk of the deal. (To learn about these calculations, check out Use Breakup Value To Find Undervalued Companies.)

However, JPMorgan will certainly feel some pain. The company stated that it expects to spend about $6 billion, pretax, for litigation and consolidation costs, and further write-downs of Bear's assets. I think this is overall a good deal for JPMorgan. Bear Stearns still technically boasts an $84 book value per share, which management claimed was still accurate on Friday. That is highly doubtful, but even if book value is $6, JPMorgan is getting a deal. There certainly are risks in that Bear's assets could deteriorate much more, but this is aided by the Fed's backing of $30 billion in risk, and a dirt-cheap price. There may be short-term pressure on JPMorgan, but the stock looks attractive long-term. (For the ins and outs of book value, read Digging Into Book Value.)

Will the Contagion Spread?
With Bear Stearns deteriorating so quickly, one has to be wary that the same could happen at Lehman Brothers (NYSE:LEH) or UBS AG (NYSE:UBS). The Fed calculated for this too, by opening up the discount window to primary brokers, which will help stave off liquidity concerns. One must ask, though, would it have saved Bear Stearns if the Fed had taken action just a few days earlier?

The Bottom Line
This is a horrible disappointment for the 85-year-old Bear Stearns. JPMorgan will have to take on significant liabilities for Bear Stearns, but I think at $2 per share, it is quite an attractive deal. This is also much better than Bear going bankrupt and dumping its assets. I think pressure will remain on the financials, but the Fed's moves will secure liquidity and help solve many of the problems being faced. I would still steer clear of the financials in general, but I think JPMorgan is a good long-term play.

By Wayne Pinsent

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