1115.org

Andrew Osterland at FinancialWeek.com has some interesting details about what he calls “the shotgun wedding between Bear Stearns and J.P. Morgan” conducted by the Fed.

(1) Pound Foolish
When JPMorgan made its $236 million offer to buy Bear Stearns (at $2 a share), it set aside “$6 billion for ‘transaction-related’ costs in the controversial deal—a good chunk of which will likely go to pay off litigious shareholders”.

The irony, of course, is that if JPMorgan had decided to offer say $4 billion (roughly $34 a share), that would have represented a premium of more than 10% over Bear Stearns’ prior market price of $30 a share, and there would be no expensive shareholder lawsuits to defend.

So JPMorgan preferred to lowball by bidding $236 million and then spend $6 billion to fight the resulting lawsuits instead of just bidding $4 billion to buy Bear Stearns and then spending only chump change on stockholder lawsuits? Or if you like, the Fed preferred the socially wasteful $6.3 billion strategy over the just-over-$4-billion strategy?

(2) Unintended Consequences?
Then there’s the very interesting question of whether the Fed had thought through what it was doing when it decided to underwrite the merger by guaranteeing the value of Bear Stearns’ “most toxic assets”.

The role of federal regulators in arranging the deal raises some interesting questions about corporate governance in times of crisis. And the decision by the Fed to shoulder the risk of up to $30 billion in illiquid securities on Bear’s balance sheet sets an unusual precedent for the central bank that could get complicated if the deal is not approved by Bear shareholders.

“We’re moving into completely uncharted territory,” said Stuart Grant, managing partner at plaintiffs’ firm Grant & Eisenhofer.

For example, if a competing bid emerged for Bear Stearns, would the same federal financing package be available to the bidder? What if a consortium of private equity firms made the offer? What if it were a foreign bank, which the 14,000 Bear Stearns employees would certainly prefer given Jamie Dimon’s penchant for cost-cutting? The Fed subsidizing a foreign purchase of a U.S. investment bank would certainly spark debate in Congress. If the Fed financing weren’t made available to other potential bidders, why is that the case, and why would J.P. Morgan be given such an enormous advantage over the rest of the market?

“The Fed will have to explain why they wouldn’t give the same deal to someone else,” said (James Cox, a corporate and securities law professor at Duke University).

So far, the central bank has explained nothing and given virtually no information to taxpayers about the risks it is assuming in the deal.

(3) The Definition Of A Complete Sellout
What took my breath away, though, was the revelation of how thoroughly the Bear Stearns board have sold out Bear Stearns stockholders in this deal.

Under the merger agreement, Bear Stearns cannot terminate the deal until March 2009, regardless of any other offers that emerge. And if shareholders vote against the agreement, it will be restructured and resubmitted to them until the termination date.

If the JPMorgan deal cannot be terminated for one year, that means no competing offer can be accepted for one year. That, of course, significantly stifles the probability of competing offers emerging.

Between this provision, and the plan to do an end-run around stockholders and issue new shares to give JPM a 39.5% stake in the company, the Bear Stearns board has bent over backwards to minimize the probability of anyone else being able to compete with JPMorgan and mount a serious bid for the company. It’s hard to see how the Delaware courts will do anything other than take an extremely dim view of this. It amounts to coercive action by the Bear Stearns board against Bear Stearns stockholders.

There are definitely going to be lawsuits. Not just to block the JPMorgan takeover, but lawsuits for damages against the Bear Stearns board. I’m not sure how “The Fed made us do it” will play as a legal defense, but given the way the board has acted, it sure as hell isn’t going to play too well in the court of public opinion. The board seems to have done everything possible under the sun to facilitate JPMorgan buying Bear Stearns for the paltry price of $2 a share. The directors seem to have comprehensively sold out the stockholders whose interests they are morally and legally bound to serve.

(4) How Sweet It Is!
One measure of how great a deal JPMorgan was getting when the Fed arranged for it to buy Bear Stearns for $2 a share is to look at how much its stock price went up on Monday, March 17 after the deal was announced. (That’s also a measure of how badly Bear Stearns’ stockholders were getting robbed.)

J.P. Morgan’s stock price bounced 10% on the Monday after the deal was announced, increasing the bank’s market cap by about $12 billion, while the share prices of other banks were falling. That suggests that the market thought J.P. Morgan was getting a steal. With a total price tag of $366 million (note: this article was written before JPMorgan raised its offer to $10 a share; the number reflects the March 20 value of the shares JP Morgan had agreed to give Bear Stearns’ stockholders under the $2 a share formula) at Morgan’s current market price, Bear is being sold at less than 0.4 times the $1 billion in annual earnings that J.P. Morgan expects it will contribute to the combined company. In other words, J.P. Morgan will make its investment back in two quarters, while the Fed will indemnify the riskiest assets in Bear’s portfolio.

So when they agreed to buy Bear Stearns for the bargain basement price of $236 million– spending a total of $6.2 billlion in the process, including legal expenses — their market value rose $12 billion on a day when other stocks in the industry went down? That’s pretty telling.

Maybe the entire $12 billion doesn’t represent undervaluation of Bear Stearns, but I can see only two components to this value increase—the undervaluation, and the boost in market value that might result from the market realizing that JPMorgan had suddenly attained Most Favored Status and would henceforth be treated like the Fed’s favorite son-in-law or something, with all kinds of financial largess being thrown its way, at least till January 2009. (Maybe a Mormon son-in-law, with some more shotgun weddings to come.)

Bear Stearns’ stock was worth $3.5 billion at the close of trading on Friday, March 14. That was the market’s valuation of Bear Stearns on March 14 without the Fed’s $30 billion guarantee. Bear Stearns with that $30 billion guarantee would have to be worth substantially more. (It might be argued that Bear Stearns was overvalued in retrospect on Friday evening — in the light of information that became available over the weekend — but let’s ignore that as we crunch our numbers. To the extent that this is true, the only thing affected in our analysis is the value of the guarantee the Fed gave to JP Morgan as a gift from you and me.)

Let’s we do it backwards, and start by asking: what’s the capitalized value of being the Fed’s favorite son-in-law? Even in the time of Bush, the Fed might have trouble throwing more than a couple more billion JPMorgan’s way between now and January 2009. So maybe we can accept the proposition that being the Fed’s favorite son-in-law couldn’t be worth more than $2 billion to JPMorgan.

Which implies that they are paying $10 billion less for Bear Stearns than it is worth today with the Fed guarantee. Which means that Bear Stearns with the guarantee is worth $16.2 billion. Which means that if Bear Stearns didn’t lose value over the weekend of March 15/16 — and was worth $3.5 billion without the guarantee on Monday morning– the guarantee the Fed handed out as a gift to JPMorgan is worth $12.7 billion.

And let’s not lose sight of the fact that under the terms dictated by the Fed, the stockholders of Bear Stearns were slated to receive only $236 million for shares that were worth $16.2 billion the way the deal was structured.

So, in my judgment, the Fed picked our pockets to the tune of $12.7 billion, and then basically held a gun to Bear Stearns’ head, and invited JPMorgan (who presumably didn’t need to have a gun held to its head) to pick the pockets of Bear Stearns’ stockholders to the tune of $16 billion.

I don’t know about you, but words totally fail me at this point. Even for the Bush administration, this seems totally outrageous. And criminally insane.