Monday, March 31, 2008

Mortgage Meltdown



The Bear Stearns meltdown and subsequent acquisition by JPMorgan (facilitated by the Federal Reserve) is in the news and hit the front pages recently. The following is a quick overview:

Who:

Bear Stearns (referred to as Bear in the rest of this write-up) is a diversified financial services holding company, and (from the company web site) “a leading global investment banking, securities trading and brokerage firm.” With approximately fourteen thousand employees, revenues of $5.95 billion (down from 2006’s $9.2 billion), net income of $233 million (down from 2006’s over $2 billion), and a profit margin of 3.2% (down from 2006’s 34.1%), the fate of Bear Stearns shows that perhaps every so often investors should pay close attention to the “Risk Factors” section of the 10-K filing, e.g. …Our businesses could be adversely affected by market fluctuations. Our businesses are materially affected by conditions in the financial markets and economic conditions generally, both in the U.S. and elsewhere…”; “…Market fluctuations and volatility may cause us to incur significant losses in our trading and investment activities…”; “…Our businesses may be adversely affected by fluctuations in interest rates, foreign exchange rates, and equity and commodity prices. In connection with our dealer and arbitrage activities, including market-making in OTC derivative contracts, we may be adversely affected by changes in the level or volatility of interest rates, mortgage prepayment speeds or the level and shape of the yield curve…”; etc., etc. Bear has been very heavily involved in mortgage-backed securities (MBS), being a major player in the creating, underwriting, trading, and investing in these financial instruments.

What happened/timeline:
  • In June 2007 two of Bear’s hedge funds that had a lot of exposure to MBS and subprime mortgages began to loose money. Bear put approximately $1.6 billion into these funds before winding them down.
  • In October Bear obtained an investment in it of $1 billion by Citic Securities (owned by the Chinese government).
  • Investors did not seem convinced (the stock gained 1.2% in value when the deal was announced, but then slipped back 2.2% the next day).
  • In Q4 of 2007 Bear reported a quarterly loss of $859 million, the first ever quarterly loss in the firm’s storied 85-year history.
  • Bear continued to hemorrhage… In March 2008 rumors began to circulate that some European financial institutions had stopped transacting fixed income trades with Bear, and as a result U.S. traders started pulling back, including other hedge funds, investment banks, money market funds, etc. Bear started to run out of liquid reserves.
  • By March 13th Bear, unable to find a white knight, was in a very serious position, and was running out of liquidity. The SEC and Federal Reserve became involved. The Federal Reserve agreed to extend a short-term (28 day) discount window loan.
  • Two days later JPMorgan (the second largest bank in the U.S. as measure by stock market capitalization; also intimately familiar with Bear’s business since they were the clearing agent for Bear’s trading activity) agreed to acquire Bear. The cost, 0.05473 of a JP share for each Bear share i.e. approximately $2 a share, thus valuing Bear at $236 million.
  • The buyout offer was amended to 0.21753 of a JPMorgan share i.e. approximately $10 a share, now valuing Bear at approximately $1.2 billion. The Fed’s loan was also “tweaked.”
  • The deal was approved by the boards of the two companies, the Federal Reserve, and the Office of the Comptroller of the Currency.

Some questions & answers:

  • How unusual was the Federal Reserve’s action in extending the discount window loan? Very, the Fed usually only makes direct loans to commercial banks. However, the Fed’s rules do allow lending to non-banks if five of the total seven Fed governors give approval, although this hadn’t been done since the Great Depression in the ‘30’s and early ‘40s. In addition, the Federal Reserve also had to use a special clause allowing it to approve the loan to Bear on an emergency basis with the approval of only four Fed governors (since currently 2 seats are empty, and one governor was outside the U.S.)
  • Why did JPMorgan’s offer increase from $2/share to $10/share? Well, one has to say that the initial and subsequent valuations only had a little to do with the “market.” After the initial $2 per share offer there was significant pushback by the shareholders that would have to approve the deal, so JPMorgan “sweetened” the deal slightly. As it is the shareholders are taking a massive “haircut.” To ensure approval of the deal, it is structured so that Bear will sell 95 million new shares to JPMorgan. This number was carefully chosen, a) since 95 million shares is approximately 39.5% of new total outstanding Bear shares (Bear is a Delaware firm, and Delaware law requires a shareholder vote prior to any company selling 40% or higher of its holdings), and, b) with this 39.5% of shares plus an approximately 5% of Bear shares held by its board they are “stacking the deck” to ensure that they get the required Bear shareholder approval. Stricter NYSE rules require that a company issuing new shares greater than 20% of a listed companies stock get shareholder approval. Here, Bear has exercised a clause that allows an exception if sticking with the normal process would seriously jeopardize the listed company’s viability.
  • Is the Fed on the hook? Yes, in theory. The Fed is making a ten year, renewable, variable rate, $29 billion loan to JPMorgan at the discount rate (currently 2.25%). The collateral that backs this loan is $30 billion of assets, of which approximately 2/3rds are MBSs. However, these assets have been “marked to market” and the Fed will only loose if the collateral ends up being worth less than that value over the length of the loan. Also, JPMorgan has agreed to bear the first $1 billion of losses, if there are any, so the Fed has a small cushion. Conceivably the Fed could come out ahead if the collateral holds and regains value over the term of the loan. . Ditto for JPMorgan, that only has a worst case scenario total potential liability of $1 billion no matter what happens, and plenty of upside opportunity.
  • Why did the Fed intervene? This is something that is being hotly debated. As mentioned above the Fed normally does not make loans to non-banks. However, the “pro” argument is that the Fed intervened to prevent Bear’s failure, which could have caused losses to cascade through its trading partners and through the wider market. The Fed is also trying to staunch the credit crisis and prevent it from spiraling into a full-blown banking crisis. The “con” argument is that by this action the Fed has taken credit risk onto its portfolio and increased the risk of “moral hazard” (i.e. the risk that by bailing out someone who has engaged in risky behavior you're likely to encourage similar risky behavior in the future.)

Some questions without answers:

Yet to be determined is if the Fed’s action actually increases “moral hazard”, and if the Fed would intervene if another “too big to fail” institution finds itself in the same position. The “moral hazard” question will undoubtedly be argued for some time…

As usual when the government intervenes there are winners and losers – the immediate losers are Bear’s stockholders and employees, while longer-term there is potential for the public to be a loser (if the Fed looses). One big loser is Bear's second-largest shareholder, British billionaire Joseph Lewis who owned 9.4% of the stock (who while amassing this stake paid an average of $107.30 per share). The clear winners are JP Morgan, and the few intrepid folk who bought Bear stock after the first offer but before the second. Citic dodged a bullet – it hadn’t yet completed its $1 billion investment in Bear and will pull out… JPMorgan gets the entirety of Bear for approximately what Bear’s Manhattan headquarters building is worth...

The Biggest Bailout in History: And Why American Taxpayers Should Get Some of the Upside
JPMorgan Agrees to Buy Bear Stearns for $240 Million (Update2)
JP Morgan Raises Offer to Buy Bear Stearns
JP Morgan Raises Its Offer For Bear Stearns


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