White knights

It’s just been announced that JP Morgan will buy Bear Stearns for $2 a share, implying a value of about $250 million. Given that the company headquarters is said to be worth about $1.2 billion, that gives the BS banking business a value of negative $1 billion. And that’s only after the Fed agreed to take on $30 billion worth of toxic waste from the BS portfolio, politely described as “less-liquid assets.â€?

Clearly, under any normal circumstances, a company like this would have been left to go bankrupt. The problem is that this would jam up the entire credit market because BS is a counterparty in a vast range of transactions with other banks. (We debated this issue a month ago here and at CT with a number of commentators arguing that the problem of counterparty risk was not such a big deal).

Some light relief is provided by the announcement by Standard & Poors, the day before Bear imploded, that the worst was over. This will go down with Irving Fisher’s comment in late 1929, that the stock market had reached “what looks like a permanently high plateau”. But at least Fisher wasn’t being paid to judge the stock market. Surely it’s now time to kill off the quasi-official role of the ratings agencies, as Justin Fox has just argued in Time

Looking ahead, the limits of the white knight strategy employed in this case must be approaching. JPM will take a while digesting this mess, and Bank of America has already done its bit when it agreed to rescue Countrywide. The other big banks have their own problems. Any future maidens in distress will have to look directly to Uncle Sam for a rescue.

Update Readers used to the natural order of things might be concerned by the implication that with such a giveaway price, the top brass at BS might be forced to bear the financial consequences of events that were obviously beyond their control. Never fear. According to this Reuters report in the Guardian, while most employees up to junior executive levels will lose both their jobs and the shares they were encouraged to buy, with no “golden parachutes”:

JPMorgan Chief Financial Officer Mike Cavanagh late Sunday said taking over Bear would generate about $6 billion in merger-related costs.
JPMorgan has not broken down those figures, but much of that will be earmarked for severance pay and potential exit packages for top executives like Schwartz.
A person familiar with the transaction told Reuters that roughly $1 billion of those costs would be earmarked for severance and retention.

98 thoughts on “White knights

  1. Terje, it’s tough trying to have a normal conversation in bald text, with other posts intervening. No offense meant, but I couldn’t quite let your post go past without a very little dig back. Of course, things were not helped by my response posting itself three times while I was writing it!

  2. its always semantics around here,

    Failure in this context refers to a bankrupcy. Bear Sterns didn’t fail, it was bought as a going concern even if it was a forced seller at a deeply depressed price.

    this is BS in its original meaning,

    everyone in the world knws bear stearns failed

    why is honesty so difficult with economics

  3. more light relief

    July 12 2007: (Fortune Magazine)

    “This is far and away the strongest global economy I’ve seen in my business lifetime,” U.S. Treasury Secretary Hank Paulson declared on a recent visit to Fortune’s offices.

  4. i obviously have too much time on my hands,
    anyway from the financial times

    martin wolf on the possible end of the hedge funds model:


    Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap.

    and john kay on warren buffets success and the weakness of the efficient market hypothesis:


    Mr Buffett’s success demonstrates the weakness of one economic
    theory, the efficient market hypothesis, and the strength of another – the central role that the pursuit and defence of economic rents plays in modern corporate life. Still, the first view remains much more popular among economists than the second. Mr Buffett became the first man in economic history to parlay an economic disputation into great personal wealth.

  5. smiths, thanks for your references. The Martin Wolf article contains nice examples of problems with performance schemes that are based on outcomes without asking why and how; ie the problem with KPIs.

    Just a small point regarding ‘economics’. The Efficient Market Hypothesis belongs to Applied Finance, specifically to the posivist version as represented by E. Fama. In the 1970s this school was very focal in distinguishing itself from Economics on the grounds of being more applied, more useful, etc.

  6. “My comment was in response to Ian’s comment about JPM expensing off Bear’s liabilities. To the extent that it assumes Bear’s liabilities then they have to be paid when due; no question of “expensingâ€? them off, otherwise JPM would be in default.”

    By expensing them off, I mean JPM can repay them over an extended period along with the other regular expenses of the business rather than having to declare them in the net reporting period as extraordinary losses.

  7. Terje: Your second paragraph at comment #43 would seem to contradict John Quiggins first paragraph in the opening article.

    Yes it does. I think John is taking an overly pessimistic view of the situation. The Fed loaned JPM $30 billion secured against assets of Bear Sterns.

    I’ve yet to see a published analysis of exactly what those assets represent so I think it’s premature to assume they’re all worthless or, as John put it, “toxic sludge”.

    To be blunt too, I suspect that the Fed will be telling JPM that if they simply walk away from those loans, even if they are legally entitled to do so, the lending window will be sh*t in any future crisis.

    Some of the loans will probably be covered by the sale of the security, a chunk of any shortfall will probably be met (over a period of several years) by JPM, only the residual will be met by the Fed. The US Treasury is only likely to become involved if the Fed needs to borrow T-bills to finance the rescue.

  8. “this is BS in its original meaning,

    everyone in the world knws bear stearns failed

    why is honesty so difficult with economics”

    Because, economics like any academic discipline has its own special vocabulary and you can’t simply redefine terms or apply them in their nontechnical sense.

  9. Just to reinforce my point about the definition of failure: BCCI failed – thousands of depositors didn’t get a cent back. Enron failed – and defaulted on billions of dollars in contracts.

    So far not a single investor with Bear Sterns or a single party to a trade with Bear Sterns has lost a cent – and the JPM takeover is designed to ensure it stays that way.

  10. BS is not bankrupt!

    In fact it’s trading around 5-6 dollars. Sure there are pleny of sad/mad shareholders but once the dust settles JP Morgan will potentially be sitting on a pile of profit and one of the greatest trades in a long time.

    There’s even a good chance the equity holders might veto the takeover.

    Meanwhile investment banks can now tap the Fed for short term liquidity. This was not available to Bear last week but a great potential buffer to others should they need quick cash.

  11. Ian, It seems to me you are using accounting-law definitions to describe something which might not fit into the accounting-law framework (ie you interpret ‘failure’ to mean ‘bankruptcy’ and ‘investor’ to mean ‘depositor’). From my perspective, the Fed-JPM deal is a deal aimed at preventing a total financial system failure.

  12. BS is not bankrupt!

    In fact it’s trading around 5-6 dollars. Sure there are pleny of sad/mad shareholders but once the dust settles JP Morgan will potentially be sitting on a pile of profit and one of the greatest trades in a long time.

    Barry Ritholtz has a better explanation:

    There is a simpler explanation, one that might surprise you: BOND HOLDERS are buying up Bears loose stock. As much as they can get.



    Consider: there is ~$75 billion in outstanding bonds (see Bloomberg screen below), and another $75 billion in other miscellaneous paper. (UPDATE: The NYT pegs it at $300B). Prior to the BSC/JPM deal’s announcement, the BSC Bonds were trading for 80 cents on the dollar.

    Imagine your fund owned a one billion dollars worth of Bear bonds (mark to market = $800 million). Isn’t it worth buying 10 million shares or so at $3 – 4 or so dollars a share? You will get $2 per share in JPM stock, so buying it a few bucks over the takeover price isn’t all that risky. Remember, insiders own 30%, and Joe Lewis also owns about 10%.

    So as mad as the accumulation appears, its actually quite rational — IF YOU ARE A MAJOR BOND HOLDER, and are doing this to capture voting stock. (All the other idiots buying BSC are pretty much f**ked).

  13. Ernestine, I wasn’t the first person to use the term “failure” or “fail” – I think it was Rog or possibly Andrew Reynolds.

    It’s pretty clear what sense of the word the original post meant – and it’s equally clear that a forced takeover which protects the interests of both lenders and counterparties doesn’t meet that definition.

    For that matter, the JPM share price is looking pretty depressed currently. In a couple of years that $250 million in JPM stock could well turn out to be worth substantially more.

  14. SJ – no the $250 million (at current values) worth of JP Morgan shares that current Bear Sterns shareholders are being offered for their shares.

  15. I imagine the extra risk will be passed on to the Fed, that is, the US general public.

  16. PrQ,
    JP will be in the first loss position for $1b on the $30b portfolio (the “toxic waste” as you put it), so if it starts going bad they will lose up to $1b on them.
    This, at least as I have read it, increases the risk above that in your original post starting this thread.

  17. To restate the same points
    (i) JPM gets Bear, minus $30 billion of toxic waste (this term is from NY Times and WSJ, not original for me) for a share issue worth about $1 billion, another $1 billion in exposure and maybe $6 billion in restructuring cost
    (ii) The Fed gets the toxic waste, currently trading at huge discounts if it can be sold at all, at a price of 97c in the dollar (allowing for the 1/30th share borne by JPM
    (iii) Bear shareholders get $10 and bondholders get 100 cents in the dollar for securities that would respectively be worth zero, and much less than 100 per cent in a bankruptcy liquidation

    You can argue about whether (i) is a good deal or not. I don’t think there is any room for dispute about (ii) or (iii).

  18. To labour the point neither JPM, Bear Sterns nor either of their shareholders are the significant beneficiaries of this action. The real beneficiaries are those that leant funds to Bears Stern. And given that most of them were banks that should know about lending risk I think they should have got a hair cut instead of a handout.

  19. No – sorry, but you are wrong (in parts) on all three. The first loss position of JPM means that they are exposed not to a share of the loss, but the entire loss up to $1bn. Only after the losses exceed $1bn does their exposure cease. So, if the losses are $500m, JPM loses $500m and the Fed loses nothing. If the losses are $1.5bn, JPM loses $1bn and the Fed loses $500m. JPM have what is known in the business as the “equity” position in the instruments – the riskiest tranche. 97c in the dollar, with someone else taking the equity tranche may be a good deal – but it is difficult to know now. They could pay out 100c in the future. OTOH, they could be worth very little if the revenues from them are low. This covers (i) and (ii).
    You are also possibly wrong on (iii) – an orderly liquidation over several years may have realized much more than $10 for Bear’s shareholders – which would have meant that the bondholders would have got 100% – but neither of them would have got it now. The way the Fed has rammed this through, though, means we will probably never know if this was to be the case. If the US economy tanks it may turn out to be a shocker of a deal. If not, it may turn out to have been inspired. The share price of JPM shows what the market participant’s view is – to the extent that we accept that verdict.

  20. Terje Says: “And given that most of them were banks that should know about lending risk I think they should have got a hair cut instead of a handout.”

    This is a bit simplistic. The actions were intended to prevent a failure of the banking system. What you call a “hair cut” translates to “failure of the banking system”.

    There’s no guarantee that it’s all going to work out well anyway.

    Breaking news is that JP Morgan is next in line for collapse.

  21. JPM estimated that BS exposure to subprime mortgage at $2B so the Fed may only have $1B to lose.

    JPM analysis put BS value much higher than $2 (as evidenced by increased offer to $10), includes the $1.6B building, but it appears that political realities were paramount.

  22. SJ,
    Regulators are very fond of justifying anything by running around saying they have saved the financial system. What they are not good at is looking at whether they are the reason it is having problems int he first place.

  23. OK, Andrew, I’ll bite. Why is the financial system having the problem in the first place?

    Terje: You know, abandoning the gold standard. That sort of thing. Ruination. Kinda, except not.

  24. Two essential elements to a JPM collapse, lowering of credit rating and increase in interest rates. JPM has $26T in derivatives, 85% of which are interest rate contracts . Either a credit rating or an interest rate move could see a major loss of revenue to JPM as clients seek more secure positions. For the time interest rates are on hold, will S&P also steady their hand?

  25. Its worth remembering one of the last times the world almost ended for US banks; the LDC (Lesser Developed Country) debt crisis starting in in 1982. I won’t give the history, just a very good link: http://www.fdic.gov/bank/historical/history/191_210.pdf

    Described then by the FDIC as the worst crisis since 1930, the major point is that all of the top 8 US banks then would have been all bankrupt on a mark-to-market basis. On average they had loan outstandings to LDC countries equal to 217% of their capital and reserves in 1982 when Mexico defaulted and started a massive chain of defaults amongst 40 LDC countries. There was plenty of warning up to 5 years before that LDC lending was out of control but the banks didn’t stop and the ratings agencies missed it entirely. To say it was the sub-prime crisis of its day is, to me, to overstate the sub-prime crisis.

    What is very important to note is the simple fact that a regulated bank having negative equity on a mark-to-market basis is absolutely no obstacle to it continuing to operate and fulfilling a role in the banking system. The US regulatory response to the LDC crisis was called, by the FDIC itself, “regulatory forebearance”. The US banks were simply given time to rebuild.

    And far from being unique it is the approach followed by regulators in almost every single major banking crisis. Consider the Japanese banking system in the 1990s. The Japanese banks together had, almost without question, net negative equity. Yet they are all still here today, and even profitable again.

    Someone even wrote a paper once about the concept of operating banks with negative equity and called them “zombie banks”. They are a feature of almost every financial crisis, and many non-crisis situations, and demonstrate again that regulated banks are very, very different animals from other firms.

    This current crisis, while it might look different, and everyone will say its different because of this and that, is really just another in a long chain of similar banking crises. You can perhaps understand why Its a great frustration to me that we don’t teach these as a core element of university finance (at least in Oz, which is my experience). Every time its like moral hazard has been discovered for the first time.

  26. SJ – unless you properly quantify “failure of the banking system” then how can we decide if saving all those stockholders profits using taxpayers money, or printed money, is tolerable or not? It seems to me that the defenders of action are fearful of some vague shadow called doom and despair. The problem with vague shadows is that we can use them to justify almost anything (such as aggresive invasion of foreign nations). Do you believe the fed saved us from total economic collapse merely because they say so?

  27. Just found another – this just popped into my inbox.
    While I do not completely agree with it, the points it makes on regulators (and the analysis behind them) looks sound.

  28. Terje, here’s what happens when you get a systemic failure in the banking system:

    1. Runs on retail banks as peopel try to withdraw their savings.

    2. Banks calling in loans from viable businesses to try and shore up their balance sheets and meet short-term liquidity needs.

    3. An effective halt to new business lending.

    4. Massive increases in unemployment resulting from 2. and 3. leading to further consumer debt defaults which weaken banks further leading us back to 1.

    Read up on the 19th century and early 20th century “Panics” in the US.

    Or for that matter read up on Indonesia in the 1990s.

  29. Point 3 won’t cause unemployment. It will merely cause some operational difficulties.

    Point 1 won’t succeed if the banks don’t have the cash. My bank has a clause in it’s terms and conditions to cover temporary liquidity shortfalls. Which seems sensible. This seems like more of a political and PR problem than an enduring economic issue.

    I’ve read about panics from the past. Most seem to have been due to errant policy – not that we lack errant policy today. However who is to say this was such a beast?

  30. Andrew, the story at the first link (#85), says that the existence of an unregulated part of the market undermines the regulation of the regulated part, by creating incentives to try to weasel around the regulations.

    The second link (#86), explicitly states that the problem lies with “the politicians, the lawmakers, the law enforcers, the regulators, the policymakers and so on”, because they failed to regulate.

    If that was the point you were trying to make, then fine, I don’t disagree.

  31. Terje, Ian has tried to describe how things work in the real world.

    “Operational difficulties” really do cause businesses to shut down, and cause unemployment. Your supplier suddenly wants cash before he’ll send you the next shipment, and you can’t get any cash from the bank. Bang, you’re out of business.

    BTW, the answer to this problem is not “gold standard”.

    There have been a lot of these “temporary problems” in the past, as Will says, and the idea is to avoid repeating them, not to try and reenact them.

  32. #75 AR, I’m sorry if I was unclear, but I fully understand JPM’s position. I’m starting from the presumption that the loss will be much more than $1 billion, and therefore as I said the $1 billion in exposure to that loss is part of the price paid by JPM for BS. The losses after that, which will be large, are borne by the Fed, in return for the very small probability of a profit based on the minimal discount to face value negotiated as part of the deal.

    The rest of the analysis follows fairly straightforwardly. It seems surprising to me, at this late stage, that you are treating this purely as a problem of psychology, accepting the claims that the underlying assets are sound, or nearly so.

    It should be clear by now that not only subprime mortgages but lots of supposedly higher grade mortgages are going to default on a large scale, and that similarly bad debts are widespread throughout the financial system. Moreover the securitisation process has clearly increased the difficulty of resolving defaults, and reduced the amount that can be recovered.

    There are further problems associated with attempts to turn ultimately illiquid assets into liquid securities. The idea of an orderly liquidation over several years makes no real sense in this context.

  33. Ian

    Your reference (post 87) to Indonesia in the 1990s raises an important point. Banking crises reach the level of widespread bank failure really only when the state itself fails economically, as it did in Indonesia then and as it did in Argentina in the 2002. When the state remains economically able to backstop the system, then illiquid assets can be turned into liquid ones.

    To go back to my example of the LDC crisis, the banks’ LDC loans were turned into Brady bonds backed by the US government, creating liquidity so could be sold by the banks, allowing them to get some certainty about their balance sheet positions and start again.

    I’m not sure we’re there yet in the context of the US banking system; at the moment none of the regulated US banks has zero or negative equity. We’re still working through the market solutions for the problems in the brokerage houses (such as JPM buying Bear). But if the major regulated banks do get in capital trouble then I expect the ultimate solution will, again, be some kind of government wrap on their illiquid assets, a la Brady.

    In that case you would see an orderly liquidation of the illiquid over several years.

  34. Terje, no-one is suggesting the financial system will “stop existing”.

    What I am suggesting is that a systemic failure will throw millions of people out of work in the developed world; wreck businesses; gut the retirement savings of millions more people and cause vastly greater suffering in the developing world.

    If we can avoid that (and in this context “we” means the major financial institutions, the major developed economy governments and the multinational institutions like the World Bank and the IMF), we should.

    I’m sorry if the suggestion that public money is used as part of that offends your libertarian sentiments but the consequences – including to the public finances – of failing to act are worse.

    which do you prefer – spending say 1% of US GDP in total over the next couple of years to prevent a systemic failure or spending far more over the next decade in unemployment benefits and foregoing a massive amount of economic growth?

  35. John, I’m still unclear as to how you come to the conclusion that the losses on the BS assets will be significantly greater than $1 billion. I’m not going to nominate a value for the likely loss – I don’t think there’s sufficient data to draw a conclusion at this point.

    As I indicated earlier I also suspect that the Fed will do substantial arm-twisting to ensure that if losses do exceed $1 billion, JPM meets a major part of the excess.

    THe principal point of the non-recourse nature of the #30 billion in loans isn’t to give JPM an escape route – it’s to convince counter-parties and other banks that JPM isn’t going to go under.

  36. What I am suggesting is that a systemic failure will throw millions of people out of work in the developed world; wreck businesses; gut the retirement savings of millions more people and cause vastly greater suffering in the developing world.

    Millions losing their jobs across the entire developed world is merely statistical noise. Whether it has any net impact on unemployment is somewhat unprovable either way. Jobs come, jobs go.

    “Wrecking businesses” means allowing people to fail. Which is one of the key strenghts of capitalism. I’m not sure why bankers should be exempt.

    Gutting the retirement savings of millions means investors carrying the can on risks that they take. And yes putting your money in the bank is an investment.

    On the flip side bailouts perpetuate moral hazard and set us up for another go at “systemic failure” a few years from now.

    which do you prefer – spending say 1% of US GDP in total over the next couple of years to prevent a systemic failure or spending far more over the next decade in unemployment benefits and foregoing a massive amount of economic growth?

    Which do you prefer, spending less or spending more? Your question is a rhetorical setup.

  37. “Whether it has any net impact on unemployment is somewhat unprovable either way.”

    Go explain that to anyone who was living in Indonesia in 1998.

    Bur your attachment to your ideology is almost admirable in a perverse way. As Stalin said “a million deaths is only a statistic”.

  38. The citizens of this country need to get their heads out of the sand and investigate all the iisues relating to politics and business. There is no reason to bail out BS. They have assets worth more than their exposure and were just in a liquidity crisis. Just like the other large banks, corporations and financial institutions, Bs had hundreds of billions in assets and should have been forced into bankruptcy to sale said assets. If the other financial institutions were so stupid and greedy to get involved in this crisis then they too should be forced to sale assets to pay for their greed and stupidity. Bank of America has over 1.5 Trillion in assets and they are not the largest bank or financial institution. These financial institution are owned by the elites who have a virulent appetite for greed and buying our poloticians to pass laws to help and protect this malvalent, if not criminal behavior. They are supposed to be leaders but have shirked this responsibilty and only care about how much money they make. Why should their destructive behavior be rewarded with bailouts and special laws and priviledges the rest of us do not receive? May they all rot in hell!

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s