The Bear Trap

The news that Bear Stearns (BSC), near collapse on Friday, was bought by JPMorgan Chase for a breathtakingly low $236.2 million in an all-stock deal won't calm rattled nerves in the market on Monday.

The deal price is nothing short of shocking and is causing whiplash-inducing double-takes on Wall Street. The bailout of Bear comes after the near-destruction of the 85-year old U.S. institution, the fifth largest investment bank in the country and the nation's second largest mortgage bond shop. The deal's price comes in at about $2 a share--Bear opened at $57 on Friday, but then suffered its biggest one-day drop in its history. So far this year, Bear has lost $6.8b in market capitalization.

The company announced late Sunday that it was cancelling its planned announcement of its first-quarter earnings today, after moving the date up from this Thursday.

All this, despite the fact that top Bear executives were out in force last year saying the company's capital position was strong. Similar to Countrywide's chief executive Angelo Mozilo's bullish statements last summer and fall about the health of the nation's largest mortgage lender, at a time when he wasn't buying shares in the bank, he was selling millions of dollars worth of shares.

The government-orchestrated takeover of Bear Stearns is historic in a number of ways. The Federal Reserve and the Treasury Department oversaw the acquisition talks, with the Fed agreeing to lend JPMorgan Chase $29b to buy Bear, backed by Bear's "less liquid" mortgage and other assets in a non-recourse deal, according to the companies' release. At the time of its collapse, Bear had $398b in assets and $387b in liabilities against $11.9b in shareholders equity.

The loan is one of the most dramatic expansions of the central bank's lending authority since the 1930s. If the collateral backing the $29b loan drops in value, the central bank, meaning taxpayers, will bear the cost by taking on that bad paper.

Also, the Fed's five governors voted unanimously to waive for the first time ever the usual restriction on Fed loans to nonbanks, The Wall Street Journal reports. At the same time, the Fed announced a quarter point cut in its key lending rate to financial institutions, its discount rate, down to 3.25% from 3.5%. I'll be reporting this story and updating this blog throughout Monday.JPMorgan, the third-largest U.S. bank by assets, is essentially getting Bear's coveted prime brokerage business for free. It is twice the size of Bank of America's prime brokerage, which is on the auction block for about $1b, reports indicate. JP, too has had its troubles, having booked $3.7b in writedowns from the credit crisis.

It's an understatement to say that it's ironic that Bear's chairman Jimmy Cayne was the same executive ten years ago who balked at putting up any of his company's capital as part of a Federal Reserve-led plan to rescue Long-Term Capital Management in 1998. That Cayne now had to sit on the other side of the table, hat in hand, can only be personally galling.

Reports indicate that Cayne was at a bridge tournament in Detroit last week as the crisis unfolded, but flew back to New York to deal with the meltdown. Forbes Magazine last year ranked Cayne ranked as Wall Street's richest CEO, with $1.3b of assets. Under the terms of the JPMorgan acquisition, his holdings are now worth about $13m.

Reports also indicate that Bear Stearns had prepared to file for bankruptcy protection in the event a deal could not be struck. That's largely due to the run on the brokerage last week and the fact that it had assets leveraged at 30 times its $11.9 bn book value.

But the government moved in rapidly, as a bankruptcy of Bear would have been catastrophic for the financial markets. It could have set off a fatal chain reaction that would have taken out other institutions, as Bear runs one of the country's largest clearing houses for trades. Counterparties would have gone bellyup from coast to coast.

The chaos is far from over.

We are in inning four of the Great Unwind, the massive deleveraging that will keep the market rocky through 2009. Skittish auditors, with the Enron-Arthur Andersen blowup fresh on their minds, are finishing up their audits now of the banks and investment houses.

Risk is now worse than a four letter word, so is debt, expect more steam pipes to burst on Wall Street. Already all of the futures indices are trending down. The dollar is now trading at a record low of $1.58 to the euro, gold last we checked was trading at $1,016.

Ken Sweet, Fox Business.com reporter, listened in on the companies' conference call about the deal. He's reporting that JP Morgan expects that the deal will add $1.2b to annual earnings, all of which will likely come from Bear's "strong" prime brokerage and global clearing operations, which provides loans and processes trades for hedge funds.

JP's execs also said that the "significant liquidity" position of the company and target capital ratios will be maintained. Notably, JP execs says its tier one capital ratio of 8% will remain in place. The two companies expect the deal to close in the next three months.

The company will also seek to delever anywhere from $5b to $6b off of Bear's balance sheet in as "orderly" a fashion as possible. A team of 200 executives worked on the deal throughout the weekend. JPMorgan, the third-largest U.S. bank by assets, has already posted $3.7b in writedowns, a fraction of the $22.4b reported by New York-based Citigroup Inc., the biggest U.S. bank.

Fox Business's Sweet also reports that the executives on the conference call repeatedly stressed that Bear Stearns' shareholders will approve the deal, despite the fact that it's a colossal 96.6% discount to what Bear's shares closed at on Friday.

I'll be watching closely to see how this deal is structured, because Bear has a host of problems. Start just with shareholder lawsuits, notably from Barclays Capital, stemming from two hedge funds at Bear going belly up last summer, which kicked off the subprime meltdown. Also a balance sheet potted with zombie securities. JPMorgan reportedly is guaranteeing the trading obligations of Bear Stearns and its subsidiaries, effective immediately.

Watch too whether JP goes ahead with talks to buy half, or $4.1b, of retail chain Target's credit card receivables. Already, China's Citic Securities is apparently bailing on its $1bn deal to swap stakes in Bear.

Bear is the first in line of what may be a long line of companies taken out by the subprime debacle. The first to go are the mind-bogglingly levered up private equity and hedge funds, who had been doing their own version of the carry trade, borrowing short big time, anywhere from $30 to $32 for every $1 in assets, and then investing long.

The subprime debacle blew in, they went upside down and the credit crisis exploded in their face, starting with Thornburg Mortgage, and next Carlyle Capital run by the secretive DC powerhouse, the Carlyle Group. This morning, Carlyle Capital says it will file for bankruptcy court protection.

A run on Bear sucked dry its capital position. And when traders started to bolt en masse because they did not want to take on any counterparty risk with Bear whatsoever, trading, the life blood of any brokerage, dried up.

But here's the deal. Check out the best gauge of the health of the nation's banks, price to book value, coming out of the Philadelphia Stock Exchange/Keefe Bruyette & Woods banking index, which covers the biggest US banks.

It says bank shares are trading at a microscopic 1.078 times book value, the lowest since the index debuted in 1992. Banks typically trade at more than three times book. At its close of $30 on Friday, Bear was already trading at a huge discount to its implied $80 a share book value. The $2 a share price is a 98% haircut--signalling Bear's assets were near worthless. The deal's value is about a quarter of the value of Bear's Manhattan headquarters of around $1.2b.

Investors are essentially saying the financial sectors' assets are not worth much.

At the boiling core of the issue are the level 3 assets, the bucket of Frankenstein mortgage- and credit-backed securities no one can get a price tag on because no investor wants them, so management comes up with its own wild guess--equivalent of sticking a wet finger in the wind.

Based on its most recent filings, Bear Stearns' level 3 stinkers amounted to one and a half times its capital, which stood at a tiny $11.9b--the Fed along with JP moved quickly to lend Bear $30b on Friday to support these dead securities. Morgan Stanley's zombie holdings outstrip its equity two and a half times over; Goldman Sachs, nearly double. At Lehman Brothers, now laying off 5% of its workforce, the Frankenstein securities amount to more than one and a half times its equity.

The problem though is notably painful for banks. Level 3 assets create a multitude of migraines, as regulators demand banks hold higher reserves against those souring assets, exerting more G-forces on bank capital pressures, on top of the write-offs on assets that they can value. So the zombie securities on their balance sheets add to the vicious graveyard spiral, as banks must meet regulatory capital ratios, so they are cutting lending and pulling back on counterparty transactions with hedge funds.

But here are other numbers you need to be aware of. According to the Office of the Comptroller of the Currency, the big financial institutions have sizable derivatives exposures. As of the third quarter of 2007, JPMorgan was ranked number one with $91.7t. Citigroup (C) came in second at $34t, Bank of America (BAC) at $32t. Bear Stearns (BSC) came in at $13t.

FOOTNOTE: Last week I reported to you about the controversy over mark to market rules, the accounting rules all of Wall Street and big insurance companies are using to book their profits. We know that many banks, brokers and insurers with trading businesses such as Goldman Sachs have been marking their holdings to market prices for some time.

It's a crucial debate, as accounting experts, government officials, companies and market watchers are saying the rules are being blamed for helping to torch billions of dollars out of the market capitalizations of the financials and are subsequently vaporizing billions of dollars out of investors' portfolios. The rules say companies must get a price tag on their asset-backed securities according to what the market would value them at. Difficult to do, when the markets for mortgage and other asset-backed securities are frozen solid.

I am quite grateful for the thoughtful, very smart responses I got on last week's blog ("What's Really Rocking the Stock Market"). This debate is picking up steam. And it too is far from over.

The use of fair value has never been uniform. Different, idiosyncratic valuation models have cropped like dandelions on Wall Street, and fair value fights are breaking out with auditors, as companies say it is unfair to apply them to assets that banks intend to hold until maturity. Also investors and traders in many corners of the market have vanished as panic has set in, making it excruciatingly difficult to get legitimate trading prices.

The Securities & Exchange Commission, the Financial Accounting Standards Board, S&P, all like the fair value rules because it adds transparency. I get that. And I get the argument from the backers of fair value, that the market is the supreme, independent judge of value.

But besides the fact that fear is clouding transparency, the fair value approach is not infallible. The rules are so debatable that now the SEC is saying it may let companies use a range of prices for these securities; Congressman Barney Frank says he may hold hearings on the controversy next month.

Again, I am grateful for the readers who wrote in with their thoughts about why they favor fair value. I'm not advocating any particular method--I'm reporting what the problems are.

I can't say it better than Christopher Whalen, managing director of Institutional Risk Analytics in Croton on Hudson New York: "Proponents of fair value accounting commit the most grievous of scientific method. They argue that a fact such as the historical cost of an asset is comparable and deserves the same forensic weight as an informed speculation as to the value of an asset without an actual market transaction. Based on this fallacy, the proponents of fair value accounting then go on to argue that the occasional prices observed for thinly traded assets likewise deserve equal treatment to prices in actively traded markets. This is like comparing the price for the private sale of a painting to an auction price at Sotheby's."

Whalen adds that fair value proponents "suffer the same derivative disease as infects many of the participants in our financial markets, namely, the belief that analytical short cuts and estimates provide the same clarity and resolution as actual measures, that is, real prices for real transactions. Mistaking facts for speculation, and vice versa, is at the heart of the confusion over fair value accounting."

So, I'll be watching for developments out of the SEC and whether ranges will be acceptable. I'll be reporting back to you, too, whether anyone takes up the example set during the Latin American debt crisis of the ‘80s, when auditors and market regulators backed off on forcing banks to rapidly fair value their lemon loans until the banks could get enough capital to write off these stinkers against, opting to submit themselves to getting every aspect of their operations examined night and day.

Martin Sullivan, AIG's chief exec, also now says fair value accounting creates "unintended consequences" and calls for its use to be postponed. The world's biggest insurer recently reported an $11b profit hit from writing down the fair value of its derivatives. Sullivan recently said that the rules forces companies to book losses even when they have no intention of selling in a downturn.

AIG instead wants auditors and companies to estimate maximum losses they are likely to incur and only book these losses in profits, with unrealized losses posted on the balance sheet but not recorded in earnings. Doing it this way would have sliced AIG's $11b writedown on fourth quarter results to $900m.

As I've said already, it's high time the market got a hold of itself and deployed some common sense in the accounting rules.