Pushed to the brink of collapse by the mortgage crisis, Bear Stearns Cos. agreed -- after prodding by the federal government -- to be sold to J.P. Morgan Chase & Co. for the fire-sale price of $2 a share in stock, or about $236 million. Bear Stearns had a stock-market value of about $3.5 billion as of Friday -- and was worth $20 billion in January 2007.1
It is unclear which part of the federal government is doing the prodding, or if the reporters mistakenly believe the Federal Reserve Banks are part of the government. In addition to Fed personnel, officials from the SEC were present at the firm over the weekend. What is known is that the Fed is taking the most risk here, not J.P. Morgan Chase.
Fed officials wouldn't describe the exact financing terms or assets involved. But if those assets decline in value, the Fed would bear any loss, not J.P. Morgan.1
The deal already is prompting howls of protest from Bear Stearns shareholders, since the New York company last week indicated that its book value was still close to its reported level of about $84 share at the end of the fiscal year.1
Thursday and Friday of last week were difficult for Bear Stearns. Other firms began to make margin calls. Bear Stearns didn't have the cash. By Friday the company had two options - sell the firm or file bankruptcy. Two days before, on Wednesday, the stock was trading well over $60 per share. The stock closed Friday afternoon at $30 per share. By Sunday, the deal was being made to sell the company at $2 per share.
Chart courtesy of: Stockcharts.com.The characteristics should sound familiar. Inflated assets on the balance sheet. Falling asset prices. Lopsided markets - lots of sellers and very few buyers. Margin calls. Bank failures. In 1929 it was the stock market. In 2008, it's the credit market (so far).
At the end of November, Bear Stearns reported total assets of $395 Billion and $384 Billion in liabilities (including just $69 Billion in long-term debt). Seems fairly healthy - not great, but not bankrupt. But if you read their annual report closely - "As of November 30, 2007... the Company had notional/contract amounts of approximately $13.4 Trillion... of derivative financial instruments."2 (emphasis mine).
These are the same derivatives that Warren Buffett called financial weapons of mass destruction in 2003.
In his annual Letter to Shareholders, Buffett said -
Even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.
Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.3
The megacatastrophe is in progress. It's not over.
In the future, there will be a great buying opportunity for stocks and for bank stocks, but we're not there yet.
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Source:
1. Robin Sidel, Dennis Berman, and Kate Kelly.
J.P. Morgan Buys Bear in Fire Sale, As Fed Widens Credit to Avert Crisis.
Wall Street Journal. March 17, 2008. Page A1.
http://online.wsj.com/article/SB120569598608739825.html
2. Bear Stearns Annual Report for Year Ending November 30, 2007.
Form 10-K. Filed with Securities & Exchange Commission. January 29, 2008.
http://sec.gov/Archives/edgar/data/777001/000091412108000077/be11750956-ex13.txt
3. Buffett, Warren. Letter to Shareholders.
Berkshire Hathaway. February 21, 2003.
http://www.berkshirehathaway.com/letters/2002pdf.pdf.
© 2008 Michael Cale
