Wednesday, April 23, 2008

Bear Stearns BAILOUT

In the next couple of weeks, I'll try to catch up on some rants I had prior to starting this blog. After that, I should be real-time ranting!

Treasury Secretary Hank Paulson denied that the Fed bailed out Bear Stearns, and to support his argument, he pointed to the fact that shareholders were only getting $2/sh, down from $30 the prior Friday, or $80 in the prior weeks. Federal Reserve Chairman Ben Bernanke also denied "bailing out" Bear, though he acknowledged that he would characterize it as a bailout of the financial system. Whether the Fed's actions were necessary are debatable, but let's at least call a spade a spade. This was most certainly a bailout of Bear.

Paulson's argument is very misleading. Yes, the shareholders lost most of their investment as the stock plummeted to the $2 original deal price. But shareholders are only one class of financiers of Bear. The creditors are the other class - this is comprised of bondholders, counterparties, etc. Because Bear was so heavily leveraged, the creditor capital dwarfed the equity capital.

Per Bear's financial statements, as of 2/29/2008, Bear had total assets of $399Bn, liabilities of $387Bn and book equity of $12Bn. Bear was leveraged 34x (399/12). Several weeks prior to its collapse, Bear stock was trading in the $80-90 range. A share price of $90 means that the total shares of the firm are worth ~$12Bn, or about the same as the book equity.

In the original deal, Bear shareholders receive $2/sh, or a total of $260mm for all the shares, so the shareholders took a nearly complete loss, from ~$12Bn just weeks earlier to $260mm. But how much were the Bear shares really worth? Consider that the Fed purchased $30Bn of the "hard-to-value" assets as part of the deal. How much would JP Morgan have been willing to pay for the shares if the Fed didn't take those questionable assets? Well, if JPM gave those assets a mere 1% haircut because it wasn't sure what they were worth, that's $300mm less it would pay for Bear. Given that it paid $260mm for the shares, it's pretty clear that JP Morgan thought that the shares were worth $0 in the absence of the Fed's actions. That's the nasty side of being levered 34:1 - even a small drop in asset value means the equity is wiped out.

So rather than getting $0, the shareholders received $260mm in the original deal, funded directly by the taxpayers. Then they complained bitterly and got $10/sh, or $1.3Bn. So instead of receiving $0 (for ALL the shares) as they would have in a true capitalist system, the shareholders received $1.3Bn. Thanks Ben!

How about the creditors? Ah, now this is who the government really bailed out. The creditors went from being owed money by a increasingly risky Bear to the rock-solid JP Morgan. So creditors didn't lose a nickel. In a true capitalist system, would the creditors have lost money? You betcha. In the days leading up to Bear's collapse, Bear credit default swaps (basically, this is insurance against a firm defaulting on its debts) were skyrocketing in value - simply put, this means the market expected Bear would default on its debts. And as the cost of insurance on the debt was increasing in value, the cost of the debt was decreasing - so the creditors had large paper losses. But the Fed's intervention, which made the JPM deal possible, made the creditors whole.

So to summarize, shareholders, representing a mere 3% (12/399) of Bear's capital, suffered a huge loss (though not a complete loss, as capitalism would have dictated), while creditors, representing 97% of Bear's capital (387/399) suffered no loss at all. If that's not a bailout, I don't know what is.

Does this create moral hazard? Of course it does. Creditors are incented to invest in financial firms that are "too big to fail". If the creditors didn't have the Fed put to rely on, the banks would either have employed much less leverage (Bear was no exception in terms of leverage - many of the investment banks are levered 30x), or would be paying much greater financing costs to achieve such enormous leverage. So you, the taxpayer, are effectively subsidizing the investment banks. Makes you feel all warm and fuzzy, doesn't it?

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