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INVESTING: Collapse of Bear Stearns may portend more woes

March 24, 2008

JP Morgan's unprecedented, purchase of Bear Stearns for $236 million raises more questions than it answers.

In a stunning series of events, Bear Stearns went from trading for $65 a share on Wednesday, March 12, to an announcement the following Monday that, with the assistance of the Federal Reserve, it was being sold to JP Morgan for $2 a share.

The collapse of Bear Stearns began the prior week with investors who had entered into securities transactions with the firm trying to unwind their positions. Some say the nervousness was fed by rumors circulated by hedge funds that had short positions in Bear Stearns.

Regardless, it soon became clear to regulators that there was a "run" on the investment firm. Fearing Bear Stearns would have to file bankruptcy, the Fed that Friday cornered JP Morgan in a room and demanded that a deal to acquire the firm be completed before the Asian markets opened Sunday night, March 16.

That Sunday evening, as the terms of the $2-per-share offer were released, Bear's executives saw their net worth in the firm decline from hundreds of millions of dollars to a mere fraction. The company's largest shareholder, billionaire investor Joe Lewis, lost $1 billion overnight.

However, since Bear Stearns' shareholders must vote to approve the deal, there is plenty of speculation that the terms of this rescue may change. And that belief is reflected in Bear's stock, which has been trading for more than $5 since this "takeunder" was announced.

Many are claiming that JP Morgan stole Bear at $2. Perhaps, but given that the firm had only a weekend to perform cursory due diligence, who can blame the buyer for making a low bid that cushions for the unknown risks?

To aid JP Morgan's purchase, the Fed loaned $30 billion to provide a backstop on the value of mortgage securities held by Bear. And even if Bear shareholders vote the deal down, JP Morgan still can acquire 20 percent of the company at $2 a share. It also was granted an option to purchase Bear's New York office building for what some are calling a bargain price of $1.1 billion.

Excessive leverage-supporting illiquid assets of declining value-was a key factor in Bear's unraveling. The balance-sheet numbers as of Nov. 30 for Bear Stearns were as follows: $395 billion in assets, $383 billion in liabilities, and $12 billion in equity.

With 140 million shares outstanding, Bear Stearns had a book value per share of about $85. With 33 to 1 leverage, it does not take much impairment in the value of the assets to cause a severe slip in equity. Note from the numbers above that if asset values were to decline just 3 percent, or $12 billion, the firm's net worth goes to zero.

In the end, the Fed clearly feared a domino effect if Bear Stearns were allowed to fail. Over the past couple of decades, Wall Street has built an increasingly complex financial foundation where the rule book for dealing with systemic problems has not been written. The big market-relief rally aside, investors remain wary of more shoes that may drop.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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