A Sweeter Bear Bid May Sour the Fed


JPMorgan raises its offer in hopes of winning over shareholders. Is the Federal Reserve too cozy with Wall Street?

The Federal Reserve has been put in an awkward position by JPMorgan Chase's (JPM) decision to raise its bid for Bear Stearns (BSC) to $10 a share from $2. The sweetened bid, announced on Mar. 24, is high enough that Bear's shareholders are getting some real value for the company—while the Federal Reserve is subsidizing the deal via a low-interest loan secured by iffy assets.

The renegotiated deal is bound to cause complaints that the nation's central bank has been sucked into supporting a partial bailout.

JPMorgan raised its all-stock bid to win the support of Bear shareholders who were threatening to vote no and kill the deal. The new deal does have one feature that slightly betters the terms for the Fed. JPMorgan is now agreeing to absorb the first $1 billion in losses if the collateral posted by Bear for a loan turns out to be worth less than Bear claims. The Fed is on the hook for the remaining $29 billion, instead of the entire $30 billion as originally planned.

To be sure, the chance that the Fed will actually lose money on the loan is fairly small because the Bear assets were priced conservatively and are likely to recover in value eventually once the housing crisis is past. The Fed can hold them for 10 years, or even longer if it chooses, waiting for them to regain value.

In case the sweetened bid isn't enough to buy the support of Bear shareholders, the new deal includes a stick along with the carrot: JPMorgan is agreeing to buy some newly issued shares of Bear Stearns, which will give it more voting power to outvote opponents of the deal. The newly issued shares equal 39.5% of currently outstanding Bear shares. Bear's management, which supports the deal, doesn't have to get permission from Bear shareholders to issue new shares as long as they represent less than 40% of the firm's value.

"Makes the Fed Look Like a Chump"

The New York Fed stepped in to prevent the collapse of Bear Stearns after other firms started demanding it post more collateral for loans than it could afford. At the time, the deal was described as necessary to avoid a domino-like collapse of firms on Wall Street.

To encourage JPMorgan to take over Bear, the Fed, through its New York branch, guaranteed Bear assets that were theoretically valued at $30 billion, but in fact would have fetched far less in a fire sale. The quid pro quo was that Bear's shareholders lost nearly all of their money, receiving about $2 a share in JPMorgan stock vs. a peak for Bear shares in January, 2007, of about $171 a share.

Bear's shares nearly doubled on Mar. 24, to 11.25, from a close Mar. 20 of 5.96. JPMorgan shares rose about 1%, to 46.55.

The new deal, at $10 worth of JPMorgan stock per share, is still much less than Bear was worth at its peak, but it's enough to raise questions about whether the Fed has inappropriately propped up the private sector. "[JPMorgan] raising its offer makes the Fed look like a chump to have agreed to the initial backstop. That will vastly increase criticism of the deal," wrote Yves Smith, in his Naked Capitalism blog.

Broad Support

In a statement, the Federal Reserve Bank of New York said, "This action is being taken by the Federal Reserve with the support of the Treasury Dept. to bolster market liquidity and promote orderly market functioning." In essence, the New York Fed will create a special company that will hold the $30 billion in Bear assets. It will lend the unit $29 billion at 2.5% interest and JPMorgan itself will lend the unit $1 billion. When the assets are liquidated, JPMorgan won't get back its $1 billion until after the Fed has been fully repaid with interest. And if there's any money left over from the liquidation after all the loans have been repaid, the Fed will get to keep it.

The heads of both JPMorgan and Bear also issued statements supporting the new terms. JPMorgan Chief Executive Jamie Dimon said, "We believe the amended terms are fair to all sides and reflect the value and risks of the Bear Stearns franchise and bring more certainty for our respective shareholders, clients, and the marketplace." Bear Stearns CEO Alan Schwartz said, "Our board of directors believes the amended terms provide both significantly greater value to our shareholders, many of whom are Bear Stearns employees, and enhanced coverage and certainty for our customers, counterparties, and lenders."

As for the issuance of new shares, Schwartz said it "was a necessary condition to obtain the full set of amended terms, which in turn, were essential to maintaining Bear Stearns' financial stability."

Coy is BusinessWeek's Economics editor.

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