JP Morgan raises Bear Stearns offer to $1.18 billion after shareholder unrest

JP Morgan has raised its proposed purchase offer for Bear Stearns to $10 a share in a move designed to assuage the anger of Bear shareholders incensed by JP’s initial offer of just $2 a share.

Under the terms of the new agreement, JP will exchange stock with Bear in a transaction with an implied value of $10 a share, while also purchasing 95 million newly issued shares, giving JP a 39.5% stake in what was once the fifth-biggest securities firm on Wall Street. The purchase estimates Bear to be worth just $1.18 billion. Despite the fivefold increase in the offer, the proposition is just a sixteenth of the sum set aside by Goldman Sachs for staff bonuses last year.

In a change to the terms of the original deal, however, JP Morgan will now assume responsibility for the first $1 billion of any losses associated with Bear Stearns assets, while the Federal Reserve Bank of New York will fund the remaining $29 billion, a move that is also been regarded as an attempt to quell complaints that the deal amounts to little more than a Fed bailout.

Bear’s mortgage book of business is in the region of $33 billion, according to figures presented by JP Morgan in announcing the initial acquisition on March 16. Approximately $2 billion is concentrated in securities backed by subprime mortgages, with a further $16 billion in commercial mortgage paper and $15 billion in prime mortgage-backed structures.

Analysts have been concerned about Bear Stearns’ extensive mortgage exposures since last June, when two of its heavily leveraged hedge funds, with extensive exposures to collateralised debt obligations of residential mortgage-backed securities, collapsed despite a $3.2 billion dollar bailout of one fund and an unsuccessful attempt to convince counterparties to shore up the other. Despite this, the swiftness of Bear’s fall has taken many by surprise.

Figures from the Securities and Exchange Commission have revealed that Bear's capital levels up until the first week of March were stable, ranging between $15 and $20 billion. As of the morning of March 11 - the day after Bear publicly announced there was "absolutely no truth to the rumours of liquidity problems" at the bank, capital level stood at $17 billion in cash and unencumbered assets.

Nonetheless, the rumours that had facilitated the previous day's announcement led counterparties to become concerned about Bear’s ability to honour its short-term liquidity commitments. As a result, many of the lines of secured funding Bear enjoyed began to dry up.

By the end of March 11, the holding company liquidity pool had declined sharply from $18.1 billion to $11.5 billion. Following a brief revival the following day, creditors withdrew $17 billion during March 13 and 14. By March 14, the day Bear instituted a secure loan facility with JP Morgan due to the “significant deteriorioration” in the firm’s liquidity position, it was essentially out of cash.

Much has been made of JP Morgan’s capture of Bear’s prime brokerage business, the lucrative hedge fund servicing and loans unit, that posted $1.2 billion in profit in 2007. While no doubt a coup for JP Morgan, for hedge funds reliant on the services of Bear’s brokerage the acquisition has raised questions.

“If a fund is dependent on a single prime broker and it becomes insolvent that is a problem, not only since any margin you had posted with the brokerage would be frozen, but also because of the rise in the use of broker derivative intermediation services,” says a fund manager at a Connecticut-based hedge fund.

To avoid the work involved in filing an International Swaps and Derivatives Association (Isda) master agreement, he says, some funds choose to use their prime broker as a hub for all their derivatives deals. But this carries a risk. "If your prime broker ends up defaulting, that could mean all of your derivatives contracts currently out there would be terminated, along with potentially hundreds of millions of dollars in margin you've posted being frozen, which can be very damaging to a fund even in the short term,” he adds.

At this stage it is far too early to speculate on whether Bear’s acquisition will in any way disrupt the operation of its prime broker arm. Those funds that relied upon a single dealer to avoid the rigmarole of establishing Isda master agreements may have difficulties finding counterparties willing to trade with them. Although an alternative to the Isda master, known as a long form, can suffice as a short-term solution, dealers report most counterparties will only permit a handful of trades like that before they want to sign an Isda master agreement.

JP Morgan has guaranteed that all trading obligations with Bear’s brokerage, the third largest on Wall Street, will be honoured. However, regulatory filings with the SEC reveal that a number of funds have established new links with other brokers. This will come as frustrating news to JP, which has long sought a presence on the prime broker stage alongside competitors Goldman Sachs and Morgan Stanley.

“We had a modest volume of business with Bear Stearns but not a great deal. The reason that hedge funds have to post up front margin with the prime broker is because we are, apparently, a poorer credit prospect than they are. At times like this, I’m not so sure that’s the case,” concludes the fund manager.

See also: Fed bails out Bear Stearns
JP Morgan buys Bear Stearns after receiving Fed guarantee
Fed will support securities market directly