Sunday, March 16, 2008 0 comments ++[ CLICK TO COMMENT ]++

JP Morgan Chase Acquires Bear Stearns

JP Morgan Chase & Co just announced that it is acquiring Bear Stearns in a stock swap deal. It values Bear Stearns at $2/share (around $270 million) and the Federal Reserve is providing up to $30 billion in funding for some of Bear's less liquid assets. Given that the shares closed at $30/share on Friday (for a market cap of $3.5 billion), it's pretty much a total loss for Bear Stearns investors. Its most recent book value (back in November I believe) was around $80/share. I have only been investing for a few years but I have never seen a company vaporize so quickly.

The situation with Bear Stearns just goes to show how opaque and complicated financial businesses, especially investment banks, are. Supposedly $16 billion in liquid cash evaported from Bear Stearns' balance sheet within a week.

The JP Morgan Chase takeover, which was facilitated by the central bank, avoids any counterparty risk that would have arose if Bear Stearns collapsed on its own. Overall this is good for the capital markets, but I would have preferred if a company other than JP Morgan Chase (say, HSBC or Royal Bank of Scotland, or even a Chinese bank) had taken over Bear Stearns. My concern is that, if I'm not mistaken, JP Morgan Chase has the largest derivatives book of any bank and taking on Bear with its mortgage assets may increase the risk (however, I will note that Bear Stearns' mortgage assets are primarily in CMBS and Alt-A mortgages, and the $30 billion from the FedRes is more than enough to provide adquate capital).

Bear Stearns' liquidity problems seem to have started due to its Alt-A mortgages--not subprime! Bear Stearns was the dominant bank working with mortgages over the last few years so it isn't a total surprise that they are the worst hit. The other big mortgage player is Lehman Brothers (LEH) and speculation seems to be that they are on more solid footing.

I remember reading a theory that stated that financial companies trade at a lower valuation (it's not uncommon for them to have a P/E around 10) compared to othe sectors because of their opaque business. Even though financial companies have done exceptionally well and have generated a large amount of profit over the last few decades (they might actually be the #1 wealth creator in the last 40 years (have to check)), they always tended to trade at relatively lower valuations. You can see how risky they are. Even Goldman Sachs, which has largely avoided the subprime virus, is reportedly going to see a 50% drop in profits (although a big chunk of it is due to the decline in the share price of Industrial & Commercial Bank of China).

(On a sidenote, some Berkshire Hathaway bears have held the view that BRK is overvalued because it trades at a huge premium to a typical insurance company. I don't have a strong opinion, either bullish or bearish, on Berkshire but just pointing it out.)

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