A Bear of a Deal

I've got to weigh in on the Bear deal. As you may recall, Bear Stearns' fall from grace has been one of epic proportions. Once the darling of the fixed-income market - especially the mortgage-backed securities (MBS) and collateralized mortgage obligations (CMO) markets - Bear has become the laughingstock of Wall Street, having impaled itself on its own area of expertise.

Bear's demise began when two of its hedge funds sank last summer, kicking off the whole credit contagion in which global markets are now mired. It ended in recent weeks, as rumors surfaced that Bear was an unacceptable counterparty risk to other Street firms due to a liquidity shortfall. Bear's new CEO, Alan Schwartz, vehemently denied the rumors, then two days later, accepted a plan, brokered by the Fed, to be bought out by JPMorgan Chase. Why? Because of a lack of liquidity - one that we were to believe had just surfaced in the 24 hours prior to the merger deal. Riiiight.

Let's put this in the perspective of a market I know all too well: wine. (I have a bottle of Penfold's Grange Shiraz, vintage 1998, that I bought in 2003 for $110. It was the most I ever paid for a bottle of wine, but it was rated a 99 by Robert Parker. I'd never seen a 99-rated wine before, and I just had to have it, so into my cellar it went. Today, it's worth $450-500, making it easily the best investment I ever made, and I'll be darned if I'm going to drink it. I'm selling the sucker.)

Bear's stock traded at more than $170 a share just over a year ago. That placed a share of Bear stock at about the value of a bottle of '99 Grange a year after its release, or a bottle of Silver Oak Napa Cabernet in a restaurant. When JPMorgan made its original offer for Bear, it was worth the same amount as a bottle of Two-Buck Chuck.

Today, Morgan upped the ante, responding to angry Bear shareholders (Bearholders?) who threatened to vote against the deal. So now Morgan will pay $10 a share for Bear. That places its value in the range of a Woodbridge Merlot - marginally better than Two-Buck Chuck, but still better suited for a salad dressing than for imbibing, let alone cellaring.

But here's the catch: Morgan's only buying a little less than 40% of Bear at that price. So to Morgan, Bear's worth a half-bottle of Woodbridge Merlot. And they're doing it with a new stock offering from Bear. Why? To circumvent a vote from existing shareholders, who are going to find themselves diluted as a result of the deal, a la Ambac. It's enough to drive a Bearholder to drink.

The ominous part of the deal is that Morgan's purchase is being funded by a very favorable loan from the Fed: ten years at the discount rate, currently 2.50%. And they don't actually start repaying until two years from the effective date of the deal. And, the Fed is setting up a company to hold $30 billion of Bear's worst crap paper, to be managed by BlackRock. Think the S&L crisis and Refcorp, only this is the Fed taking the action, not a bank regulator, which is virtually unprecedented.

The reason the deal is ominous is not only because of the cheap rate on the loan, or the fact that the Fed - which gets its money from the taxpayers - is in effect bailing out Bear Stearns, which nobody seems to get. The most ominous part is the ten-year term.

Some observers figure that the reason for the ten-year term of the deal coincides with the benchmark for the mortgage debt - the ten-year Treasury - that the Fed is letting Morgan ante up as collateral for the loan. (Very crappy mortgage debt, mind you.) However, I see it differently.

I think the Fed is saying that, best case, this whole credit market imbroglio is at least two years - the time frame for the commencement of repayment - from being resolved. And its full effects may be felt for a decade. That should tell us all something.

But, naturally, the message didn't reach stocks, which rallied to the tune of a near 200-point gain in the Dow. That makes sense, right? Let's see, Bear - which was deemed to be worth two bucks last week - is now worth ten, so let's rally. Only the ten is for less than half the company. In a new, dilutive offering. Funded by what is in effect a taxpayer bailout, accompanied by an acknowledgement from the Fed that this mess is anywhere from two to ten years from being over. Said bailout provided to another Street firm, that, if it were healthy, wouldn't need the Fed's help, calling into question just how far down the chain of dominoes Morgan stands. And let's not forget that, whether the price is $2 or $10, Bear's stock has fallen almost 100% in a year, and absent a bailout, it would have failed outright.

Thank God I'm short stocks. And long wine (good wine).