Bear bailout can't save shareholders

NEW YORK (Fortune) -- One painful lesson of the Bear Stearns meltdown is that even firms that are deemed too big to fail can leave their shareholders feeling wiped out.

JPMorgan Chase (JPM, Fortune 500) agreed to buy Bear Sunday evening in a deal worth $2 a share, or $240 million. The agreement came at the behest of the Federal Reserve, which stepped in to guarantee $30 billion worth of Bear Stearns loans. The Fed-JPMorgan team's work saved Bear Stearns (BSC, Fortune 500) from filing Chapter 11 bankruptcy - an event that would have exposed the firms that trade with Bear to massive lossses, potentially leading to a wave of failures at other financial companies.

The last-minute rescue of Bear shows that the government is willing to take unusual steps to keep the financial markets functioning. The Fed's guarantee of possibly toxic mortgage loans on Bear's books shows that officials are willing to take the risk of saddling taxpayers with billions of dollars in obligations in the name of keeping the banking system running.

But the token buyout price for Bear - whose shares fetched as much as $170 a share over the past year - also shows that none of the Fed's ingenuity will go to bailing out shareholders. That lesson has been learned the hard way lately by investors such as Joseph Lewis, the currency-trading billionaire whose bad bet last summer on Bear appears to have cost him $1 billion. And it was taken to heart by holders of other financial stocks, which dropped sharply in early trading Monday and remained lower even after a solid rally later in the day.

"While we believe BSC's case is unique, what will not be unique, in our view, is a resulting major negative revalution of financials," Oppenheimer analyst Meredith Whitney wrote in a note to clients Monday.

Other than Bear, the firm that was hit hardest by the revaluation was Lehman Brothers (LEH, Fortune 500), which saw its shares tumble 19% on top of a 13% decline Friday. Investors fear the firm's exposure to mortgage-backed securities will lead to massive losses and test Lehman's solvency. Lehman insists that it has ample access to cash, and the firm's CEO Dick Fuld said Monday that he believes the liquidity issue is now "off the table" with the Fed having made emergency loans available to securities firms.

Numerous other firms with big mortgage exposure fell sharply as well, as investors wagered that their being too big to fail won't save shareholders. Citi (C, Fortune 500) fell 6% to a 52-week low, and Washington Mutual (WM, Fortune 500) dropped 13% for the second day in a row.

So why are financial stock investors in a panic even though the Fed has signaled its willingness to act? Anant Sundaram, a professor specializing in company valuation at Dartmouth's Tuck School of Business, says the problem stems from a lack of transparency on the the condition of big firms. Last week's whipsaw action in Bear Stearns - the firm claimed its balance sheet and liquidity were adequate just days before it was forced to take an emergency Fed-backed loan from JPMorgan - didn't do anything to shore up investors' confidence in these companies.

"Fundamentally this is an information problem," says Sundaram. He says that not only don't investors know what each firm's exposure to risky bets is, they also lack data on how risks at various firms combine to create risk to the financial system. The opacity of the financial firms' doings raise the prospect of "cascading information failure," Sundaram says.

He adds that the question of whether a firm is too big to fail is beside the point. In the Bear episode, the feds pushed for a quick sale of the firm in large part because they didn't want a bankruptcy filing that would have left firms that trade with Bear with huge losses. Given the sharp growth in derivatives trading in recent years, so-called counterparty risk looms large.

"It's not 'too big to fail' that matters," Sundaram says. "It's really 'too connected to fail.'"

For shareholders, it may be a distinction without a difference.