Last Updated: March 19, 2008: 2:11 PM EDT
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Why the Bear rally can't last

A huge spike in Bear Stearns' stock price in recent days doesn't mean buyer JPMorgan is going to have to boost its $2-a-share offer.

By Roddy Boyd, writer

NEW YORK (Fortune) -- The spiking share price of cash-strapped investment bank Bear Stearns suggests savvy traders are wagering that JPMorgan Chase is going to have to increase its lowly $2-a-share bid.

Note to Bear Stearns shareholders: Don't hold your breath. A higher bid isn't likely to happen.

The recent jump in Bear Stearns shares, which on Wednesday were trading 64% above Monday's opening price and 160% higher than JPMorgan's bid price, appears to be largely a function of bond traders buying blocks of stock to guarantee the JPMorgan (JPM, Fortune 500) takeover goes through. They are doing so because the deal, which saves Bear Stearns (BSC, Fortune 500) from a near-certain bankruptcy filing, is subject to the approval of Bear Stearns shareholders.

The logic behind the stock buys is simple: Friday's collapse of Bear Stearns represented a fantastic opportunity for distressed debt players and risk arbitragers at hedge funds and brokers to buy the firm's debt and credit default swaps at fire sale prices, on the belief that a merger or bailout would be engineered.

The speculators were right - and lucky too. JPMorgan, rated AA-minus, is assuming the debt and guarantees of Bear Stearns, which on Friday was sporting a triple-BBB credit rating. Bear Stearns credit default swaps, which are insurance for bondholders in case a company defaults on its debt, were being written for 1,000 basis points - costing the buyer $1 million to purchase insurance on $10 million worth of Bear Stearns debt. But they have since pulled into the 335-point range. By way of comparison, J.P. Morgan swaps cost 130 points at the market close Tuesday.

Trading in Bear Stearns debts tells a similar story. The 7.25% bonds due in 2018, which traded down to $79 - or $790 per $1,000 bond - on Friday, were being peddled Tuesday afternoon by Credit Suisse at $93.75.

As such, the Bear Stearns stock purchases serve as a necessary counterweight to the large blocks of stock held by insiders and several high-profile investors, like non-executive chairman James Cayne, Tavistock's Joseph Lewis and Private Capital Management's Bruce Sherman. These people could potentially vote against the deal on the thinking that their options can't get much worse than accepting a buyout at $2 a share.

But Bear Stearns shareholders who don't like the deal don't have a lot of options. The merger agreement, or at least the parts of it that have been disclosed, appears ironclad in the advantages it gives JPMorgan. For example, the bank has the right to purchase up to 20% of Bear Stearns' equity at $2 per share, giving it an effective blocking position against another suitor. If another buyer does emerge, JPMorgan has the right to buy Bear's headquarters building at $1.1 billion.

Conversations with senior Bear Stearns executives make clear their preference to withhold their votes on the JPMorgan buyout, even if it pushes the firm into bankruptcy. They are not alone: Joseph Lewis, who owns 9.4% of Bear Stearns common stock, scoffed at the deal Monday, calling it "derisory."

What pained investors are overlooking is just how disastrous a Bear Stearns bankruptcy would be for them. A Bear Stearns bankruptcy would have very little in common with a traditional corporate bankruptcy, where companies often emerge with new management and cleaner balance sheets - and new equity. That's because Bear Stearns' value as a business is centered on its access to huge amounts of short-term financing; a manufacturer or service provider, on the other hand, uses capital to the extent needed to provide goods or services. In a Bear Stearns bankruptcy, lenders would refuse to extend credit for fear of having it tied up in years-long legal proceedings.

What's more, Bear Stearns' assets wouldn't be of any service in a bankruptcy. The firm's assets are pledged against more than $102 billion in repurchase agreements it had as of late November - and in a bankruptcy, those assets would be frozen. Clients would avoid Bear on the prime brokerage side, which would further handicap its operations, since the cash balances and liquid securities held in its customers' margin accounts were used to obtain additional lines of credit. It's possible too that regulators would seize Bear Stearns' core broker-dealer business.

There is also the so-called downstream effect of a Bear bankruptcy on its thousands of clients. Immediately, there is the $13.4 trillion (according to its 10-K) worth of derivatives that Bear has exposure to. Without JP Morgan's AA- credit rating, the systemic risk is unthinkable. On a smaller scale, hundreds of its hedge fund clients would be forced to recognize odious losses as they marked down the value of cash and securities temporarily trapped in a post-Chapter XI. While the funds would eventually recover most if not all of their assets, it is likely that many clients would seek to flee these funds.

With no access to capital and a balance sheet full of liabilities, Bear Stearns' operations would collapse. Needless to say, with a worthless stock and no cash generation, the firm's ultimate franchise - its employees - would walk.

And then what would Bear Stearns' investors have left? Zero. That's a lot worse than $2. To top of page

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