Bear Stearns second brush with bankruptcy
The firm wasn't out of the woods even after its initial agreement to merge with JPMorgan, a filing shows.
(Fortune) -- Bear Stearns nearly collapsed not once but twice before the cash-strapped brokerage firm was rescued, a regulatory filing shows.
By now it's well known that JPMorgan Chase (JPM, Fortune 500) agreed on March 16 to buy Bear for $2 a share in a Fed-brokered agreement to fend off a possible bankruptcy filing at the cash-strapped brokerage firm. A week later the sides agreed to boost the value of the all-stock deal to $10 a share. That move, announced the morning of March 24, was widely portrayed as JPMorgan chief Jamie Dimon having thrown a bone to the restive Bear investors who were threatening to veto the agreement when it came up for shareholder approval.
But Bear Stearns' (BSC, Fortune 500) latest proxy statement, filed Monday with the Securities and Exchange Commission, shows that the stakes were much higher. Bear believed that if it failed to get a new agreement that reaffirmed JPMorgan's guarantee of Bear Stearns' obligations, Bear could have been cut off from JPMorgan's Fed-backed funding and forced into bankruptcy - an outcome that many investors assumed had been forestalled by the March 16 merger agreement.
The dispute that nearly brought Bear down a second time turned on whether JPMorgan would stand behind Bear Stearns' massive credit default swap book and other liabilities. The firm's lack of access to other funding had Bear lawyers preparing for a possible bankruptcy the weekend before the revised merger agreement was unveiled.
The filing says that Bear execs noted continued reluctance by market players other than JPMorgan and the Fed to lend to Bear even in the wake of March 16's $2-a-share buyout pact. The execs feared they could be left without funding as they sought to clarify the pivotal guarantee issue. In the initial merger agreement, JPMorgan appeared to guarantee Bear's obligations. Later in the week, however, JPMorgan attempted to float the story that this guarantee had slipped into the agreement in error.
Without the JPMorgan backing, the filing says, "Bear Stearns would not be able to open for business on Monday, March 24, 2008, and would have no choice but to file for bankruptcy by that morning. Bear Stearns' bankruptcy advisors were instructed to be prepared for this contingency by the end of the weekend."
The knowledge that other market players doubted the JPMorgan guarantee put both sides in a tricky spot. Without any other financial institution providing liquidity to it, Bear had drawn heavily on JPMorgan's credit, borrowing a total of $9.7 billion - $3.6 billion of which was unsecured. The bank also had $3.7 billion in repurchase agreements with Bear. JPMorgan had, as they say, skin in the game.
Meanwhile, Bear's customers and competitors, with nearly $13.4 trillion worth of derivative exposure to the firm, were refusing to do business with Bear. The loss of customers was highly concentrated in Bear's once-vaunted prime brokerage unit. Specializing in clearing trades and providing margin for the world's largest hedge funds, this group regularly provided a double digit percentage of Bear's net income. Without Bear's prime brokerage unit, and with Bear's mortgage unit at the crossroads of the securitized market collapse, JPMorgan was at risk of buying a business with little profit potential. For their part, Bear managers knew that a bankruptcy filing might mean liquidation of the firm, which would wipe out shareholders and could have left many creditors holding worthless claims.
The filing shows that as the week of March 17-21 came to a close, the sides began discussing a renegotiation of the terms of the deal. "Representatives of JPMorgan Chase informed Bear Stearns that during the week the New York Fed had repeatedly requested that JPMorgan Chase guaranty Bear Stearns' borrowings from the New York Fed, and that JPMorgan Chase was at this time unwilling to do so," the filing states. "Both parties perceived that the absence of JPMorgan Chase's guaranty could place continued funding from the New York Fed in jeopardy."
In response, JPMorgan proposed a deal that would allow it to purchase more than two-thirds of Bear's stock, to fend off the shareholder uprising, and that the deal be sweetened via the issuance of a security whose value would be contingent on the performance of some Bear Stearns mortgage securities. Bear's board rejected that deal, saying it wanted more money for shareholders.
Working through the weekend of March 23, Bear and JPMorgan boards managed to cobble together an agreement that increased the bid to $10 per share, which took the likelihood of a shareholder blocking action off the table. In return, JPMorgan bought enough stock to guarantee the deal's completion - thus safeguarding its loans to Bear. Bear's customers got an operating guarantee from JPMorgan that clearly spelled out the bank's assumption of Bear's obligations.
But while the deal is now securely in place, it's not certain that a happy ending is in sight. After the merger, JPMorgan - with around $91.7 trillion in total derivative exposure - will solidify its position atop the derivative league tables. Citigroup (C, Fortune 500) is a distant second at $34 trillion, according to the Office of the Comptroller of the Currency.