If you head over here, David Neubert has a slightly cryptic explanation of why Bear Stearns shares are trading in the $7 range. After IMing with him, I think I’m clear on what he’s saying, so let me try to clear it up. In a nutshell: those shares are being bought by Bear’s creditors, in the hope that the deal will go through and the stock will fall.
The big winners from the Bear Stearns acquisition are Bear’s bondholders. They came close to an event of default this weekend; if all goes according to plan, they’ll soon own nice safe debt from JP Morgan Chase. The only thing which can derail their glide path (if Krugman can mix his metaphors, so can I) would be if the deal doesn’t go through at $2 as planned.
The main thing that needs to happen for the deal to go through is that shareholders vote in favor. And the only way that bondholders can ensure yes votes for the deal is to own those shares and vote them themselves. Says Neubert: "They will eat the difference between where they buy the equity and $2.00 in order to protect much higher numbers in debt."
There’s another reason for bondholders to buy stock above $2. Explains Neubert:
Think of equity as an option on the assets of the company. Higher uncertainty means the equity has more value, just like an option…
Think of the equity as an out-of-the-money call. Implied volatility has more influence on the price of out of the money call options that the price of the asset.
What he’s saying here is that if the deal falls apart, the value of the company might go down, all the way to zero eventually. But on the way there, volatility will be huge – and if volatility is high then the value of the equity will go up. In this sense, the equity is a hedge against the deal falling apart. If JP Morgan doesn’t buy Bear, bondholders’ bonds will fall in value – but their stock will rise, helping to offset the loss.
Looking at the big picture, then, people aren’t buying Bear stock at these levels because they think it’s going to go up: rather, they’re buying stock because they hope it’s going to go down. Ain’t finance wonderful?
Update: Roddy Boyd seems to be thinking along the same lines.