Felix Salmon

Many people believe that Bear Stearns was brought down by a classic "bear raid" – where a rumor gets started, snowballs, and becomes self-fulfilling. In nervous markets, someone who shorts a bank and then starts a rumor that it’s in trouble can end up destroying billions of dollars in value.

You think such a thing doesn’t happen in reality? Well, it just did, in London. False rumors started getting passed around the market about major high-street bank HBOS, and before long the Bank of England staged an unprecedented series of phone calls to media outlets to try to extinguish the rumors before they became self-fulfilling.

Expect someone to try the same stunt in the US, before long.

A lot of the back-of-the envelope sums surrounding the Bear Stearns shares assume that Bear’s employees, who own 30% of the outstanding stock, are likely to vote against a deal. But given that New York City’s comptroller has already started investigating Bear Stearns, that might not be the case.

Steven Davidoff notes today that if Bear gets bought by JP Morgan, then Morgan will pay any legal liability that Bear’s executives might hold:

[JPMorgan] shall and shall cause the Surviving Company to, to the fullest extent permitted by applicable law, indemnify, defend and hold harmless, and provide advancement of expenses to, each [officer and director of Bear Stearns] against all losses, claims, damages, costs, expenses, liabilities or judgments or amounts that are paid in settlement of or in connection with any Claim based in whole or in part on or arising in whole or in part out of the fact that such person is or was a director or officer of [Bear Stearns] or any of its Subsidiaries, and pertaining to any matter existing or occurring or alleged to have occurred, or any acts or omissions occurring or alleged to have occurred, at or prior to the [acquisition].

Davidoff points out that this gives Bear executives a strong incentive to vote in favor of the deal:

Face bankruptcy and possibly no indemnification or receive JPMorgan’s assurances on this? Hmm. Let me think about that one.

Now most Bear employees aren’t executives, of course. But on the other hand, Bear’s executives tend to have much larger shareholdings than other employees. So there could be a sizeable chunk of Bear’s employee-owned shares getting voted in favor. What’s more, Bear’s non-executive employees might well be selling their shares right now, with the stock well above the offer price, in the reasonable assumption that it’s the best price they’re likely to get for the foreseeable future.

Davidoff also explains how a bondholder can buy up shares above the $2 price and not lose too much money even if he votes in favor of the deal at $2 per share:

The creditor buys Bear shares and a put at the price. Creditor then sells a call to pay for most (but probably all) of the put. Creditor waits for the record date of the Bear shareholder vote so it can vote. It votes yes. Immediately thereafter the creditor sells its shares.

Because the creditor owns a put struck at the price he paid for the shares, he’s protected against downside in the stock; the only cost is the cost of the put option, less the cost of the call option that he’s sold. All very clever.

That confounding Bear Stearns share price! Unsurprisingly, my explanation yesterday for why BSC was trading well above the offer price doesn’t seem to have persuaded everybody (or, frankly, anybody, really). It was mentioned by DealBook, but the "first best explanation" from the likes of the WSJ and Bloomberg still blames "speculators" for the price: people who are buying high because they think that, eventually, Bear Stearns will get sold for even more money than they’re paying.

I got an email from Yves Smith last night:

Is no one at Bear capable of reading a merger agreement? Evidently. Per the analysis at Dealbook (I read the key put provision in the merger agreement, and an analysis on Conglomerate, there is absolutely zero possibility that anyone other that JPM will own Bear, and JPM is under no obligation to pay more, merely restructure the deal.

A firm full of people who have clearly failed to master the basics of the securities industry, like reading legal documents and understanding their implications, deserves to be history. And you can quote me on that.

The analysis on Conglomerate is pretty complex, but essentially it boils down to the fact that if Bear’s shareholders reject the deal, JP Morgan can simply return again and again until the shareholders accept it – all the way into March 2009, if that’s what it takes.

I’m still convinced that BSC will go to either $2 or $0, in bankruptcy. Shareholders who think they’re going to get more than $2 in bankruptcy are likely deluding themselves: they’re at the bottom of the capital structure, and bondholders are convinced that they would have to take a haircut if Bear went bankrupt. If bondholders lose anything, of course, shareholders lose everything.

I’m also pretty sure that bondholders are behind a lot of the share-price dynamics. Yesterday, I speculated that they were buying shares so that they could force the deal through in a shareholder vote; the WSJ points out today that people who are short bonds also have every incentive to buy shares, so that they can vote no and drive the price of the bonds down. Basically, BSC’s equity is a small dinghy getting buffetted by strong winds from much bigger players, since the amount of Bear debt out there dwarfs the value of the equity, even at $7 per share.

All of this is being complicated by the options dynamics, too. As a commenter on this blog pointed out, if you want to vote the shares, it’s cheaper to buy calls than it is to buy the stock outright. And options volume in BSC has indeed been through the roof in the past few sessions. So some of the share price might be driven by options arbitrageurs.

Between them, options traders, bondholders, CDS holders, and plain old-fashioned momentum and day traders are more than sufficient to explain all of the volatility that we’ve seen in the BSC share price. There might be speculators too, but it’s not nearly as obvious as a lot of commentators seem to think.

Update: Landon Thomas buys the thesis that it’s the bondholders buying.

In today’s earnings report, Lehman Brothers reported that its book value rose one cent to $39.45 per share. The stock is doing great this morning, up $6 or so to $37.80, which puts Lehman on a price-to-book ratio of 0.96. Now that Yahoo Quotes has been updated, let’s update that league table:

Everyone’s down, with the exception of JP Morgan, and now that the panic of the weekend seems to be subsiding, there’s quite a lot of upside just to get back to the levels of last week. The buy here would probably be Lehman, but for suspicions that it still hasn’t taken the writedown medicine which devastated the balance sheets of most of the other banks on the list. In any case, the number of banks trading below book value has increased by one since last week, even with today’s spike in Lehman shares.