I know, I know, not another Bear Stearns article, right? I don’t know about you, but my eyeballs have gone crazy lately scanning headline after headline and reading article after article about the Bear belly flop and the JP Morgan bargain basement acquisition.

I’m so over it. So hopefully this is the last I’ll ever mention it.

With so much written about the topic, I was fairly convinced that someone would write a story exploring the following angle; however, I haven’t found any such article. So I’ll just throw this out there for consideration. Much of it will be speculation based on rumor and innuendo, but I think that we haven’t fully followed this path of reasoning - and I think it’s important.

Unfortunately, most of what I’ve read so far in the popular press either details Bear’s demise, praises JP Morgan’s (and Jamie Dimon’s) shrewd acquisition, or discusses the Fed’s reaction to the whole mess. Fairly little has been written about what this means for JP Morgan and why JP Morgan likely felt compelled to purchase Bear. And like Steve Randy Waldman at Interfluidity suggests, I think this acquisition raises more questions than answers (see More Questions than Answers on Bear).

But one question that has been answered unsatisfactorily in my opinion is why JP Morgan might want Bear in the first place. OK, so here’s my theory:

I’ve always firmly believed that in order to understand the behavior of economic actors (be they firms or individuals), one must understand their incentives. With that in mind then, we have to ask what JP Morgan’s incentives were to acquire Bear.

Much has been written about how JP Morgan was looking to acquire businesses in which Bear was strong (e.g., prime brokerage), and some even maintain that JP Morgan was looking to buy a regional bank.

This may be, but I believe that there is another explanation that has been little explored because, quite frankly, the data that would allow one to gauge this motivation are not publicly available.

Specifically, I believe that JP Morgan acquired Bear because they stood to lose the most from a Bear Stearns bankruptcy. For example, as Barry Ritholtz of the Big Picture points out (see here), JP Morgan has the greatest derivative exposure of any of the I-Banks. Now, I do not know how much of that exposure was to Bear Stearns as the counterparty, but I bet it was a fair amount (in fact, see Jesse’s Cafe Americain for information on Bear’s credit derivative exposure).

If Bear were the counterparty (insurer) to JP Morgan on much of its mortgage-backed security portfolio, it then becomes transparent why JP Morgan had to step in. They would have had to step in to avoid a Bear bankruptcy so that they would not be forced to take toxic assets back onto their own balance sheet and avoid massive write-downs. Were JP’s exposure to Bear large enough, then JP Morgan itself could have been left significantly impaired.

This might also explain the Fed’s interest in Bear. For example, if it were only Bear at risk and their exposure was spread relatively evenly across counterparties such that many of the big, primary banks were not at risk as a result, the Fed would have had no interest in this event. Instead, it would have just let Bear fail. But the Fed could not let Bear bring down JP Morgan with it. So it stepped in to orchestrate an orderly wind-down of Bear while facilitating its acquisition by JP Morgan.

But this still doesn’t explain why JP Morgan ended up with a relatively “cheap” price for Bear. Here is the second part of my theory. Namely, that Bear was into JP Morgan so deep (on the bad side of so many counterparty trades with them), that the Fed effectively negotiated a price that would have made Bear more or less whole on its obligations to JP Morgan. This too could explain why many other suitors dropped out so early in the process - because the Fed was not prepared to offer the same deal to those other “interested” buyers.

So for Bear’s sins, JP Morgan gets the pieces of Bear’s businesses that it would have liked to acquire in the market someday; it acquires some talented bankers; it gets a building (Bear’s headquarters) that is worth considerably more than the total price paid for the acquisition; and it gets the Fed to backstop the toxic parts of Bear’s assets (up to $30 Billion - fairly generous).

All in all not a bad deal if you’re JP Morgan (as many have pointed out), and maybe exactly what they deserved if Bear truly “owed” them as much as I suspect they might have.

But in the end, the whole episode certainly makes you wonder whether the Fed’s move represents a rescue of Bear or an effective bailout of JP Morgan.

This entry was posted on Tuesday, March 18th, 2008 at 10:21 pm and is filed under Corporate Strategy. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.