
Ask YC: Can someone explain this JP Morgan buyout of Bear Stearns for me? - mk
Here is what I understand. Bear Sterns did not have enough liquid capital to distribute to investors seeking to withdraw their money, a bank run like in "It's a Wonderful Life". And now the Fed has helped or guaranteed those investments so that JP Morgan can buy them for $2 a share. I probably have something wrong there. My question is 1. Is what I just said somewhat right, and 2. What is the impact on the tax payer? Did the Fed provide any money to JP Morgan to buy Bear Sterns? And if they did is it a loan that they will have to pay back or a free handout?
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dpapathanasiou
_Bear Sterns did not have enough liquid capital to distribute to investors
seeking to withdraw their money, a bank run_

Bear couldn't cover their margin calls
(<http://en.wikipedia.org/wiki/Margin_call#Margin_call>).

 _And now the Fed has helped or guaranteed those investments so that JP Morgan
can buy them for $2 a share._

JPM wasn't going to touch Bear's liabilities without some guarantees from the
Fed.

Details of the plan haven't been released, but here's a pertinent quote from
the Journal
([http://online.wsj.com/article/SB120569598608739825.html?mod=...](http://online.wsj.com/article/SB120569598608739825.html?mod=special_coverage)):

 _To help facilitate the deal, the Federal Reserve is taking the extraordinary
step of providing as much as $30 billion in financing for Bear Stearns's less-
liquid assets, such as mortgage securities that the firm has been unable to
sell, in what is believed to be the largest Fed advance on record to a single
company. Fed officials wouldn't describe the exact financing terms or assets
involved. But if those assets decline in value, the Fed would bear any loss,
not J.P. Morgan._

Note that last sentence means the U.S. government (i.e., ultimately every
taxpayer) is on the hook for that $30 billion.

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iamelgringo
In a nutshell, banks work like this: People give them money to hold by putting
it into checking/savings accounts. Banks then turn around and lend that money
to others via loans. Sometimes they use that money to invest for themselves.

A bank’s primary asset is trust. For a bank to work, the consumers must
believe that their money is safe with their bank. Otherwise, they will not
give their own money to the bank for safekeeping, and the bank would have no
money to lend to others or invest. The irony is that banks cannot possibly
have the cash on hand to give back to all their customers at once. But, as
long as people believe in the bank, and keep their money in the bank, the bank
stays afloat.

The problem that we're having now, is that certain banks that lent out a lot
of customer’s money in bad mortgages. So, with as many foreclosures that we’ve
had, banks have lost a lot of money, and people lose trust in their banks.
When people lose trust in a bank, they withdraw their money, creating a “run
on the bank” just like in _It’s a Wonderful Life_. This is what happened to
Bair.

The big fear is fear itself. Worst case scenario is that the entire nation
would have a loss of trust in the entire banking system. This could cause a
run on the banking system, and lead to a chain reaction of banks imploding.
This is what happened during the Great Depression.

That’s why the Fed stepped in, and said that they would cover Bair’s bad debts
to avoid a big bank’s collapse. It sucks, because the rest of the country is
on the hook for Bair’s losses. And, the US dollar is gets weaker when the
government prints money to cover bad debts. But, it beats a chain reaction of
banks imploding.

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aristus
Somebody set us up the moneybomb! All your basis points are belong to us.

Bear is an investment bank, and does not have direct access to borrow money
from the Fed. Lat week JP agreed to act as a kind of conduit for loans backed
by some of Bear's more toxic assets.

Sounds stinky, eh? The thing is that the Fed and everyone else is scared stiff
that Bear would default. That would set of a ricochet all through the banking
and trading system. This buyout is actually the lesser of two evils, and the
price is so low because no one really knows what liabilities and losses are to
come.

~~~
mk
Let me get this straight. JP is taking a loan from the Fed to buy Bear?

~~~
aristus
Yes & No. JP is buying Bear with its own cash. It's only $230-odd million. The
Fed allowed an unusual transaction in which $30B of Bear's toxic assets were
put up as collateral for Fed loans in order to keep its (Bear's) operations
and trades going. The Fed took some of the pressure off of Bear's balance
sheet to make it more attractive to JP and reduce the damage to JP's balance
sheet once the entities merge.

Bear: "Mein Leiben!"

Fed: "Holy sh*t, this can't happen! You, JP! You hold a lot of Bear's paper
already. We need your help, and we'll sweeten the deal, ok?"

JP: "I'm gonna make you an offer you can't possibly refuse..."

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brentr
I used to work in the industry, so I will take a stab at explaining this:

Bear was overleveraged. The summer of 2007 saw the failure of two internal
hedge funds at the company, a confidence crusher. As 2007 wrapped up, the
subprime issue spread to other credit markets, effectively freezing the
financial system. Bear found it more and more difficult to obtain short-term
funding to cover their existing debt that was coming due. Last week, the CEO
came on CNBC and stated that there was no liquidity problem at that time. I
don't doubt that statement. Then came Thursday morning. A fund at the Carlyle
Group failed, and Bear had a lot of business with the Carlyle group. It was
the failure at Carlyle that finally TKOd Bear, but it was only a matter of
time before it did indeed happen. Now, had Bear declared bankruptcy, which
they would have had it not been for JP Morgan, a panic none of us have seen in
our lifetime would have ensued. Bear would have been forced to dump all of its
assets on the market, even the ones that Wall Street doesn't even know how to
price. A complete breakdown of the US financial system would have ensued, and
there would have likely been a run on not just an investment bank, but a
retail bank as well. The Federal Reserve is not in the business of bailing out
companies that mismanage their businesses, but they are in the business of
maintaining an orderly market (in addition to their mandate to control the
money supply). When Bear went to the Fed on Friday, the Fed knew they'd have
to find someone willing to take Bear. JP Morgan was the company best situated
to buy Bear; JP Morgan had the capital and was looking for a prime brokerage
division and better clearing operations. While Bear provided both of those,
there is a large set of unknowns on Bear's balance sheet, and had the Fed not
offered to cover up to $30 billion of the more illiquid assets, the deal would
have fallen through. Part of the taxes you pay will be used to eat any losses
the Fed takes.

~~~
projectileboy
Excellent summary. Thanks!

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jellicle
Let me see if I can sum it up in small words. Bear Stearns bought a lot of
mortgage-backed securities over the past couple of years. These securities are
currently worthless - no one will purchase them at any price. Bear Stearns has
debts, but no assets = bankrupt. JP Morgan sought to buy Bear Stearns, but is
unsure just how much of Bear Stearns' portfolio is worthless, so they're not
sure how much they'd be willing to pay. So they got a bailout from the Federal
Reserve. The Federal Reserve agreed to 'loan' $30 billion to Bear Stearns,
secured only by - this is important - utterly worthless mortgage securities.
This means that if BS doesn't pay the money back, the Federal Reserve can ONLY
take those worthless securities and can't come after any other assets of BS or
JPM. In other words...... it's free money. (If I loaned you $10,000 using a
single toothpick as collateral and agreed that if you didn't pay it back, I
could only keep the toothpick and couldn't go after any other assets you may
have, that would be a gift, right? Would you pay back the money and get your
toothpick back, or keep the money?) BS will never pay back the $30 billion.
It's a free gift from taxpayers to the financial industry. Even with the free
gift, JPM still didn't deem BS to be worth very much. Indeed, sinec BS's
office building is worth $1 billion and JPM paid $236 million for all of BS
including the office building, JPM forecasts that after the $30 billion gift,
BS is worth about negative $750 million or so.

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xg
Other people did a good job explaining the basics. The issue is about book
value and the complexity of the risk. The risk is similar to what the firm
Citadel did with E*Trade.

The risk on the books of Bear Stearns can't be fully calculated and JP Morgan
is assuming that risk, hence the low price. The Fed is possibly going to limit
the downside risk of JP Morgan to keep stability in US financial markets,
though they are not putting up any additional capital upfront.

Roger Ehrenberg has some great blog posts on the topic (he used to run a big
hedgefund and now has an NYC startup called Monitor110):

[http://www.informationarbitrage.com/2008/03/the-bear-
facts.h...](http://www.informationarbitrage.com/2008/03/the-bear-facts.html)

[http://www.informationarbitrage.com/2008/03/i-bear-ly-
knew.h...](http://www.informationarbitrage.com/2008/03/i-bear-ly-knew.html)

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jey
There's great discussion about this in this thread if you haven't seen it:
<http://news.ycombinator.com/item?id=138508>

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symptic
This instance reminds me of a video I saw a while back, 'Money As Debt'.

[http://video.google.ca/videoplay?docid=-9050474362583451279&...](http://video.google.ca/videoplay?docid=-9050474362583451279&q=money+as+debt&total=4017&start=0&num=10&so=0&type=search&plindex=0)

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stevengg
The Money Masters is a good watch if you have time
[http://video.google.ca/videoplay?docid=-515319560256183936&#...</a>

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noodle
i think this is a pretty good explanation: [http://www.portfolio.com/news-
markets/top-5/2008/03/14/The-B...](http://www.portfolio.com/news-
markets/top-5/2008/03/14/The-Bear-Facts)

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TrevorJ
The biggest potential impact on the taxpayer in the extreme short term won't
have as much to do with the complete truth of the situation as it will with
how the public and the markets interpret the move.

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aswanson
Investment tip: Never, ever put money in a fund with the word 'Gaussian' in
it.

