The feds backed a takeunder of Bear Stearns (BSC) by JP Morgan (JPM) with a $30 billion special financing. JP Morgan will buy Bear for about $2 per share or $236 million, a 93% discount from $30 close on Friday. This week so far, BSC shares, although suffered a monumental loss, always traded significantly above the $2 mark. The lowest it got was $2.84. Now it is trading close to $7, a full 250% above the takeunder price. The market is simply not buying the Feds BS and don't believe that the deal would go through or is necessary.
There have been several explanations offered on why BSC price is trading well above the takeunder price. None of them hold any water. One explanation is the credit default swap
One possible group of buyers are the hedge funds that were selling so-called credit default swaps that protect the purchaser against a possible bankruptcy at Bear Stearns. Spreads on Bear Stearns CDS soared to 1,000 basis points Friday - meaning it cost $1 million to insure against a default of $10 million face value of bonds. Those spreads have since narrowed to around 350 basis points, or $350,000 per $10 million in insurance, in light of the prospect that JPMorgan Chase will take over Bear’s obligations. So a seller of a Bear Stearns credit default swap on Friday, having taken in $1 million in premium, can now turn around and protect himself against a default in Bear Stearns for $350,000. That translates into a $650,000 gain -and the potential profit stands to get bigger as the close of the transaction approaches and Bear spreads move more in line with JPMorgan’s, which are around 115. Those dynamics give hedge funds a big incentive to make sure the deal goes through.
Another explanation is the bond holders
Holders of Bear Stearns debt want the deal to go through so they won’t end up fighting with other creditors in bankruptcy court over the remains of the firm - the likely outcome if Bear shareholders turn the deal down. And Bear Stearns bonds that recently traded as low as 80 cents on the dollar could soon be worth 100 cents if JPMorgan goes through with its purchase.
The problem is, they can all get the stocks they want at much closer to $2 if there are not other buyers in a bidding war against them. In other words, for the above explanations to make sense and consistent with the price that is several times above $2, there have to be a lot of people who don't want the deal to close to bid up the price.
Another way to look at this, is that if the deal is such a certain thing, then a lot of outside money would rush in to arbitrage between the prices of BSC and JPM. They would short BSC and long an equivalent amount of JPM as long as BSC price is well above the 0.05473 ratio of JPM price (that would be about $2.31 using today's intraday JPM price of $42.26). As long as the deal is going through, this is risk free money. Why isn't everyone on Wall Street doing this until the price of BSC is pushed back to $2.31? Because most people on Wall Street do not believe that the deal will go through.
There are three outcomes if the deal doesn't go through. 1. BSC goes for bankcrupcy. This is highly unlikely - the Feds already put in a lot of money (and its prestige) to allow it happen. Besides, people are not buying a stock at $7 knowing it's going to zero. 2. Another bid comes in at above $7. 3. BSC survives without being bought. Evidently the market thinks that either 2 or 3 are highly likely. In either case, it shows that the Feds panicked unnecessarily last weekend by forcing through the deal with JPM. Note also the fact that JPM price rose about 16% since the deal was announced, or about $23 billion. Is it a coincidence that this is almost the amount of financing provided by the Feds? Are the Feds using our tax money to enrich JPM shareholders, especially if BSC doesn't need to be bought (at $2 per share)?