BSC: Why Paying $5 Per Share for Bear Stearns Might Make Sense
By all accounts, JPMorgan (JPM - Annual Report) has all the leverage to complete its proposed acquisition of Bear Stearns (BSC) for $2.00 per share. Actually, since it is a stock deal and JPMorgan shares have risen since the announcement, the acquisition price is now $2.40 per share.
Still, for a deal likely to be made at $2.40 per share, why would anyone be willing to pay $5.00 per share for the stock today? One answer that keeps getting bandied about is that bondholders are buying the stock in order to vote for the deal, as it is worth losing some money on the stock to preserve the value of the bonds.
That argument makes some sense, but I believe it doesn’t tell the whole story. It is possible for the bondholders to not only preserve the value of their bonds, but to lose very little on the stock in the process.
While the stock has been getting all the news, options on Bear Stearns have seen enormous trading volume. I think the bondholders are buying the stock, but hedging their bets by creating synthetic short positions.
A synthetic short consists of writing a call option and buying a put. Here’s how I think a bondholder can be playing this:
Buy 100 shares for $5
Write an October $5 call option for 2.10 (bid price as I write this)
Buy an October $5 put for $2.45 (ask price as I write this)
Net cost for this transaction is $5.00 + 2.45 – 2.10 = $5.35. At expiration, it will be worth $5.00 no matter where the stock is trading. So, for $0.35 per share, or $35 for every $500 of exposure, the bondholders can buy the right to vote on the deal.
Given that the bonds were trading at $700 per $1,000 face value on Friday, and are worth $1,000 when backed by JPMorgan, it is pretty simple math. For every $1,000 of bond exposure, you can pay $70 to vote in favor of a deal that is worth $300 to you.
What’s more, since there was so much more debt than equity, only a small fraction of the bondholders need to make this bet to gain an overwhelming majority of the equity votes. Or, each bondholder could insure a smaller portion of their value.
Taking that into consideration, paying $5.00 for the stock starts to make sense.
Provided, that is, you already own the bonds.
[...] of bond exposure, you can pay $70 to vote in favor of a deal that is worth $300 to you,” they write. “What’s more, since there was so much more debt than equity, only a small fraction of the [...]
This assumes: 1) bondholders can accumulate enough shares from shareholders who would have voted against the deal and 2) the deal gets passed before the shares get called away – if the shares get called away, the bondholders are just out the $70. At current prices it looks like the shares would be called away before the vote…
True, but that’s one reason I picked October calls. I’m pretty sure the first vote will be before then. The deal would also be feasible, though a bit more expensive, using January 2009 leaps.
That’s fine logic unless they are American options (callable before expiration).
…by the way, who do you think bought the call from and sold the put to the bondholders (for a net gain)? Probably the same people who would call the shares away and vote against the deal, wouldn’t you say?
Point well made re: the American vs European calls. There is certainly a risk that it would be called against the owner ahead of time, regardless of the prevailing market price at that time.
So your point is that, rather than buying the shares at $5 a speculator would go synthetic long using options for a net gain on the option transaction. Then they would call the shares if it looked to go in their favor?
I guess that makes more sense than buying the stock, but with JPMorgan still holding all the cards it seems like an easy way to lose a couple of bucks per share.
It could be speculators. Or it could be existing BSC shareholders taking the other side of your bondholder trade. (The same shareholders who will vote against JPM’s steal, and pocket $70 in the meantime). Until the vote passes they hold all the cards, not JPM, not the bondholders.
JPM would probably like nothing more than to have the vote go against them. They could then take the keys to the building, flip their 20% stake for a quick profit and be done with the deal. Bear, with no place to do business, would be worth less than $2 at that point.
I think a more likely explanation for the call buyers is that people are playing the deal through multi-leg option strategies, buying at one strike and selling at another to hedge risks.
Of course JPM can’t lose – that’s why they made the deal! The question is, can existing BSC shareholders? Is the value placed on BSC after JPM exercises its option on the building and takes its 20% really less than $2/share? I think the market knows it is worth WAY more, despite what the rumors (started by whom? Hmmm… who gains from this?) may suggest.
There are so many iterations on this, it would boggle the mind. For example my hypothetical bondholder could currently buy all the $7.50 calls and $5.00 puts he wants for a nickel apiece. Your trader who went opposite him and called the stock away could see the bondholder say “backatcha.”
There are so many smart, rich players with ulterior motives that could be playing this thing that my strategy becomes simple: sit on the sidelines and shake my head.
I couldn’t agree more. It will be very interesting to see how the BSC bondholders and options traders will end up as compared to the BSC shareholders who actually hold the power to vote on the deal. Will they sell out, refuse to sell out and blow themselves up, or refuse to sell out and come out huge winners? I think the market suggests the latter. No matter what happens I know JPM is the biggest winner for its roll in all of this!