JP Morgan and Bear Stearns Essay

BackgroundIn the run low 3 decades, the US banking system has changed its investment procedures and its endangerment management due to changes in government regulation. Furthermore, external shocks, such as the inflationary period during the 70s and the recession in the 80s, led Banking institutions to alternative ways of investment in order to remain profitable. The average annual inflation rate from 1900 to 1970 was approximately 2.5%. From 1970, however, the average rate clear about 6%, topping out at 13.3% by 1979. This period is also known for stagflation, a phenomenon in which inflation and unemployment steadily increased. A loose monetary policy led to very number 1 interest rates. Corporations were relieveing large steps to finance leverage buyouts (LBOs), which led to higher and high interest burden. atomic number 53 of the main instruments used was financial derivatives, which gave Banks additional profit. Moreover, this instruments represented off counterbalanc e sheet activities, thus serving bank capital.Nonetheless, these instruments were risky and could led to enormous losses. In the late 70s and early 80s saw the rise of a number of financial products such as derivatives, high brookoff an structured products, which provided lucrative returns for investment banks. Also in the late 1970s, the facilitation of corporate mergers was being hailed as the last gold mine by investment bankers who assumed that Glass-Steag completely would someday collapse. At this time we could see the setoff efforts to loosen Glass-Steagall restrictions and some brokerage mansions begin encroaching on banking territory by offering money-market accounts that pay interest, allow check-writing, and offer credit or debit cards. Moreover, in 1974 NOW (Negotiable Order of Withdrawal) accounts were created by a small bank in Massachusetts, offering negotiable orders of withdrawal to permit payments on near-checking accounts at banks. In 1980, they were permitted for all institutions, with rate ceilings eliminated in 1986. take up Sterns and crisisAs an investment bank, soften Stearns & Co. had three main operating(a) businesses. The first one was Capital Markets, which included brokerage services, market-making and proprietary trading in both equities and resolved income. Moreover, this Capital Markets business also included investment banking services such as securities issuance and advice on mergers andacquisitions. Its fixed income business represented the highest contribution to its revenue. The second operating business was Global Clearing run which included the connections well-regarded prime brokerage business. reserve Stearns provided trade execution and securities clearing, custody, lending and financial backing to circumvent funds and broker-dealers as a prime broker. The third operating business was Wealth steering which included Bears Private Client Services group, which served high-net worth individuals, and Bear Stear ns Asset Management, which managed hedge funds and former(a) investment vehicles.Bear Stearns & Co. was an investment bank, a financial intermediary that performed a soma of services. As an investment bank it specialized in large and complex financial transactions. Its primary governor was the Securities and Exchange Commission and did non have access to the Federal Reserve discount window, which allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquid state caused by internal or external disruptions unlike mercenary banks. The main difference between a commercial bank and an investment bank such as Bear Stearns was that musical composition commercial banking involved both taking deposits and making loans that remained on the lenders balance sheet, investment banking involved the underwriting of debt and equity securities, get them from the issuer typically with a syndicate of other(a) firms and t hen selling them on to investors.Many years agone it was difficult to say whether a bank engaged in commercial activities or investment activities, however, the carnal knowledge prohibited investment banking and commercial banking in the same firm in 1993. But in 1999 these laws were modified and some commercial and investment banks consolidated although Bear Stearns as well as other banks such as Goldman Sachs and Lehman Brothers chose not to enter the commercial banking business so as a result they did not have access to the Federal Reserve discount window. FED Chairman Christopher Cox said that Bear Stearns was adequately capitalized at all times but facing skeptical lawmakers, Cox acknowledged that the firm had massive liquidity problems and that capital is not synonymous with liquidity. He said the SEC is working with the pentad biggest Wall Street firms to make sure they increase their liquidity pools andredouble their focus on risk practices. On March 13, he indicated that liquidity at Bear Stearns fell from $12.4 trillion to $2 billion because of the complete evaporation of confidence in the familiarity.Considering Mr. Coxs statements, we ask ourselves if all well-capitalized financial institutions argon vulnerable to crisis periods. In order to arrive to a conclusion in this matter we have considered a well-capitalized as a firm with a healthy liquidity status. From our point of view, we consider that some financial institutions, such as big investment banks, are so important to the global providence that should they fall, the repercussions would be too fatal and governments would be forced to intervene and rescue them in order to keep the economy from collapsing. This is the reason why the term to big to fail arose. In spite of this, as Nassim Nicholas Taleb said, we could face a black swan case, which refers to an event, positive or negative, that is deemed improbable yet causes massive consequences. Bears activities were financed with a mix of long term debt, equity, and financing collateralized with securities from Bears inventory.Besides this, Bears trading business required the investment bank to constantly hold an inventory of securities these securities were used as collateral for short term borrowing agreements known as repurchase agreements (repos). If we compare Bear with other financial institutions like, for example, Leman Brothers, Merrill or Morgan Stanley we can easily see that those companies had much more weight in liquidity than Bear Stearns. It was below those three in repo financing and repo lending too. Specifically, Merrill Lynch had total liquidity of 181.9 while Bearn Stearns had 35.3 and total liquidity as percentage of repo financing was 77% in Merrill and 345 in Bearn Stearns. Bear Stearns almost collapsed not once but twice before the cash-strapped brokerage firm was rescued.The leverage suffered by Bear Stearns at that time increased the risk of becoming bankrupt. This was because, with a big leverage, losses are large and can consume the firms entire equity to the point where the book encourage of the company is zero or even negative. In the worst case scenario, Bearn Stearns, being counterpart for many repo agreements and other financial instruments could result in default on their payments, which is why it ended up being rescued. By knowing this facts we can tell that the firms value would indeed be negatively bear upon by a potential bankruptcy.ValuationTo give a price to pay for Bear Stearns ongoing businesses we have to use a valuation method. Being unable to perform an adequate due application we are not going to be able to know the actual risk of many of the assets, and whence unable to use the real value. For this reason, the valuation method we are going to use is the Book esteem per Share, which by definition indicates the remaining value of a company for its shareholders, should it dissolve, which is quite similar to the process Bear Stearns is going th rough. To come up the book value, we have to take the total shareholder equity and subtract from it all preferred equity. In order to do so, we have to take a look at the balance sheet, provided in the Exhibit 2, where we can find the unaudited balance sheet for the Q1 2008.There we can see that marrow Stockholders Equity in that period was $11,896 million. From that equity we have to subtract the preferred stock, which is $352 million. 11544 Doing so we obtain a value of $11,544 million, which divided by the number of total shares outstanding should give us the book value per share of the company. Looking at the balance sheet, we can see that it gives the outstanding shares. We have 500,000,000 shares authorized as of November 30, 2007 and 2006 184,805,847 shares issued as of November 30, 2007 and 2006. We can see it better this wayNov. 30, 2007Nov. 30, 2006Authorized500,000,000500,000,000Issued184,805,847184,805,847This makes a total of 1,369,611,694 shares. But the company also has Treasury stock, it has repurchased some of the shares it had previously issued. It says that the treasury stock is composed of common stock 71,807,227 and 67,396,876 shares as of November 30, 2007 and 2006, respectively. This means that the company has bought, in total, 139,204,103 shares. Subtracting thevalue to the issued and authorized shares, we have the total number of outstanding shares. So, to find the Book Value per share, we divide the $11,544 million of equity by the 1,230,407,591 shares, turning to be $9.38 per share, very close down to the price JP Morgan ended up paying. However, I would say this value is too high, due to the great amount of uncertainty regarding the exposition of Bear Stearns to the MBS market and the great illiquidity risk it is facing.