Bear Stearns’ False Statements To The Investing Public Deserve Greater Attention

March 2008

Over the weekend of March 15 and 16, the Federal Reserve (aka the Fed) brokered a deal for JPMorgan to purchase Bear Stearns for approximately $2 per share - a small fraction of Bear Stearns' recent stock trading price. From its high in January of 2007, Bear Stearns lost more than $19 billion in market capitalization. The loss, the merger transaction, and the surrounding events are historic because:

1. The Fed became directly involved by loaning $30 billion of taxpayer funds necessary to allow the transaction to occur. The Fed also coordinated all other government approvals that would ordinarily have taken months to address. During every significant financial strain, including immediately following the Sept. 11, 2011 attacks, the Fed reminds financial markets that it has the power to lend money to financial institutions. However, the Fed has not actually used this authority in decades.
2. An enormous amount of investor losses occurred with heavy trading volume in just the few days prior to the confirmed failure. The unprecedented losses occurred because of Bear Stearns’ inaccurate information that propped up its stock price in the days just before its imminent collapse.

The original deal gets renegotiated

On Monday, March 24, 2008, JPMorgan and Bear Stearns agreed to an enormous restructuring of the deal. It is not clear that the Fed, already appropriately concerned about the use of taxpayer dollars to bail out Bear Stearns’ shareholders, will agree to the restructured deal.

The March 24 deal includes the following:

1. Each share of Bear Stearns common stock would be exchanged for 0.21753 shares of JPMorgan Chase common stock (up from 0.05473 shares), reflecting an implied value of approximately $10 per share of Bear Stearns common stock.
2. JPMorgan will purchase 95 million newly issued shares of Bear Stearns common stock, or 39.5% of the outstanding Bear Stearns shares after giving effect to the issuance. The purchase will be at the same price as provided in the amended merger agreement, and is expected to be completed around April 8.
3. The boards of directors of both companies approved the amended agreement and the purchase agreement. All of the members of the Bear Stearns board of directors indicated they intend to vote their shares in favor of the merger.
4. The Federal Reserve Bank of New York's $30 billion special financing is amended. JPMorgan will bear risk for the first $1 billion of the Bear Stearns assets being financed, and the Fed will fund the remaining $29 billion on a non-recourse basis.

The New York Stock Exchange generally requires shareholder approval prior to the issuance of securities that are convertible into more than 20% of the outstanding shares of a listed company. However, the NYSE's Shareholder Approval Policy provides an exception in cases where the delay involved in securing shareholder approval would seriously jeopardize the financial viability of the listed company. Based on that exception, Bear Stearns' Audit Committee and its full board of directors unanimously approved Bear Stearns' intended use of the exception.

Apparently, one thing the revised deal will not change is the coverage of legal fees for Bear Stearns’ top management in the upcoming wave of civil (and perhaps criminal) prosecution. In a filing with the Securities and Exchange Commission on Wednesday, March 19, 2008, Bear Stearns announced that it amended its bylaws to pay for potential lawsuits. The amendment allows for costs (such as legal fees) to be paid or reimbursed by the company upon employee request. Even with the sweetened deal, based on the events summarized in the next section, Bear Stearns’ management will need this legal assistance.

Bear Stearns’ management lies to the public

So far, the press on this widely covered failure has been too busy covering the restructured deals terms and tales of frightened employees to have adequately focused on the issues of securities and disclosure violations. We suspect that this will be remedied with time.

We appreciate that the word “lies” in the above heading is a harsh judgment. However, in this case, the inaccuracies are so large that any other interpretation is a bit far fetched. Here are the details.

Near the end of January 2008, Bear Stearns files its Form 10K. The 10K discloses what is required by SFAS 157 regarding recording investments at “fair value” (See our November 2007 article that discussed fair value accounting for the investment banks and their subprime mortgage investments.) Here is what Bear Stearns reported:

“On December 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS”) No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. …

Fair value is generally based on quoted market prices. If quoted market prices are not available, fair value is based on other relevant factors, including dealer price quotations, price activity for equivalent instruments and valuation pricing models. Valuation pricing models consider time value, yield curve and volatility factors, prepayment speeds, default rates, loss severity, current market and contractual prices for the underlying financial instruments, as well as other measurements.”

On January 9, 2008, shortly after Bear Stearns recorded a $1.9 billion write-down of its subprime investments in its fourth quarter (ended November 30, 2007), CNBC interviews CEO Alan Schwartz. The only substantive topic CNBC asks Schwartz is “Are there going to be any more write-downs?”, and then a follow-up question that confirmed, “So, the worst is now over?” In response to these two questions, Schwartz states:

“We think we are adequately marked.” [This refers to the SFAS 157 requirement to mark investments down to market value, as disclosed above. The adequacy of asset write-downs is repeated in subsequent disclosures, as summarized below.]

“We think we are conservatively marked.”

“We feel pretty comfortable and confident where we are.”

On Monday, March 10, 2008, Bear Stearns’ Alan "Ace" Greenberg, a former chief executive who currently serves as chair of its executive committee, told CNBC that the liquidity rumors surrounding the company are "totally ridiculous." He said "It's ridiculous, totally ridiculous."

On the same day, after the close of trading, Bear Stearns issued a brief press release that denied market rumors regarding the firm’s liquidity. The company stated that there is absolutely no truth to the rumors of liquidity problems that circulated today in the market. According to the release, Alan Schwartz, President and CEO said, “Bear Stearns’ balance sheet, liquidity and capital remain strong.”

A day and a half later, on Wednesday, March 12, 2008, in response to Bear Stearns’ stock price dropping, CNBC interviewed CEO Alan Schwartz. Schwartz’s comments included the following:

We have “no problems… There is absolutely no truth to the rumors of liquidity problems.”

“None of the speculations are true…. We don't see any pressure on our liquidity."

“Our liquidity and balance sheet are strong.”

“Our balance sheet has not weakened at all.”

“We have a $17 billion cash cushion that is virtually unchanged since year-end …. $17 billion of excess cash is sitting on the balance sheet as a liquidity cushion.”

Perhaps even more important, Schwartz also confirmed that he was “comfortable” that first quarter 2008 earnings will fall within the range of estimates that analysts on Wall Street forecast for the fiscal quarter that ended last month. This announcement was to occur in about a week, on March 20. According to a Thomson Financial survey, analysts forecast a profit ranging from 46 cents per share to $1.61 per share. Importantly, this meant that:

1. Bear Stearns would not incur any write-downs to fair value pursuant to SFAS 157, since any such write-downs would cause Bear Stearns to miss these income projections, and
2. Absent any such write-down, the fair value of Bear Stearns assets were worth at least $84 per share, at a time when the stock was trading in the mid-$50 range. Traders were effectively encouraged to make around $30 per share by taking advantage of the untrue speculations that Schwartz was criticizing.

Based on the above information, trading in Bear Stearns stock was frantic. Between the time of the above statements and the announcement of the Bear Stearns’s deal with JPMorgan, volume equal to over 200 percent of the company’s shares traded hands.

Remember that Enron’s Jeffrey Skilling is now in prison for comments made nine months before Enron’s failure. Schwartz’s and the other Bear Stearns’ comments took less than a week to prove incorrect.

Schwartz’s subsequent complaints

After making comments which one might charitably be called inaccurate, but then agreeing to the JPMorgan acquisition at approximately $2 per share, Mr. Schwartz complained that Bear Stearns collapsed because hedge funds and other banks withdrew their business and credit lines last week, making it insolvent. Mr. Schwartz was quoted in The New York Times that "we here are a collective victim of violence". Blaming others for your own mistakes is understandable, but is also inaccurate.

Companies depending on short-term loans (such as all the major brokerage firms) rely on the cooperation of its lenders. When any such borrower cannot roll over its short-term debt, the creditors can create massive problems by refusing to lend more money. This is all pretty basic. Mr. Schwartz’s job as CEO is to manage the business so that Bear Stearns is not subject to a large mismatching of short-term liabilities and long-term assets. If Bear Stearns is a victim, the perpetrator is its own management who failed to address the situation earlier and then attempted to cover up the problem with incorrect public statements.

SFAS 157 requires Bear Stearns to value its financial assets at an exit price. If Bear Stearns applied fair value accounting in the manner that it disclosed, Bear would have valued its financial assets at an exit price that would allow it to raise additional funds without incurring additional losses. Mr. Schwartz’s confirmation of expected profits on March 12, 2008 effectively also confirmed that no further write-downs were needed using this standard. Stated otherwise, in describing Bear Stearns’ situation just a week earlier, Mr. Schwartz claimed that no such additional write-down of illiquid assets was needed based on current market conditions.

Fulcrum Inquiry performs forensic accounting and valuations.