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March 25, 2008

A Big Win for the BSC Bondholders
by Thomas Tan

A couple of weeks ago, Barron's had an article evaluating the equity value of BSC. They indicated that the building itself is worth around $12 per share, plus the value from their other business, such as prime brokerage service, wealth management, investment banking, etc. It adds up to at least $20. But the article failed to mention that besides equity holders, there are also bondholders who have different priority and incentive than shareholders.

There have been some rumors that JPM was actually willing to pay around $15 instead of the initial $2 at their 1st proposal. But the Fed and Treasury Dept had some other concerns. First of all, they didn't want this to be viewed as a bailout since public would criticize that the government is sided with Wall St. With $2 fire sale with BSC equity almost totally wiped out, government can point out to the public that BSC gets punished severely and doesn't get any compensation and rescue for all the bad things they have done wrong. Secondly, there is speculation that government wants to panelize BSC for being the only large investment bank not participating in the bailout of LTCM back in 1998. Now with JPM raising the price to $10 with almost 40% of shares secured, this deal will most likely go through with bondholders' help, with shareholders against the buyout having little chance to succeed.

The biggest win in this deal is actually the BSC bondholders. I went directly to BSC's own website to look at their latest 10K with link shown below.

http://www.bearstearns.com/includes/pdfs/investor_relations/proxy/10k2007.pdf

At page 43, it shows $66B in long term debt and about $9B in unsecured short term debt.

JPM's buyout really makes no material difference to shareholders. With employees owning 1/3 of the company at much high costs, probably over $100 at 3 digits, getting $10 back vs. zero doesn't make big difference at all. However, there is a huge difference for bondholders. In bankruptcy court, usually the trade counterparties received the highest seniority on BSC assets, then if anything left, it goes to the next tier of secured long term bond holders, then next tier of unsecured short term debt holders. BSC equity will definitely get wiped out, likely most of the $9 unsecured short term debt holders. Depending the value of the assets and trade partners' claims, the $66B long term bondholders will likely take a big loss and years to recoup their money, or turn into shareholders of a new BSC company if emerging from bankruptcy (the nice BSC building along with other business will go to them, not the shareholders as Barron's suggested). Thanks to the buyout, suddenly BSC bondholders holding deeply discounted junk bonds get a freebie, now their bonds are back to investment grade guaranteed by JPM with little default risk unless JPM is going under water which is unlikely.

Also the unconventional $30B "non-recourse loan" to JPM from Fed and Treasury helps bondholders even before this JPM buyout was announced, since this $30B loan is secured only by the shaky BSC mortgage debt which is worth little. This time, it is JPM getting the freebie. What is a "non-recourse loan"? It gives JPM incentive but no liability to buy BSC. If the collateral of those mortgage shaky tranches go to zero, homeowners underlying this debt will go into foreclosure, losing their homes, Feb and Treasury will lose money or actually taxpayers like us will lose money. But not JPM, since the debt is non-recourse and they are not liable. More importantly BSC bondholders not only will not lose money, but also they get $30B cash as backup from the federal government. With the buyout, they are actually being lifted from junk to investment grade, with previously holding bond claims to BSC being upgraded to now holding claims to JPM which is a much bigger and solid bank. So they get double covered.

In general, both JPM and government in this buyout really upgrade BSC bondholders but severely panelize equity holders. This is probably part of the reason why BSC was trading much higher than $2 last week since bondholders want to buy shares to get the voting rights to make sure that this deal will go through, at the expense of shareholders and us taxpayers. The only risk for BSC bondholders now is that this buyout deal doesn't go through.

Why is there such big disparity between the two classes of investors?

Thomas Z. Tan, CFA, MBA

Those interested in discovering more about me and reading my many other blogs can visit web site at Vestopia.com.

Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.

Copyright © 2006-2008 Thomas Z. Tan

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