Bear Fight - A most bearish view on Bear Stearns in a bear market

Bear fightThis is an introduction and precursor to the work being done over at Reggie's laboratory concerning Bear Stearns, who has seen its share price halved since the credit market melee kicked off. A melee that many say the Bear is responsible for igniting. I don't know how fair a comment that is, but I do know one thing, though. In terms of equity devaluation for the bear, you probably ain't seen nothin' yet. Bear Stearns will soon be, if not already, in a fight for its life. It is beset with the possibility of a criminal indictment (no Wall Street firm has ever survived a criminal indictment), additional civil litigation, and client defection and aliention. Despite all of these, the biggest issues don't seem all that prevalent in the media though. Bear Stearns is in a real financial bind due to the assets that it specialized in, and it is not in it by itself, either. It's excessive reliance on highly "modeled" and real asset/mortgage backed products in its portfolio may potentially be its undoing. See Banks, Brokers and Bullsh1+ part one for a run down on model risk and part two for my take on counterparty credit risk as a backgrounder before reading this piece.

I thought of sharing with you some of the key observations that we've made while doing the valuation model for Bear Stearns, which admittedely is quite late. I first took interest in Bear Stearns in June, but only recently got around to addressing the investment banking sector in a matter suitable for the blog over the last month. During that month, BSC has seen aggressive adverse price action. My research tells me that this price action is not only justified, but will have to continue in order for BSC to be adequately priced. There will be details that support this assessment in the final report.

Bear Stearns first caught my interest at around $130. When we started with the original shortlist of the investment banks for formal analysis on December 13, 2007, Bear Stearns stock price stood at $98.39. The stock price has fallen by more than 27% since then and now trades at $71.17.

External fundamentals behind my call for additional adverse price reaction

The company's exposure to the asset and mortgage backed securities is as follows:

Mortgage and Asset backed inventories of $43.6 billion

Amount in US$ billion
CMBS	15
RMBS and others	28.6

Total	43.6

See the following charts for the macro fundamentals beneath the adverse future price movement in both RMBS and CMBS.

Residential Price Movement Expectations

Shiller housing forecast

Commercial Price Movement Expectations

Commericial Rents

Bear Stearns' Mortgage and Asset backed Securities of $46 billion

Amount in US$ million
Subprime Mortgage loans	500
Investment grade subprime securities	1,100
Below investment grade securities	200
ABS CDO	750

Total	2,550

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Internal fundamentals behind my call for additional adverse price reaction

The company's top employees sold stocks worth over $20 million in December 2007. In fact, before resigning a couple of days back, Bear Stearns Chief Executive James Cayne sold $15.4 million of stock in December 2007. Cayne exercised and sold 172,621 shares of stock vested under a capital accumulation plan according to a filing with the SEC. However, Cayne still owns 5.6 million shares, or about 5% of the company.

In addition, In a Form 4 filed with the SEC, Bear Stearnï¿½s President, Alan Schwartz reported he exercised options December 21, 2007 at no cost as part of a compensation plan and sold 67,900 shares the same day for $89.01 apiece. Further, An Executive Vice President exercised options for 102,408 shares of common stock according to a SEC filing. The bankï¿½s Treasurer exercised options for and sold 25,927 shares of common stock in the same month.

Furthermore, On 08 January 2008, Moody's Investors Service downgraded the ratings of 46 tranches issued by Bear Stearns in 2006 and placed under review for possible downgrade the ratings of 11 tranches from eight Alt-A deals issued by Bear Stearns in 2007. The ratings of 24 tranches were downgraded to junk status, while 13 others had their ratings lowered but remained above junk status. In addition, the nine tranches already considered as junk status were cut further. Moody's said it took its action based on higher-than-anticipated rates of delinquency, foreclosure and banks owning real estate relative to credit-enhancement levels. We are trying to get some more information on the exact tranches which could impact the companyï¿½s estimated earnings in Q108 and FY2008. This is directly related to the work that we did with Ambac and MBIA (see list of links at end of article), for Ambac insures some of these tranches and we find the leverage and exposure for Ambac to be a disaster waiting to happen. There is also a direct connection to the model risk (of which Bear Stearns has singificant amounts) and counterparty credit risk that was loosely described in the Banks, Brokers and Bullsh|+series (Banks, Brokers, & Bullsh1+ part 1, Banks, Brokers, & Bullsh1+ part 2).

The company in its previous quarterï¿½s earnings call also mentioned that it has considerable investment in the troubled bond insurer ACA Capital Holdings. ACA Capitalï¿½s bond insurance unit has been taken over by the Maryland insurance administration owing to the troubles faced by the bond insurer. The company was recently downgraded to junk territory by S&P, resulting in a cash shortage for the company. ACA recorded a $1.04 billion loss in third quarter owing to recent turmoil in the credit market. A substantial exposure to collateralized credit obligations with a significant amount of asset-backed or mortgage-related debt obligations contributed to the company's third quarter loss. The relationship between the types of assets Bear Stearns holds in its inventory, the current default rates, the litigous liability exposure, the precarious situation of the mononlines (actually, the multi-lines, since the only ones that are in trouble are the ones that strayed from their knitting) and where my research says the underlying must move price wise to achieve equilibrium, just may cause Bear Stearns to enter into a spiral where no amount of PRUDENT capital may be able to rescue it. For more on my findings of how the flaws of this monoline turned mult-line business model will reverbrate throughout Wall Street and Main Street, start with A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton, then follow the bullet list down at the end of this article.

Despite these negative developments, Bear Stearns has managed to find investors. British financier Joseph Lewis owns 9.6% of Bear Stearns. He has acquired nearly 2 million more shares. In September 2007, Mr. Lewis had become the single-biggest investor in Bear Stearns, acquiring shares soon after two Bear hedge funds collapsed because of bad bets on securities backed by mortgages. He spent some $860 million to buy 7% of the company when the stock was trading at more than $100 a share. However, with the stock's fall, Mr. Lewis has a paper loss of well into, if not over the $100 to $200 million range. The latest SEC filing said Mr. Lewis has spent about $1.19 billion to buy Bear shares, spending an average $107.31 each. Also, in October 2007, Bear Stearns and Beijing investment bank CITIC Securities Co. agreed to invest about $1 billion each for minority stakes in one another. The companies agreed that CITIC's resultant ownership in Bear Stearns can be expanded to as much as 9.9%, and Bear's combination of convertible-securities holdings and five-year options in CITIC could, over time, amount to about 7% of the Chinese investment bank. These investors, obviously have an outlook on the bank that is contrary to mine, and would obviously be on the opposing side of any trades that took place.

Model Risk Bear Sterns Companies Inc
In $ Billion	Level 1	Level 2	Level 3	Impact of netting	Balance as of August 31 '07
Financial instruments owned, at fair value
Non-Derivative trading inventory	26.8	85.7	14.6	-	127.2
Derivative trading inventory	2.2	94.3	9.0	(90.9)	14.7
Total FI owned at fair value	29.1	180.1	23.6	(90.9)	141.9
Other Assets	0.7	0.9	3.7		5.3

Total Assets at fair value	29.8	181.0	27.3	(90.9)	147.2

This has already presented itself in the dual hedge fund blow up over the summer, the recent and massive losses, and the recent announcement that they will be moving at least 7 billion dollars to the level three (BS) category. Bear Stearns has also very recently announced another hedge fund blow up, which doled out significant losses to investors and is attempting a liquidation.

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Counterparty Risk

In $ million		OTC Derivative credit exposure ($ million)
The table summarizes the counterparty credit quality of the company's exposure with respect to OTC derivatives
Rating(2)	Exposure	Collateral (3)	Exposure, Net of Collateral (4)	Percentage of Exposure, Net of Collateral	Total exposure a % of Total assets	Net exposure as a % of Total assets	Net exposure as a % of equity
AAA	3,369	56	3,333	42%	0.8%	0.8%	25.6%
AA	6,981	4,939	2,153	27%	1.8%	0.5%	16.6%
A	3,869	2,230	1,784	23%	1.0%	0.4%	13.7%
BBB	354	239	203	3%	0.1%	0.1%	1.6%
BB and lower	1,571	3,162	322	4%	0.4%	0.1%	2.5%
Non-rated	152	223	94	1%	0.0%	0.0%	0.7%
	16,296	10,849	7,889	100%	4.1%	2.0%	60.7%

(1) Excluded are covered transactions structured to ensure that the market values of collateral will at all times equal or exceed the
related exposures. The net exposure for these transactions will, under all circumstances, be zero.
(2) Internal counterparty credit ratings, as assigned by the Companyï¿½s Credit Department, converted to rating agency equivalents.

Mortage securitizations, BSCs primary value driver has dried up, thus so has their excess returns, and the vast majority of their normal returns as well

Securitizations, BSC's bread & butter value driver has dried up, and this dearth of cash flow will reverbrate throughout their business model, on a leveratge basis for their is still some risk from past products as the headlines have made clear

Net Income looks to be sparse for some time due to the loss of their main value driver

Net Revenues dropped significantly in Q407, unadjusted forcast sees 60-65% return. This may be adj. down once my proprietary housing forecasts are applied

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Capital Markets Revenue show a similar pattern, and is primarily what cause the drain on the company, along with asset management (unhedged hedge funds), of course

BSC Leverage::Like many banks on the street today, BSC uses enough leverage to get it in trouble with large moves in the undelying assets

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In the news:

Probe of Bear Stearns Hedge Funds Is Broadened
Probe of Insider Trading at Bear Stearns - According to a commenter on this article, the "authors fail to raise the issue of Bear Stearn's ongoing appeal against a court ruling regarding its handling of the Manhattan Fund scandal almost 8 years ago. Clearly, the firm's hedge fund troubles go back some way."

I will be presenting my full analysis of Bear Stearns, complete with my realistic valuation models, on the boombustblog.com some time next week. Stay tuned.