by John Berlau
March 27, 2008

After an outcry from Bear Stearns shareholders in the takeover brokered by the Federal Reserve Bank, JPMorgan Chase has just upped its offer from $2 to $10 per common share. But Bear's shareholders, as well as U.S. taxpayers, are still getting a lousy deal.

The deal is lousy not because of the share price offered — although $10 a share still may be chump change for a company selling for $30 just before the deal was announced a week ago and more than $80 at the beginning of the year.

Bear's officially stated book value is also $84 per share. Perhaps that is too high, but even if the book value were half that, $40 is still four times higher than the $10 that Morgan plans to pay shareholders.

But the real reason the deal is so flawed is the unprecedented government-sanctioned breach in corporate governance practices. Shareholders, the true owners of the company, are being denied a voice in the fate of the firm.

Forcing the merger of Bear with Morgan, which is basically what the government did, and offering $30 billion in guarantees so there will be very little downside risk for Morgan is a horrible long-term precedent for the taxpayers, shareholders and the U.S. economy.

In this bailout, the government sided with creditors at the expense of shareholders of Bear Stearns common stock. By forcing this fire sale, the Fed ran roughshod over thousands of investors' interests, and whatever effects this has on the credit market, the precedent may do untold damage to the retail investor market for equity in firms through common shares.

It's Their Company

Investors may think twice about buying common stock given this precedent of the government strong-arming shareholders into a bad deal.

The Morgan acquisition still has to go to a shareholder vote, so despite impressions from the media, it is far from a done deal. Other banks, brokerage houses and private equity firms reportedly have expressed interest in acquiring all or part of Bear. But the government has made it difficult for them to do so by giving Morgan the special backing of accepting its mortgage-backed securities as collateral.

It's not too late for the government to do right by taxpayers and Bear shareholders. Now that the Fed is lending to investment banks at the discount window — whatever the merits of that policy — there is even less justification that this brokered deal is still needed to avert a panic.

The government should withdraw its offer to Morgan to guarantee Bear's mortgage-backed securities, and at the very least, not ride further roughshod over shareholders and Bear's other potential suitors.

The government should do this not because Bear's investors have any sort of entitlement to a higher share price, but because they are entitled, as every company's shareholders are, to a voice in the running of their company.

Shareholders, like creditors and bondholders, take different risks when they bet their money on a company. As owners, shareholders reap more returns when a company does well, but are the last in line — behind creditors and then bondholders — when a company goes bankrupt.

Private Solution

But in this case, the government played favorites and backed a deal that shielded creditors and others from risk by likely worsening the result for shareholders. The justification that Bear was "too big to fail" and default on it creditors doesn't stand up to scrutiny. If creditors knew that the government wouldn't protect them from their own risks, Bear likely wouldn't have gone bankrupt.

If Bear were truly "too big to fail," then its creditors would have a vested interest in keeping it from failing. They would negotiate payment plans that would keep it solvent and able to repay them, albeit perhaps a little slower than they would like.

Without a bailout, creditors probably would be "pressuring each other not to flee . . . institutions like Bear," argued Manhattan Institute financial expert Nicole Gelinas in The Wall Street Journal.

This is especially true given that the value of mortgage-backed securities are in flux. Any value is an estimate because no one knows how many loans in the securities will be repaid. But given that, according to the latest National Delinquency survey, only 2% of mortgage loans are in the foreclosure process, it's a safe assumption that a good many loans will probably be repaid.

Bear's investors have every right to seek a better offer, pursuant to company bylaws and the laws of the state where the company was incorporated. The Fed and the Feds should not stand in their way. A freeze in the rule of law is still much more dangerous than even a severe chill in the credit markets.