The Bear Stearns Takeover Game

by David Epstein and Sharyn O'Halloran

There is a standard story emerging about how we should think of the Bear Stearns takeover.  Not in regard to its effect on capital markets, now or in the future, but the actual back-and-forth negotiation of whether JP Morgan was going to take over Bear Stearns, and if so at what price and under what conditions.

We tell the story three different ways. First, the conventional wisdom as of now, which paints a picture of frantic negotiations to avert a looming crisis, but which, we argue, leaves some important questions unanswered. We then offer two different game-theoretic analyses of the takeover which address those questions, albeit in different ways. The end result, we believe, is an interesting example of how the tools of game theory can help analysts understand the strategic underpinnings of economic transactions.

1. According to the usual story, JP Morgan went into the weekend of bargaining thinking it could offer $10 per share of Bear Stearns. Over the weekend it started doubting that price, and it was about to walk out on the deal when the Fed, anxious to avert a total financial meltdown, negotiated a $2 per share price instead. This was sufficient to let the deal go through, but then the shareholders revolted and JP Morgan got a lot of bad press in the ensuing days. To improve its image JP Morgan upped the bid back to $10, which was then accepted to everyone’s mutual satisfaction.

This story makes sense as far as it goes, but then why all the poison pills/lock-in provisions in the deal? Why were these insisted on, and why did the Fed agree to them? And in this story James Dimon, the JP Morgan CEO, is portrayed as misjudging his initial offer, complaining about not being able to send Bear Stearns into bankruptcy, and then reversing course under pressure. Did he really make such basic errors?

2. The second story is an incomplete information game theory story; unusually, it is more straightforward in this case than the complete information story to come next. According to this version, JP Morgan didn’t know how much Bear Stearns stockholders would accept, so it started low and bid up from there, as any game theory text would tell them to do. This strategy had risks for both sides; if bargaining fell apart then the firm could implode, to no one’s benefit. This means that the negative reaction to the initial bid was a truly costly signal, and JP Morgan understood it as such, hence raising the offer.

This story makes Dimon look more like a shrewd negotiator than the previous one; we might even be able to excuse his complaining about not being able to send Bear Stearns into bankruptcy as a bit of theater, aimed at moving the negotiations along. But we still need an explanation for the lock-in provisions, and the Fed’s eager acceptance of them.

3. Finally, the complete information game theory story. Here we’ll more carefully define preferences and the game being played, illustrated in the figure below. Let’s assume that there are three options: continued operations by Bear Stearns (O), bankruptcy (B), and a takeover by JP Morgan (T). Bear Stearns management and the board had preferences O-T-B: they would have liked to keep operating, perhaps with an injection of liquidity from the Fed, but they preferred an orderly takeover to bankruptcy. The Fed and JP Morgan both had preferences T-O-B, preferring the takeover most of all, and again fearing the chaos of bankruptcy. Bear Stearns shareholders had preferences O-B-T; they could try to tough it out as things were, otherwise they actually preferred bankruptcy to a takeover, since in the former option they could bargain with bondholders to get a higher share price than they would from JP Morgan.

The game is played as follows. First, the Fed decides whether or not to offer Bear Stearns the opportunity to borrow short-term to cover its debts. If it chooses to lend, then Bear Stearns management (BS^Mgmt) gets to choose whether to try and keep operating or go into bankruptcy. Once the Fed denies Bear Stearns the liquidity, then operation really isn’t a choice any more, and the only question is whether a takeover can be arranged. JP Morgan has to approve any takeover; if they reject then bankruptcy is the result. If they accept, then Bear Stearns equity holders (BS^Equity) have to accept as well, or again we have bankruptcy. 

And here, perhaps, is the solution to the problem. Note that every player except the equity holders had bankruptcy as their least favorite option. But since the equity holders have the last play in the game, and they prefer bankruptcy to a takeover, the whole deal would be in jeopardy. That’s why the lock-in provisions were so important; they raised the costs of declining the deal so that the equity holders would actually prefer the takeover to bankruptcy. Dimon was upset because he realized those provisions were insufficient to close the deal, forcing JP Morgan to pay more to get shareholders to agree than they had planned. And the Fed favored these provisions as a necessary element of getting a deal done and avoiding Chapter 11.

The insight gained from this analysis is that the weakest link in the ratification chain drives outcomes in takeover deals. Here, it was the equity holders, with the most to lose from the takeover, whose preferences shaped the final bargain. Note too the differences between outcomes here and outcomes in the usual bargaining games. When any party to a bargain can simply walk away from the table and thereby enforce the status quo, then in equilibrium all other players usually have to pay extra to accommodate the party most reluctant to make the deal. In the brokered takeover scenario depicted here, though, the Fed made the status quo untenable by refusing to lend to Bear Stearns initially, thereby weakening the equity holders’ bargaining position. So rather than make them better off, the deal was structured to make them worse off; the lock-in provisions made bankruptcy less appealing and coerced the equity holders to settle. Thus bargaining in a brokered settlement looks more like politics, with coalition formation and strategic agenda control, than the standard alternating-offer bargaining scenario of economics.

Contrast this result, then with Washington Mutual’s recent rejection of JP Morgan’s takeover bid of $8 a share. Since this was not a brokered takeover, WaMu management simply walked away from the deal and instead sold the equivalent debt to a private equity fund. This maneuver was probably not in shareholders’ interest (the stock price fell the day the deal was announced), but it let the current managers keep their jobs. Here, the managers were the weakest link in the chain, and since the JP Morgan offer did not make them unequivocally better off, they preferred a white knight to selling.

 

Comments

[Wow]

You make some interesting assumptions:

1) The Fed prefers a takeover to continued operations (T-O-B). Why? Because a takeover benefits JP Morgan and the Fed’s interests are aligned with JP Morgan at the expense of Bear Stearns? I think you hit the nail on the head with “…more like politics, with coalition formation and strategic agenda control…”, but this seems like an odd stance for the Fed to take.

2) “If it chooses to lend, then Bear Stearns management gets to choose whether to try and keep operating or go into bankruptcy.” I don’t see how this is necessarily so. This presumes the Fed is unable to make lending conditional on Bear Stearns management making all efforts to avoid bankruptcy - which we can both agree would be their default preference (O-T-B).

3) “The lock-in provisions made bankruptcy less appealing and coerced the equity holders to settle.” Which equity holders have settled? As of today nothing has been voted on or finalized by shareholders.

Based on the shares consistently trading above the offer price it seems as though there won’t be a settlement. And maybe this is, in the end, exactly what the Fed wanted. Back to my first point – it seems the Fed actually wanted O-T-B and this is a very convoluted way of getting it. The elaborate methods employed were necessary to buy Bear Stearns some time – and time is all that was really needed to restore confidence in the company.

What the actual deals are (behind closed doors) and how all the public deals get cancelled out in order to return to normal will be interesting to see.

A very interesting case study indeed!