reflectivepundit

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.

 

Delegating Super Powers

By Sharyn O'Halloran

The great non-bailout bailout of ’08—the shotgun wedding (heard around the world) of Bear Stearns and JP Morgan—has generated widespread calls for a new, more capacious regulatory environment in which a Super Regulator (for instance, the Fed), will be delegated super powers to monitor firms’ risk profiles and demand higher reserve ratios to make it less likely that a single firm’s collapse can bring down the entire economy. The Treasury’s long-awaited “blueprint” for streamlined regulation, for instance, was finally released publicly, even though it failed to address the types of transactions that led to the Bear Stearns collapse.  The idea is to bring the shadow banking system out from under its penumbra and into the light of day.  

While this logic has gone from radical to common wisdom in the space of a few short weeks—the Treasury had delayed releasing its blueprint for month for fear that it would destabilize financial markets—its corollary has yet to be fully understood: namely, that the Fed will need to acquire a parallel set of obligations vis-à-vis elected officials. Let me explain. 

The Federal Reserve actually has two functions. In the first, acting though its Open Market Committee, the Fed sets the federal funds rate and the discount rate; the combination of these instruments determines the rates at which banks lend money to consumers. Its other, lesser-known, hat is that it acts as one of the chief regulators of the banking system. For a bank to open a new branch, for instance, it needs Federal Reserve approval. International financial institutions seeking to do business in the US are also subject to Fed supervision.  It is not for nothing that the entire Federal Reserve System employs over 20,000 individuals at an annual cost of over $1.2 billion. It is this second role that allows the Federal Reserve to make loans to individual banks, extend credit, and act as the lender of last resort, including its $29 billion “loan deal” to facilitate JP Morgan’s acquisition of Bear Stearns, which looks an awful lot like an equity purchase. 

And here is the rub. The Fed’s actions to salvage the financial system were bold, innovative and probably necessary. In its former roles as setter of monetary policy and overseer of the banking system, the Fed operated in relative autonomy. But in its new guise as Super Regulator, performing deeds of derring-do to rescue helpless (hapless) investment banks tied to the railroad tracks and about to be run over by structured investment vehicles, the Fed is itself taking on additional responsibilities without the accompanying political oversight. Standard theories delegation and discretion argue that in politically sensitive areas such as using taxpayer monies to cover billions of dollars of bad loans made by private sector financial institutions, elected official will want to have, and properly should have, a role. 

For instance, no one in the frenzied weekend of deal making bothered to notify congressional committees as to what was transpiring; the Fed will no doubt be feeling some of the backlash for its political misstep in Senate Banking Committee hearings later this week. 

This does not mean that Congress has either the desire or the capacity to micro-manage the Fed’s actions; indeed, committees will need to hire specialized staff members just to regulate the regulators. Especially in current times when banks are continually, devilishly inventive, devising new ways to move risky transactions off the balance sheet, Congress needs the expertise possessed by Fed officials to keep a handle on the system.  But just as importantly, the Fed needs the cover and legitimacy that only elected officials can provide when taking actions claimed to be in the public interest. As it now stands, the Fed has the enforcement powers of the DOJ combined with a hands-off system of minimal oversight. In the long run, this is a recipe for disaster. 

So by all means, let us give a single regulator the authority needed to oversee and efficiently manage the safety and soundness of our financial institutions for transparency and accountability. But at the same time, the amount of discretion such a super regulator will and should have must be balanced by the public’s need for transparency and accountability in the regulator’s own actions as well. 

The Clintons’ Tax Return

By Brigitte L. Nacos
The numbers in Hillary and Bill Clinton’s tax returns for the last 8 years are breathtaking—a total of $109.2 million since 2000 and $20.4 million in income last year alone. Most of this wealth was brought in by the former president on account of his fees for speeches all around the world. His and her book advances were not shabby either. According to a list of the Bill Clinton’s speeches from 2001 through 2005, he collected between $28,100 (London School of Economics) to $400,000 (Mito City Political Research Group, Japan) per speech for a total of $31 million during that period. But Bill Clinton is not unique among former presidents. After leaving the White House, Ronald Reagan collected $2 million for two speeches in Japan. George Herbert Walker Bush, too, made more than some change on the lecture circle—although he, unlike Clinton and Reagan, was never known as a great communicator. His son, the current president, told author Robert Draper, that he too wants “to hop on the lecture circle when he leaves office” and “replenish the ol’ coffers.” He guessed that his Dad made about 50,000, 75,000 dollars a speech.

To be sure, Bill Clinton does not only love to talk—he does it well, often and for eye-popping fees. Yet, I found it hilarious when NBC’s Andrea Mitchell reported this morning with great seriousness on the high income of the Clintons and the yet unknown implications for her presidential campaign. After all, Mitchell’s husband, former Federal Reserve Chairman Alan Greenspan, has used his retirement to give many speeches here and abroad for a reported $150,000 per speech. Since neither Greenspan nor Mitchell run for public office, they do not have to reveal their tax returns. But it is entirely possible that the former Fed chair earns as much for his speeches as Bill Clinton—or comes at least close to the former president. The $8 million advance for his book authored after his departure from the Fed is major league as well.
The Clintons are not an exception. Ex-presidents as others who leave high offices use their name recognition or notoriety or both to make money—big style.
And sitting and former first ladies and first sons and daughters collect hefty sums as well as authors or in other endeavors.
Whether we like it or not, that’s the reality.

Spitzer: A Democratic Tragedy

As reported in the Times, NY Gov. Eliot Spitzer's career just ended when he was caught arranging to meet with a high-priced prostitute in Washington. Unless he can convince the voters that he was -- sorry about this -- engaged in an undercover investigation of the damage that top-of-the-line calls girls wreak on society, he will have to leave office in disgrace.

Spitzer was a rare politician who did enormous amounts of good as NY state attorney general. He had a rough beginning as governor -- he was, after all, elected to be the unstoppable force that could reform the immovable object that is Albany -- but I think he would have grown into the job in time, and is one of the few people you could imagine being president someday. This is a loss for New York state and a loss for the Democratic Party.

Blog Newspaper The Issue: A Jewel in the Blogosphere

By Brigitte L. Nacos
If you are tired of surfing the blogosphere and look for more than your favorite blogs, there is a wonderful option: The non-partisan blog newspaper The Issue . This site resembles a quality print newspaper in a welcome departure from the noisy tabloid look that seems on the rise in the vastly expanding blogosphere. While the sophisticated lay-out is a bonus, it is the content and its presentation that stand out here. Most importantly, the editors present in literally each issue a marketplace of ideas consisting of pertinent posts chosen from a multitude of blogs—most of them not among the most popular sites.

The selected posts address a wide array of important questions and issues of our time and are organized along the line of broadsheets. Under “Featured Stories,” each issue of the blog newspaper presents contributions addressing current and/or generally important events, developments, problems, and the like. Today, for example, there are four featured stories, among them, “How much fiscal stimulus? Dollar amounts versus Efficacy.” The showcase section is the “Issue of the Day” with important topics discussed in posts from various blogs. “The Future of NATO,” “The Science of Aging,” “The Media’s Political Influence,” and “The Future of the GOP” were among recent topics with typically three different contributions and a short introduction by the editors.

Finally, the “Best of the Blogosphere” selections are presented in six sections: U.S., World, Business, Science & Health, Art & Culture, and Musings. There are cartoons, a book review section, and several other interesting features.

I need to disclose here that the The Issue has featured several of my reflectivepundit posts in the “Issue of the Day” and “Best of the Blogosphere” sections, but this is certainly not the reason why I visit this exceptional site regularly and why I recommend it. 

Abuse of Presidential Power: Will Giuliani top the Bush/Cheney Regime's Power Abuse?

By Brigitte L. Nacos
On my blog here, I have written repeatedly on the opportunistic and problematic positions that the former mayor of New York City Rudy Giuliani decided to take for the sake of hoping to bolster his chances to win the presidential nomination of the Republican Party. He certainly is a turn-coat on a whole range of issues—immigration, gun control, the perennial pro-choice/ pro-life controversy. At least some of his fellow-Republicans have caught on to this and attack him on these counts,. I have repeatedly posted on the extreme hawkish positions that “America’s mayor” takes against Iraq—in tune with his neo-conservative advisors who—we should not forget—got us into the Iraq mess in the first place. But thanks to an excellent report in the “Washington Monthly,” a publication I find to be a credit to the best in American journalism's tradition, the perhaps most important question about a possible Giuliani presidency concerns his style of governance—a democratic and transparent approach versus an authoritarian and secret model in the by know well known Cheney/George W. Bush mold. These are a few sentences of what Rachel Morris writes (and you should read her whole article at the Washington Monthly on-line site,

 

• Many Giuliani watchers already understand that Rudy is a hothead and a grandstander, even a bit of a dictator at times. These qualities have dominated the story of his mayoralty that most people know. As that drama was unfolding, however, so was a quieter story, driven by Giuliani's instinct   and capacity for manipulating the levers of government. His methods, like those of the current White House, included appointments of yes-men, aggressive tests of legal limits, strategic lawbreaking, resistance to oversight, and obsessive secrecy. As was also the case with the White  House, the events of 9/11 solidified the mindset underlying his worst tendencies. Embedded in his operating style is a belief that rules don't apply to him, and a ruthless gift for exploiting the intrinsic weaknesses in the system of checks and balances. That's why, of all the presidential      candidates, Giuliani is most likely to take the expansions of the executive branch made by the Bush administration and push them further still. The blueprint can be found in the often- overlooked corners of his mayoralty.

Bully-in-Chief Rudy Giuliani: The Risk of Whacking Hillary Clinton

By Brigitte L. Nacos
Assessing the latest debate of the look-alike lineup of Republican presidential hopefuls David Broder concludes in his column in the Washington Post that “Giuliani seized every opportunity to whack Hillary Clinton…” Even more constant in Giuliani’s public appearances than his phony phone-ins by his third wife are Rudy’s relentless attacks on the only female candidate in the large field of presidential contenders. Not surprisingly, Mitt Romney and John McCain on the Republican side and John Edwards and Barack Obama among Democrats attack Senator Clinton’s positions regularly as well—she is, after all, the front runner in the Democrats’ race and should be questioned and scrutinized. But Rudy has taken on the role of bully-in-chief in his efforts to score brownie points with conservative Clinton haters so that they might overlook what they see as his considerable personal and policy flaws.

Perhaps Giuliani will become the Republican presidential nominee by whacking Hillary and convincing his party’s primary voters that he is the only one who is tough and mean enough to beat Senator Clinton in next fall’s election. But in the long run, this tactic may entail more risks than benefits and come to haunt the candidate. Giuliani’s premier selling point is his tough guy image--tough on criminals, tough on terrorists, and tough on national defense and homeland security. By declaring the other night that Iran is more dangerous than Iraq was, he left no doubt about his preference for dealing with Iran: the Cheney way. On this count, too, he lashed out at Hillary Clinton as not tough enough although she is criticized by fellow Democrats in the presidential race for being too hawkish on Iraq and Iran, etc.

 

Alberto Gone-zales

by David Epstein

My fellow Americans, our long national nightmare is over. Alberto Gonzales has --- at long last, and somewhat surprisingly --- resigned.

The analogy to Watergate is apt; not since Nixon has the executive branch done so much damage to the Constitution. But historians will have a hard time, I predict, determining whether Gonzales did more damage with the policies he promoted, as opposed to his spectacular mismanagement of the Justice Department, which has now been gutted of many of its skilled, dedicated employees, to be replaced by partisan hacks. Gonzo, you did a heck of a job.

The timing is a bit curious, too. Is this Gonzales's version of leaving on his own terms? Rove wouldn't resign after the 2006 elections; he gutted it out for another half a year in order to prove that no one was forcing him out. (On the other hand, this had a price: the fact that his leaving was treated as a bit of a non-event just underscored how irrelevant he had become in the interim. Better, I think, to leave at the zenith of your unpopularity than to slink away as a diminished former-someone.) Perhaps Gonzales didn't want to leave right after one of his so-horrible-it's-(almost)-funny testimonies before Congress, but before he was actually impeached or indicted for perjury. (And if he really did commit perjury, that investigation should continue, but of course it won't.)

So, what's next for his former eminence? He's still a close Bush friend, of course, which would indicate at least a cushy lobbying job or a high-end law firm in Texas. But he might have made himself radioactive by agreeing to wash the administration's dirty laundry for so long. Perhaps the Hoover Institution needs another senior scholar....

Cheney’s 1994 Conclusion: Take Over of Iraq Would Cause Quagmire

By Brigitte L. Nacos
When searching archived video tapes for material to be part of a day-long program about the “Life and Career of Dick Cheney” on C-SPAN 3, producer Emmanuel Touhey discovered a C-SPAN interview with the former secretary of defense from 1994. At the time of this interview, when Cheney himself contemplated a run for the White House, C-SPAN’s Bruce Collins asked him why he had been against U.S.forces moving on to Baghdad during the first Persian Gulf War. Cheney said, “It’s a quagmire, if you go that far and try to take over Iraq.”Moreover, as the video material now available on YOUTUBE reveals, nine years before the 2003 invasion of Iraq and the removal of Saddam Hussein, Cheney predicted precisely what has unfolded in Iraq since the invasion and the fall of Saddam Hussein. In 1994 he asked rhetorically, what would happen after the removal of Saddam Hussein and the central government? His answer was that that pieces of the country would be “flying up” and that Syria would try  to take a piece of western Iraq, Iran part of the Eastern part, and a consolidated Kurdish part would be a threat to Turkey. Noting that 146 Americans had died during the Persian Gulf War, Cheney asked furthermore: How many additional dead Americans is Saddam worth?"

As of today (according to Iraq Coalition Casualties), 4,004 members of the coalition forces have died since the invasion started in March 2003—3,707 of them American servicemen- and –women. 23,308 coalition forces, 23,877 of them Americans, were wounded or for other reasons medically evacuated. And it is a good bet that many, many more innocent Iraqis were killed and maimed and millions forced to leave their homeland.
Mary Ann Akers wrote in the Washington Post that Cheney during an interview with ABC News earlier this year was asked “how his views had changed from 1991, when he also spoke of military action in Iraq as a ‘quagmire.’ ‘Well, I stand by what I said in '91," Cheney told ABC. "But look what's happened since then -- we had 9/11."
Since there is no credible evidence for a connection between Iraq and Saddam Hussein on the one hand and 9/11 on the other, it is high time for the vice-president to ask: How many additional dead Americans are the dead Saddam Hussein and the Iraq quagmire worth?

“Bush’s Brain” Quits: What Next for Karl Rove, the White House, and the GOP?

By Brigitte L. Nacos
In their fascinating book Bush’s Brain: How Karl Rove Made George W. Bush Presidential, James Moore and Wayne Slater write that “without Karl Rove, there would be no President George W. Bush.” According to the authors, the brilliant and ruthless campaign consultant Rove, who has had long ties to the Bush family, was instrumental in George W.’s gubernatorial and presidential campaigns. When he moved into the White House, he became President George W. Bush’s permanent political consultant and, as befitting for “Bush’s Brain,” something like a co-president. Now, after several top White House aides have left their posts already, Rove announced his departure in an interview with Paul. A. Gigot, the Wall Street Journal’s editorial page editor. But although under clouds for his role in the CIA leak case and, as today’s Washington Post put it, “under scrutiny by the new Democratic Congress for his role in the firings of U.S. attorneys and in a series of political briefings provided to various agencies across government,” Rove is  upbeat with respect to President Bush’s remaining time in office and the chances of the Republican Party in the 2008 presidential election. While insisting that he is through with political consulting, Rove is already thinking ahead to 2008 telling Gigot, “if we keep our nerve and represent big things, we'll win." Jim VandeHei and Mike Allen write in The Politico, “In happier days, friends expected Rove to serve — whether in government or not — as the liaison between Bush and the ’08 GOP presidential nominee. Now Rove recognizes the nominee needs to be his own man, with separation from an unpopular administration, so any role he plays will be very behind the scenes according to colleagues.” In other words, while not signing on with another presidential campaign, Rove is likely to play some role in the GOP and the campaign of his party’s presidential nominee.