Bankruptcy Fears In Bear Stearns Options

There was wild action in Bear Stearns options today as share prices hit a 5 year low following Moody's downgrades of Alt-A deals.

Shares of Bear Stearns (BSC) Cos. tumbled to a 5-year low Monday, weighed by downgrades of Alt-A deals by Moody's Investors Service, as well as a negative comment on brokers in general from Bernstein Research.

Moody's downgraded the ratings of 163 tranches from 15 deals issued by Bear Stearns ALT-A Trust, with 78 downgraded tranches remaining on review for possible further downgrades.

Moody's said the downgrades are based on 'higher-than-anticipated rates of delinquency, foreclosure and [repossessed foreclosures] in the underlying collateral relative to credit enhancement levels.' Separately, Bernstein said it would not recommend buying broker stocks at this time as they are still susceptible to further book value reduction.

Bear Stearns Weekly Chart


click on chart for sharper image

Normally I would suggest the chart tells the story but in this case the rest of the story is quite interesting, and Minyanville was on top of it.

Bankruptcy Fears In Bear Stearns Options

Professor Jon Najarian (Dr.J) had this to say:

Bear Stearns (BSC) volatility in the front month March calls now tops 160 for the at the money 60 puts. Volatility in April at the money options is also sky-high, pricing at 125%. As a metric for comparison, the 100 day average volatility in Bear Stearns was 55%.

We've got very active put buying all the way down to the March 30 puts, but the institutional paper is trading in the March 60, 55 and 50 puts. In other words, the amateurs are buying up what they perceive to be “cheap” puts below the 50 strike, but most professional paper is more realistic.

The April 55 put (BVDPK) are up $3.90 to $6.00 on double the open interest. Volume tops 6,300 puts at this strike, against 3,200 open interest. Just how desperate are the put buyers?

Well, my DepthCharge shows buyers of the January 10 puts of 2009, where nearly 3,000 puts have trade up $.55 to $.85, a gain of 185 percent on the session. Like the action in Washington Mutual (WM) we cited Friday, this is bankruptcy fear rearing its ugly head in Bear Stearns, folks.

On the session over 95,000 puts have changed hands in BSC, or nearly five times the open interest in the first 2 ½ hours of trade.

Daisy Chain Reaction

Professor Bennet Sedacca was writing about Lehman (LEH) and Bear Stearns (BSC) in Changing the Benchmark. Let's take a look.

When I look at the Lehman Brothers' (LEH) balance sheet and see it levered 40 to 1, I wonder how on Earth did anyone allow it to get that leveraged? Consider that Lehman has four times as many ‘Level 3 Assets’ (those that are ‘hard to price’) as it does capital. Hard to price in my book equates to ‘hard to sell’.

Perhaps the most interesting part of all of this is that Lehman recently announced a share repurchase of 100 million of its shares for a cost of $5 billion or so. At the same time, it floated a preferred stock deal at 7.95% and issued billions of dollars of new debt for itself. This occurred just as the firm's mortgage and other debt related write-downs began that will likely run into the tens of billions of dollars. In other words, rather than de-leveraging, it's adding leverage. I guess this is why my firm is short Lehman debt.

The same goes for Bear Stearns (BSC) and many others. To prove the point, what do you think would happen if Lehman and Bear were told by regulators to sell its ‘hard to price’ assets? I find it highly doubtful it would be able to sell them and hence, this leads me to question their solvency. What about the other $600 billion of assets on Bear's balance sheet? Could it sell them? Doubtful. The reason is that everyone else owns the same type of securities and the company is being instructed to sell, yet cannot.

So the ‘daisy chain ‘has started whereby when one firm is forced to sell, it must ‘mark to market’ which means everyone else who owns the same security has to mark theirs down as well. Wouldn’t one conclude that firms like Lehman should have been shrinking its balance sheet over the past year? Of course, but lo and behold, its balance sheet grew by over 30% year over year.

See Lehman’s balance sheet below, courtesy of Bloomberg. Just for emphasis, I added Bear Stearns’ balance sheet as of November 2007. Both of these companies will be reporting quarterly earnings in the next couple of weeks as their quarter ended in February.

If you were their auditor (and I have asked many CPA’s this question), would you sign their 10-Q knowing they have no idea how to price what they own? If they are forced to mark their assets to market (as if there actually is a market for many of their holdings) they might be forced into bankruptcy.

Lehman Balance Sheet as of November 2007
Bear Stearns Balance Sheet

Desperate Moves by Desperate People

Ever since I saw Trading Places back in the 1980’s, the phrase ‘SELL, Mortimer, SELL!’ has stuck with me. The worst feeling an investor can have is to be leveraged and have prices go against you and be told you have to sell. This is otherwise known as a margin call. But what happens if you're told to sell and there's no market for what you have to sell? What do you do? What does your counterparty do? They expect you to sell but you can’t. In ‘Trading Places’, the Duke Brothers got ‘wrong-sided’ in orange juice futures and had to sell to Eddie Murphy and Dan Ackroyd. They were leveraged to the hilt, and of course had to sell at precisely the wrong time. Such is the case with Thornburg Mortgage (TMA) and many others. They are being told to sell, but cannot. Banks and brokers ‘have no balance sheets’ as they like to tell all of us. Others like my firm refuse to bid so the market goes into limbo and we're left to guess if these firms are actually solvent. There's just not enough liquidity left in the system to absorb the forced selling.

Later in the day, Sedacca quipped "Now the stock is plummeting and its CDS has blown out from 450 basis points to 750 basis points. I smell something rotten and am still short their debt along with others."

Earlier today I wrote The Great Pretender. I would like to add another point: We are now pretending our entire economic system is sound. Clearly it's not. And the Fed specifically, and central bankers in general are two big reasons why.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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