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Bear Deal Shakes Market

Click to see a related story in the American Banker.

As municipal market participants arrived at work Monday morning, many set to examining the magnitude of JPMorgan's purchase of Bear, Stearns & Co., the fifth largest investment bank in the country.

JPMorgan Chase & Co. bought Bear Stearns for $240 million Sunday, guaranteeing commitments put at risk by margin calls that occurred over the last week. The draw of funds out of Bear Stearns led to many concerns that the bank would not be able to stand behind its commitments in the municipal market, where it serves as a counterparty on billions of dollars in derivative transactions.

Though not the largest, Bear Stearns is one of the "big eight" firms responsible for municipal derivatives, said Peter Shapiro, managing director at Swap Financial Group.

The deal, in which JPMorgan guarantees the trading commitments of Bear Stearns, appears to ease concerns that the troubles of the bank might spread to the governments and municipalities.

"JPMorgan Chase stands behind Bear Stearns," said Jamie Dimon, chief executive officer of JPMorgan Chase. "Bear Stearns' clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns' counterparty risk."

In surveying the news, and gauging the depth and safety of JPMorgan's guarantee, issuers and their advisors turned to the documents and conditions underlying the deals where Bear served as the counterparty. What they found is that in most cases, two subsidiaries are listed as counterparties: Bear Stearns Capital Markets and Bear Stearns Financial Products.

With the assumed completion of the JPMorgan deal - expected to be finalized by the end of the second quarter - the larger bank will serve as the guarantor of last resort. Much like investors asked for additional credit enhancement on bonds backed by downgraded bond insurers, JPMorgan will now serve as an additional guarantee for those subsidiaries, said one source.

"The way we read it, it looks like a strong guarantee," Shapiro said. "We're still sorting through the fine print."

One concern, Shapiro said, is for those issuers whose exposure to different counterparties is not diversified. If a large percentage of the portfolio is exposed to JPMorgan and Bear Stearns, the resulting portfolio after the transaction is completed will have even greater reliance on JPMorgan.

Market saturation in derivatives is certainly possible as the merged JPMorgan-Bear Stearns company would be the number one underwriter in 2008, serving as senior manager on 52 deals worth a combined $8 billion through March 16, according to Thomson Financial. Going back to 2000, the merged company would have been second or third most active senior manager every single year.

The nature of each swap agreement depends on what is written into the International Swaps and Derivatives Association swap document language, called the master settlement. The specific agreements govern whether a concerned issuer can exit a derivative transaction after a deal such as the JPMorgan-Bear transaction.

"Every transaction is different," said Linda D'Onofrio, partner at Blank Rome LLP.

Under ISDA regulations, there are standard events of default and termination events included in the documents. Within those, the parties can make changes or ensure that certain ones do not apply. A number of provisions also relate to mergers and acquisitions, and of those, three main conditions apply where an issuer can terminate the swap.

One of these is a termination event called a "credit event upon merger." In this case, a buying firm takes over the selling firms' assets. An issuer can terminate this transaction if the newly created firm is materially weaker from a credit standpoint than the original firm tied to the swap. The terms of this provision appear to most closely resemble the recent JPMorgan transaction, but the conditions do not because of JPMorgan's relative strength to that of Bear Stearns prior to the transaction.

"Traditionally Bear Sterns in the last several years has been among the lower rated among the top underwriters," said Peter Block, managing director with Standard & Poor's.

On Friday, all three rating agencies downgraded the corporate rating of Bear Stearns, and Monday Fitch Ratings updated the rating to reflect the beneficial effects of JPMorgan's involvement, moving Bear's rating to A-minus, from BBB. The rating remains on watch positive. Standard & Poor's moved the Bear rating to watch with developing implications, while Moody's Investors Service placed the rating on review for upgrade. All three affirmed JPMorgan's rating at AA-minus, AA-minus, and Aa2, respectively.

The second condition relates to an event of default called a "merger without assumption." This happens only in the case when the credit event upon merger does not occur, when the stronger entity fails to take responsibility for the assets and obligations of the weaker firm. The default occurs only as long as the credit support document - in which some transactions pledge the credit of a separate entity - does not apply.

And the third condition in which an issuer can terminate a swap related to a merged company under ISDA rules is through additional credit events, negotiated by the two parties before agreeing signing the contract. This could be tied to the ratings of the counterparty or any other event to which the two parties agree.

Many of these conditions depend on the deal's final structure, and many market participants agreed in saying that it was early in the process and difficult to predict the exact nature of the deal.

In the meantime, JPMorgan will guarantee the existing contracts, as well as all those completed between now and the date the purchase is completed or canceled. The Federal Reserve has already given its approval, and the sale is now subject to the approval of shareholders.

And while shareholders may be reluctant to approve the sale because it values the shares at such a deep discount - $2 a share when the stock traded near $30 on Friday - they may not have a choice. Many analysts have suggested that if JPMorgan had not agreed to the deal, Bear Stearns would be forced into bankruptcy.

Senate Banking Committee chairman Christopher Dodd, D-Conn., seemed to agree when he told reporters yesterday during a conference call that the federal government and JPMorgan took the "right action over the weekend" because "the alternative was a filing of bankruptcy by Bear Stearns."

With months to go before the final approvals are secured and the deal finalized, Shapiro advised issuers to keep a close watch as the details of the merger take shape.

"The major concern we have is if Bear shareholders turn down the merger," Shapiro said.

Lynn Hume, Ted Phillips, and Caitlin Devitt contributed to this story.

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