By all accounts, JPMorgan (JPM) has all the leverage to complete its proposed acquisition of Bear Stearns (BSC) for $2.00 per share. Actually, since it is a stock deal and JPMorgan shares have risen since the announcement, the acquisition price is now $2.40 per share.
Still, for a deal likely to be made at $2.40 per share, why would anyone be willing to pay $5.00 per share for the stock today? One answer that keeps getting bandied about is that bondholders are buying the stock in order to vote for the deal, as it is worth losing some money on the stock to preserve the value of the bonds.
That argument makes some sense, but I believe it doesn’t tell the whole story. It is possible for the bondholders to not only preserve the value of their bonds, but to lose very little on the stock in the process.
While the stock has been getting all the news, options on Bear Stearns have seen enormous trading volume. I think the bondholders are buying the stock, but hedging their bets by creating synthetic short positions.
A synthetic short consists of writing a call option and buying a put. Here’s how I think a bondholder can be playing this:
Buy 100 shares for $5
Write an October $5 call option for 2.10 (bid price as I write this)
Buy an October $5 put for $2.45 (ask price as I write this)
Net cost for this transaction is $5.00 + 2.45 - 2.10 = $5.35. At expiration, it will be worth $5.00 no matter where the stock is trading. So, for $0.35 per share, or $35 for every $500 of exposure, the bondholders can buy the right to vote on the deal.
Given that the bonds were trading at $700 per $1,000 face value on Friday, and are worth $1,000 when backed by JPMorgan, it is pretty simple math. For every $1,000 of bond exposure, you can pay $70 to vote in favor of a deal that is worth $300 to you.
What’s more, since there was so much more debt than equity, only a small fraction of the bondholders need to make this bet to gain an overwhelming majority of the equity votes. Or, each bondholder could insure a smaller portion of their value.
Taking that into consideration, paying $5.00 for the stock starts to make sense.
Provided, that is, you already own the bonds.
