Is JP Morgan in a Quagmire?

Mr. Jamie Dimon, Chairman and Chief executive of JP Morgan recently raised the bid price for Bear Stearns to $10 a share which takes the bid to $2.1 billion. This is supposed to be a fair deal, or at least fairer than the last offering, much to please the investors and the employees. But still 1/3^rd less than the valuation on March 14, 2008. Valuations and the actual crisis at Bear Stearns aside the earlier valuation of $240 million or so was really a joke for a firm like Bear Stearns. The bailout by the Fed will be in end be financed by American tax payers money. One can argue that the actual fall would have been even more damaging to the American financial system.

Bear Stearns currently owns $30 billion of least liquid assets out of which $29 billion will be financed by the Fed and JP Morgan will bear losses of $1 billion. JP Morgan already has set aside $6 billion for lawsuits and merger costs. This is three times more than the cost of acquisition itself . Besides being big in home equity loans (read subprime mess), it is number one in the US in Credit Default Swaps. This really should be worrying.

What is a Credit Default Swap (CDS) anyway?

It’s an agreement between two parties to take responsibility for the credit risk for a third party entity can offer.

Alright, so what does it mean?

For a buyer:

A buyer will pay a periodic fee to a seller of a CDS to offer him protection in case a third party is to default on a payment. This offers him guarantee that his liability over this credit risk is limited.

For Seller:

In case a third part defaults on credit taken the seller of a CDS has to pay the buyer of a CDS with whatever sum agreed. The seller here can either take over the defaulted credit position or pay upfront to the buyer of a CDS whatever is the difference.

Mr. Dimon has sure has a tough task at hand at merging Bear Stearns and keeping his own firm in sound financial health.

Time magazine here has an excellent write up regarding a potential CDS crisis.