We got a call today asking about our thoughts on the mystery of the Bear Stearns stock price. How and why could the stock trade so far above the buyout price, now a bit higher than $2?
Our reply was that the theories of purchases by bondholders, owners of credit default swaps, or current shareholders made little sense. It was more likely that buying was coming from those who already had a concentrated position, like Joe Lewis. News released after the close today confirmed that our opinion was correct.
Why? The problem is a classic case of "collective action."
The Logic of Collective Action
In 1965 Mancur Olson, Jr. wrote a seminal book (now on our reading list) linking theories in political science and economics. The basic thesis was that free markets had difficulty with situations where benefits were concentrated and costs were diffuse. Wikipedia has an acceptable summary:
The book argues that individuals in any group attempting collective action will have incentives to "free ride" on the efforts of others if the group is working to provide public goods. Individuals will not “free ride” in groups which provide benefits only to active participants.
Public goods are goods which are non-excludable (i.e. one person cannot reasonably prevent another from consuming the good) and non-rival (one person’s consumption of the good does not affect another’s, nor vice-versa). Hence, without selective incentives to motivate participation, collective action is unlikely to occur even when large groups of people with common interests exist.
The book provides a rationale for when government action is necessary. A classic case would be national defense. We all want it, but it would not be adequately funded if we passed around a hat. Each person would have the choice of free riding and enjoying the benefit of the public good.
Incentives for Various Participants
There are several good discussions of what is going on with Bear Stearns stock. Adam Warner at the Daily Options Report (one of our featured sites) has a nice explanation and discussion of the incentives for those with positions in Credit Default Swaps (CDS). The Wall Street Journal cites several incentives, including those doing a trade where they short bonds, buy CDS's, and buy stock, then voting to nix the deal. Felix Salmon (another of our featured writers) cites the theory of bondholders buying stock to make sure the deal goes through.
The best overall survey of possibilities comes from Colin Barr at Fortune's Daily Briefing (now added to our list of featured sites). In this article he reviews the various players, incentives, and some of the theories. In today's article he steps through the incentives for some of the potential buyers.
Collective Action and the Bear Stearns Mystery
Let us apply Olson's theory to the actors in the Bear Stearns situation. Suppose one is a bondholder. It is true that you want to see the deal go through so that your bonds are backed up by JP Morgan (and the Fed). But how can you make this happen? (We do not know the exact concentration of bondholders, so this is theoretical.) Let us say that you are a fund manager with $10 million worth of bonds. The amount of stock you might buy to offset this position is inconsequential in the vote. Briefly put, your participation does not matter. It is only relevant if you have a huge position and think that your buying will reach a tipping point.
The conclusion is more dramatic for the Wall Street Journal scenario. Shorting bonds and buying CDS's is an interesting trade, but buying stock does not make it an arbitrage. No matter how much stock you buy, you are at the mercy of the rest of the shareholders. There is no reason to buy stock at $6 and collect $2, even if the overall profit on the trade is positive. Your stock trade does not affect the outcome -- unless many others like you do the same thing. Even if they do, you have the choice of free riding.
Collective Action Exceptions
There are a few exceptions to the collective action principle. If a very few participants have large stakes, they may enter a collaboration to achieve the desired outcome. This was our reason for suspecting Joe Lewis. If he believes that Bear insiders might already be predisposed to vote down the deal, his own interest may be enough to build a majority. Sure enough, Joe Lewis seems to be acquiring the shares necessary to reach a tipping point.
One might contrast this with hedge fund interests or those of bondholders. They would have to reach an ad hoc agreement where all would buy stock to protect the mutual interest. Think OPEC, with a short time frame and absolutely no way of enforcing the mutual pact.
Some of the buying is, no doubt, is from speculators who believe that JP Morgan will see an advantage -- avoiding legal issues? -- from sweetening the deal. The more plausible this outcome becomes, the more attractive is the trade for speculators.
Mancur Olson describes various ways of avoiding the collective action problem -- beyond our scope here -- but they all require a high level of organization and association of participants. Trade unions are one example. The AARP is another. The organization offers selective goods to induce participation and devotes some resources to collective action objectives.
Part of our point in describing this is to illustrate once again how knowledge commonly recognized by policy analysts is relevant to market problems. Older examples include the Long-Term Capital Management bailout, where the parties at risk all invested equal amounts to avoid a collapse. The driving force was that they were all around a table with the moral suasion of the New York Fed. And it was not quite all parties. Notably, Bear Stearns, the firm with the most at risk, did not join in. One wonders what would have happened if a second firm had opted out.
A more recent example is the monoline insurer problem. The difficulty in getting a solution there was that there was not a single party to be "rescued" and the participants had widely differing stakes. It defied a simple solution, as Mancur Olson would have predicted. This explains why the eventual resolution took so long to accomplish.
There are many other situations like this right now, including all of the proposed bailout plans for homeowners. It explains why government is likely to act in this arena. The free market will not generate a solution.
The collective action problem is a key reason for government to act. Those focused on punishing the parties who made poor decisions should have this theory in mind.