Thursday, June 25, 2009

Bernanke Testimony and Bank of America

The following is an excerpt from Bernanke's prepared remarks to the House Oversight Panel:

In responding to Bank of America in these discussions, I expressed concern that invoking the MAC would entail significant risks, not only for the financial system as a whole but also for Bank of America itself, for three reasons. First, in light of the extreme fragility of the financial system at the time, the uncertainties created by an invocation of the MAC might have triggered a broader systemic crisis that could well have destabilized Bank of America as well as Merrill Lynch. Second, an attempt to invoke the MAC after three months of review, preparation, and public remarks by the management of Bank of America about the benefits of the acquisition would cast doubt in the minds of financial market participants--including the investors, creditors, and customers of Bank of America--about the due diligence and analysis done by the company, its capability to consummate significant acquisitions, its overall risk-management processes, and the judgment of its management. Third, based on our staff analysis of the legal issues, we believed that it was highly unlikely that Bank of America would be successful in terminating the contract by invoking the MAC.
As for the first point, we'll never know. If Bank of America was truly a sound institution (it wasn't/isn't), they could have reaped windfall gains from a "systemic" event (they would not have been allowed to fail). As for the third point, I'm not a lawyer, but it seems odd that a marked deterioration of a target company's financial situation wouldn't be considered a material adverse event. It, of course, depends on the precise wording of the MAC clause.

I find the second point simply absurd. It was well-recognized in the market that this deal was rushed and that there was no way that any significant due diligence could have been performed before the deal was announced.

Shareholders and bondholders would expect a couple of things in such an instance. First, Bank of America should have put its army of lawyers to work in drafting an agreement with Merrill that provided Bank of America the ability to walk away cheaply if significant problems arose during the continued due diligence (the MAC clause). Recall, Merrill would have likely been out of business by the next morning if the deal wasn't announced. Merrill needed Bank of America more than Bank of America needed Merrill. Bank of America was in the driver's seat and should have been controlling the terms of the deal.

Second, stakeholders would have expected Ken Lewis to walk away from the deal or lower the deal price if further due diligence discovered serious problems. Bernanke claims that walking away would have raised serious doubts about the competence of management. He has it completely backwards. Walking away after a more thorough analysis would have increased the credibility of management. Financial market participants would have more confidence that management was actually managing the company for its stakeholders as opposed to embarking on an empire building ego trip.

It's crucial to remember that this deal was rushed by the Fed and Treasury out of a fear that Merrill (and possibly the entire financial system) would be next to collapse if a "white knight" wasn't immediately found. Given the complexities of Merrill's balance sheet, it was never possible or reasonable to expect adequate due diligence to be performed on such short notice, and the market was aware of this.

I'm in no way defending Mr. Lewis or Bank of America. Whether he was threatened or compelled to complete the deal by the Fed and/or Treasury, it's difficult to argue that he acted in the best interest of his shareholders, and for that he should be removed.

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