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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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Thain's Inflated Sense Of Self-Worth

He's not going to get it, but I can't get over the fact that Merrill Lynch chief John Thain actually thought he deserved a $10 million bonus for the year. Apparently, a few months ago it was suggested to the compensation committee that Thain's bonus be north of $30 million. From Thain's perspective, he must have felt he was making quite a sacrifice by only asking for $10 million.

To accurately evaluate Thain's request of $10 million we need to look at his accomplishments during the year. For starters, Merrill Lynch stock has fallen 71% this year. In addition, Merrill has reported losses of over $12 billion year-to-date. According to my trusty abacus, Thain apparently thinks he's worth $1 million for every 7% decline in the stock and every $1.2 billion in net loss. I don't want to brag, but I would have been willing to generate half those losses for a mere $5 million bonus.

According to people at the firm, Mr. Thain says he deserved the bonus "because he helped avert what could have been a much larger crisis at the firm." I find that simply incredible. He's basically saying, "Look guys. Sure the stock is down 71% due largely to a lot of poor risk management and decision-making under my watch, but if I hadn't acted boldly in selling the firm to Bank of America, we might have ended up in bankruptcy! Clearly, I deserve $10 million for only losing $61 billion of market value." It's kind of like a kidnapper demanding freedom for not having murdered.

Asking for a $10 million bonus in light of the facts demonstrates either a massive ego or a complete detachment from reality (the two often go hand in hand). And it doesn't matter that he only joined Merrill in late 2007. He came to the firm with a fresh set of eyes and had every opportunity to examine the firm's balance sheet, risk exposures, and risk management practices. This guy is lucky to still have a job (as is the rest of senior management though I'm sure many of them will soon be "leaving" following the merger).

Let's also not forget that Thain is pulling down a base salary of $750,000. He might not be happy with that, but I can think of about 533,000 recently unemployed folks who would kill for a piece of that.

Disclosure: The Rubbernecker is short overpaid company-killers.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

The Merrill Defense

The New York Times is out with an article entitled "Merrill's Chief Defends Recent Sale" which discusses Merrill CEO John Thain's reasons behind Merrill's recent CDO sale to Lone Star. According to the article:

A week after he stunned Wall Street by selling billions of dollars of toxic mortgage investments for pennies on the dollar, Mr. Thain defended his decision on Monday, saying he needed to take decisive action to shore up the Wall Street giant and morale among its employees.

“We have over 60,000 people working every day,” Mr. Thain said in an interview after eight tumultuous months as chief executive of Merrill. “All the efforts of these people were overwhelmed by the write-downs in the mortgage-related assets.”

Employee morale? That's touching, but it's a bit anticlimactic. This is an investment bank. I was expecting to hear something about maximizing shareholder value or improving risk-adjusted returns. If he wanted to boost employee morale he could have offered chair massages, personalized "We're #1" paperweights, or more stock options. Well, he could have offered the paperweights or massages.

The article adds:

At the end of Merrill’s whirlwind month, investors are still questioning its C.D.O. sale. Not only did Merrill sell $31 billion at a fire-sale price of $6.7 billion, but it also lent $5 billion to the buyer, Lone Star, a private equity firm in Dallas.

“We went to a lot of trouble to get this deal done, and we structured it in a way where there is very little chance that we ever get these C.D.O.’s back or take the same risk back,” Mr. Thain said.

Let's take a closer looks at the deal. Merrill lent $5 billion of the $6.7 billion price tag, and that $5 billion loan is only secured by the CDOs that were "sold." Merrill is protected from the first $1.7 billion of losses on the securities, but they are still on the hook for that $5 billion loan. If Thain really thinks there's "very little chance that we ever get these CDOs back" then he must believe that no more than $1.7 billion of the securities will default. For the deal to also make sense for Merrill, Thain must believe that the CDOs will not be worth more than the $6.7 billion (I'm simplifying) sale price, otherwise he's leaving money on the table.

Lone Star basically wins if the net effect of any future defaults, any future appreciation, the interest expense on the $5 billion loan, and the income from the securities provides an adequate return on the $1.7 billion of equity at risk. But, even if Lone Star doesn't default on this loan, Merrill will have taken a loss of 78% on these CDOs. That oughta boost morale.

Here's my favorite part of the article:

A broker in California said it just seemed to be more of the same. Customers, he said, still complain to him that “Merrill Lynch can’t control its money — why should I give you mine?”

Great question! I just can't believe that there are still any customers there to ask it. These Wall Street financial titans want to manage money, raise capital for firms, advise businesses on mergers and acquisitions, and use shareholder money for proprietary trading, but they thought it was a good idea to lend billions of dollars to people with bad credit, no money, and no verified income to buy assets at inflated prices with no equity. You can't make this stuff up.

Disclosure: The Rubbernecker is long chair massages and short investment bank CEOs.