Finance September 2009

The Final Days of Merrill Lynch

Last September, as Wall Street turned to rubble and panic threatened to come unleashed, Ken Lewis, the CEO of Bank of America, agreed to swallow one of the country’s most toxic investment houses. The deal was not altogether voluntary; as details have slowly emerged, the coercive role of the Fed and Treasury has loomed larger. What exactly happened in the weeks leading up to the merger? Did the deal save us all from economic apocalypse? And what does the government’s unprecedented role in it portend for the future of our economy?

Lewis showed up at the Federal Reserve in Washington at the appointed hour, along with Joe Price and Brian Moynihan, Bank of America’s newly named general counsel (Moynihan would later succeed Thain atop the newly acquired Merrill Lynch). By then, Paulson had arranged for Bernanke to be there, too.

Lewis kicked off the discussion by talking about how Bank of America, in the fourth quarter of 2008, would likely suffer its first quarterly loss in 17 years—a loss entirely independent of the Merrill deal—and then Price walked Paulson, Bernanke, and their aides through the magnitude of the losses that Merrill had taken. “The main thing we were concerned about was the very large hole that would have been created” in Bank of America by Merrill’s losses, Lewis said in his deposition. The Bank of America executives then broached the idea of invoking the merger agreement’s MAC clause. But Paulson and Bernanke were unreceptive. They warned Lewis and Price against taking that step, and they urged caution. Lewis was told to “stand down” for the moment, he recalls, until Paulson and Bernanke had a chance to put their heads together. “And so we left,” Lewis said.

By December 20, Bernanke had come to the view that “the MAC threat is irrelevant because it is not credible,” according to an e-mail written that day by Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond, who had just spoken to Bernanke. “Also,” he wrote, Bernanke “intends to make it even more clear that if they play that card and then need assistance, management is gone.”

On Sunday, December 21, Lewis tracked down Paulson to talk more about the possibility of invoking the MAC clause. Just that morning, at 8:17, Mac Alfriend, a senior official at the Richmond Fed, had sent an e-mail to his colleagues: “Merrill is really scary and ugly.” About two hours later, Bernanke had written to his Fed colleagues, saying he thought Lewis’s “threat to use the MAC is a bargaining chip, and we do not see it as a very likely scenario at all.” He urged them to come up with “some analysis” to convince Lewis why calling the MAC “would be a foolish move and why the regulators will not condone it.”

Lewis first tried to call Paulson at Treasury, and was given his cell-phone number. He eventually reached the Treasury secretary at a ski cabin in Colorado. Paulson—known as “The Hammer” since his days on the offensive line at Dartmouth—did not mince words with Lewis. “I’m going to be very blunt,” he said, according to Lewis’s deposition. “We’re very supportive of Bank of America and we want to be of help, but the government does not feel it’s in your best interest for you to call a MAC.” According to Lewis, Paulson told him the government felt “so strongly” about this that he said, “We would remove the board and management” if Lewis tried to invoke it. At that, a shaken Lewis stood down again. He later said he knew that Paulson wasn’t joking around, and “that he wouldn’t say something that strong if he didn’t feel like it was a systemic risk as well.”

“Hank, let’s de-escalate this for a while,” he told Paulson. “Let me talk to our board.” Paulson seemed happy with Lewis’s suggestion to ratchet things back. “Good,” he said. “I’ll call Ben and tell him that.”

The next day at 4 p.m., Lewis convened a special board meeting via conference call, to convey management’s recommendation that the merger with Merrill Lynch be completed on its original terms. He reiterated Paulson’s view that a failure to complete the merger would result in a “systemic risk” to the U.S. economy—and that invoking the MAC clause would cause the Fed and Treasury to remove Bank of America’s management and its board of directors.

Although the government’s threat was unprecedented—and would have been almost inconceivable before the collapse of Bear Stearns in March 2008—Lewis argued against challenging Paulson and Bernanke. He also chose not to inform his shareholders or the public about his conversations with Paulson and Bernanke. “We bank 99 percent of the Fortune 1,000, … a third of all commercial companies, [and] every other American,” he said in his deposition. “If it’s bad for America, then it’s bad for us.” In his interview with Maria Bartiromo in February, Lewis elaborated. The decision, he said, came down to “enlightened self-interest. Because we’re so inextricably tied in with the U.S. economy and have such large market shares, what’s good for America is good for Bank of America.”

Enlightened or not, Bank of America’s self-interest would only later be fully disclosed: in return for swallowing Merrill despite its worsening troubles, Paulson and Bernanke had verbally promised Lewis more money from the TARP—the $700 billion Troubled Asset Relief Program, which had become law in October 2008—to bolster the capital of the combined firm. In addition, they promised to take billions of dollars of toxic assets off the company’s balance sheet.

Although this new deal with Treasury and the Fed could not be completed by the time the merger was to close on January 1, Lewis told his board he had received an oral commitment that the capital infusion and toxic-waste removal would be in place by January 20, the day Bank of America was to release its 2008 earnings report. Lewis said Bernanke told him, “We view you as strong and having acted appropriately in difficult circumstances … We’ll make sure you continue that way … We want to do something that when the public hears about it [the new government financing], your stock goes up.” That must have sounded welcome to Lewis. Around the time of the conversation, Bank of America’s stock had fallen, from almost $34 a share before Lewis had decided to buy Merrill to about $13.50 a share.

The board urged Lewis to try to get Paulson and Bernanke to put the government’s offer of more capital into writing, and he dutifully picked up the phone and called Bernanke to ask. “Let me think about it,” Bernanke told him. In the end, Bernanke didn’t speak to Lewis about the promised new financing; Paulson did. He told Lewis he didn’t want to put anything on paper. “First, it would be so watered down,” Lewis remembered Paulson telling him, “it wouldn’t be as strong as what we were going to say to you verbally. And secondly, this would be a disclosable event, and we do not want a disclosable event.” (Some legal authorities, of course, believe the discussions and correspondence to that point should have been disclosed to shareholders, since they were material and might reasonably have been expected to affect the trading of the securities of the two firms.)

Just before 5 p.m. on December 22, Lewis sent his board an e-mail. “I just talked with Hank Paulson,” Lewis wrote. “He said that there was no way the Federal Reserve and the Treasury would send us a letter of any substance without public disclosure which, of course, we do not want.” “Thought so,” board member Thomas Ryan, the CEO of CVS Corporation, wrote back five hours later.

Still, no board revolt came to pass. The minutes of the board meeting that day reveal a splendid piece of legal ass-covering: the board states for the record that it “was not persuaded or influenced” by the government’s threats to remove it and the management, and that it would reach the decision that was in the “best interest of the Corporation and its shareholders” without regard to the “representation”—threat—by Paulson and Bernanke. That noted, and snarky e-mail aside, the directors seemed content to follow Lewis’s lead.

Lewis, of course, had a problem on his hands. Because he could not get the government’s offer in writing, by going through with the deal he would be putting his company and his shareholders at a huge financial risk if Paulson and Bernanke changed their minds. Still he went forward, with no disclosures to his shareholders. “I had verbal commitments from Ben Bernanke and Hank Paulson that they were going to see this through, to fill that hole, and have the market perceive this as a good deal,” Lewis said in his deposition in February. “I was going on the word of two very respected individuals high up in the American government.”

When asked about whether he would have disclosed the risk to which he was exposing his shareholders if it had been up to him, Lewis replied, “It wasn’t up to me.” The particulars of the deal, he noted, were not up for debate either: “It was said that, ‘We want this deal done on time and on these terms.’ There wasn’t an ability to renegotiate.” But every deal can be renegotiated, right? “Not when you’re told that you can’t,” Lewis said. Asked whether he was angry that he didn’t feel he had a choice in the matter, Lewis replied, “I think I was a little shocked. Everything got back to the fact that I was shocked at how strongly they felt about the consequences… I think they were doing it in good faith. They thought everything they said—about the danger that Merrill’s failure would pose to the financial system—“was true.” Lewis conceded he could have said no and resigned, but he never considered doing that.

But there is no question that Lewis was growing increasingly worried about potential shareholder litigation. On December 22, Bernanke confided in an e-mail to his Fed colleagues that Lewis “now fears lawsuits from shareholders for NOT invoking the MAC, given the deterioration at ML.” Bernanke said he told Lewis that he didn’t “think that’s very likely,” but Lewis “asked whether he could use as a defense that the gov[ernment] ordered him to proceed for systemic reasons. I said no.”

Lewis nonetheless wanted a letter from Bernanke that could be used in Bank of America’s defense. Bernanke asked Scott Alvarez, the Fed’s general counsel, if they could give Lewis a letter saying that he had been formally advised that “a MAC is not in the best interest of his company.” On December 23, Alvarez wrote back: “I don’t think it’s necessary or appropriate First, we didn’t order him to go forward—we simply explained our views on what the market reaction would be and left the decision to him. Second, making hard decisions is what he gets paid for and only he has the full information to make the decision—so we shouldn’t take him off the hook by appearing to take the decision out of his hands.” Bernanke still wondered, “What would be wrong with a letter, not in advance of litigation but if requested by the defense in litigation, to the effect that our analysis supported the safety and soundness case for proceeding with the merger and that we communicated that to Lewis?” In response, Alvarez advised Bernanke to “hold fast” on any such letter. “I want to avoid the Fed being the centerpiece of the litigation,” he wrote.

On December 30, at another Bank of America board meeting, convened two days before the Merrill deal was to close, Lewis reported that since the December 22 board meeting, he had told “federal regulators—primarily Kevin Warsh, a Federal Reserve Board member—that “were it not for the serious concerns regarding the status of the United States financial-services system” and the consequences that would have befallen the financial system as “articulated by the federal regulators,” Bank of America would have invoked the MAC clause and sought to renegotiate the terms of the deal. He explained to his board that he had also told regulators that it was “appropriate” for the federal government to make Bank of America “whole for the deterioration in Merrill Lynch’s operating results and financial condition.” In his conversations with Warsh, Lewis explained Bank of America’s “needs and expectations” regarding the financing that Paulson and Bernanke had informally promised.

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William D. Cohan, a columnist for BloombergView, is a contributing editor at Vanity Fair and the author, most recently, of The Price of Silence.

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