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 also reminded his board that Treasury and the Fed would not put its commitment to him and Bank of America in writing, because such “assurances” would require the “formal action” of the Fed and Treasury, and thus “require public disclosure,” which might have caused another crisis. Still, Lewis told the board, management had documented the commitment as best it could through “e-mails and detailed notes” of the conversations with Warsh and others. Lewis and Price shared with the board the various ideas they had discussed with Warsh, Bernanke, and Paulson about how the government’s new capital injection might work, and concluded by saying they would “continue to work” with federal regulators to make it all happen by January 20. “Robust discussion ensued,” the meeting minutes deadpanned, “including the Corporation’s recourse should the federal regulators fail to comply with their assurances on which the Board and management have relied.”

On January 1, Bank of America closed its deal with Merrill Lynch, as had been agreed in September. No aspect of the original terms was renegotiated. “We created this new organization because we believe that wealth management and corporate and investment banking represent significant growth opportunities, especially when combined with our leading capabilities in consumer and commercial banking,” Lewis said, mouthing the pabulum that typically attends corporate-merger announcements. He didn’t mention any of the profound events of the previous weeks. “We are now uniquely positioned to win market share and expand our leadership position in markets around the world.”

Bank of America ended up releasing its 2008 financial results 15 days later. Tucked into the press release was the news that Merrill Lynch had lost a staggering $15.3 billion in the fourth quarter. In the same press release was the first public announcement of Bank of America’s secret deal with Paulson and Bernanke. The government would invest another $20 billion into Bank of America—bringing the total TARP funds at the bank to $45 billion—and would also “provide protection against further losses” on $118 billion in toxic assets, primarily taken from the Merrill Lynch balance sheet.

In a narrow sense, Lewis’s gamble had paid off. But the merger—even with the government’s largesse accounted for—has proved so far to be a lousy deal for Bank of America and its shareholders. On January16, the bank’s stock closed around $7 per share, as investors worried about both the size of the losses and the need for another government bailout. It reached its nadir of $3.14 per share six weeks later, a collapse of 90 percent since before Lewis decided to do the Merrill deal. (In June, after the bank raised $38 billion, $4.1 billion more than the $33.9 billion of new capital mandated by Treasury’s “stress tests,” the stock was trading at around $12 a share.) The backroom dealing and arm-twisting that kept the deal moving may have succeeded in saving Merrill from immediate collapse, but only at the expense of the health and stability of the nation’s largest bank—an institution far more important, systemically, than Merrill, and one that must now be propped up, indefinitely, no matter the cost.

On one level, the merger between Bank of America and Merrill Lynch is a simple story of executive hubris and cowardice. Leaving aside the question of whether Lewis’s failure to publicly disclose new information—about Merrill’s losses, about his deal with Paulson and Bernanke—was legal, his passivity throughout the process was, in the eyes of some financial-industry insiders, contemptible. One senior Wall Street executive, upon learning of Lewis’s actions, was incredulous. “There is no question what I would have done if I were in his shoes,” he told me. “I would have told [Bernanke and Paulson] I was calling the MAC, was releasing the decision publicly, and dared them to fire me and the board—and that never would have happened, trust me.” Even a former Merrill Lynch executive, who was involved in the sale of the company to Bank of America and was familiar with the MAC language in the contract, said Lewis should have used Merrill’s fourth-quarter losses and the threat of calling a MAC as leverage to renegotiate downward the absurd price of the Merrill deal. “He could have used the MAC clause as a pretext to renegotiate the deal,” he said. “That would have been a prudent thing to do.”

Mark Sunshine, the president of First Capital, an international commercial lender, is somewhat more charitable. He worries that Ken Lewis’s decisions have exposed Lewis to civil liability, and “could have criminal implications.” But he also told me he knows how difficult it would have been for Lewis to ignore the requests of the Treasury secretary and Federal Reserve chairman in a time of financial crisis. And he said he is not sure, under the circumstances, whether he would have acted all that differently. “In those circumstances, most people would do what they were asked to do,” he said.

A moment later, after some reflection, he added, “But it also sounds an awful lot like what happens in a banana republic or in Putin’s Russia, when the captains of industry did favors for the government in exchange for economic subsidies. How do you stop from going down the slippery slope and becoming like Putin’s Russia?”

The most important questions arising from the Bank of America–Merrill Lynch merger do not involve Ken Lewis. They involve Hank Paulson, Ben Bernanke, and the U.S. government.

In an interview with Andrew Cuomo, Paulson “largely corroborated” Lewis’s rendition of the events of December 2008, Cuomo wrote in an April 23 letter to federal officials. “Secretary Paulson indicated that he told Lewis that if Bank of America were to back out of the Merrill Lynch deal, the government either could or would remove the Board and management.” Paulson told Cuomo he “made the threat [to Lewis] at the request of Chairman Bernanke”; but Bernanke would not discuss the matter with Cuomo, invoking the Federal Reserve’s little-known “bank-examination privilege,” which was designed to preserve candor in communications between bankers and examiners. Bernanke did testify before Congress on June 25: “I did not tell Bank of America’s management that the Federal Reserve would take action against the board or management,” he said. A spokesman for Paulson later said Paulson’s admonitions to Lewis were “his own” and not made at the behest of Bernanke. Regardless, the pressure that both Bernanke and Paulson put on Lewis was extraordinary—and questions about the legality and propriety of these actions are serious enough to have spurred a congressional investigation, still ongoing at the time of this writing.

Some observers are convinced that government officials crossed a line—“There’s no question there was coercion and bribery here,” argues Sunshine. But based on available evidence, none of the legal experts with whom I spoke believed that the government clearly broke any laws. H. Rodgin Cohen— the senior partner at the law firm Sullivan & Cromwell and an ultimate Wall Street insider—does not fault public officials for doing what they believed at the time to be in the best interests of the financial system. “There are differences between persuading and helping people understand where their best interests lie, and actually abrogating a contract,” he told me. “People want a proactive administration, but there is a difference between being proactive and violating the Constitution. You can adhere to the rule of law and have a clear sense that the rule of law can be used proactively to accomplish what you are trying to accomplish.”

In any case, and for better or worse, the federal government has reached deep into the financial-services industry in its response to the crisis. Through the extension of TARP funds and other mechanisms, it has gained heavy leverage, and is likely to retain that leverage for at least the next several years. And as the long aftermath of 9/11 has shown us, novel exertions of federal power and the suppression of private rights, undertaken in moments of crisis and confusion, can become cancerous precedents.

The question many Wall Street executives are asking themselves—and the single most important question to come out of the whole affair—is whether last December’s undisclosed pas de deux between Lewis, on the one hand, and Paulson and Bernanke, on the other, represents a onetime event or whether, in the post-TARP world, both Wall Street and Main Street should expect to see the long arm of the government interfering with business deals and private contracts on a more regular basis.

“As a legal matter, the sanctity of contracts is fundamental,” said Cohen, who has been a legal adviser to many of the banks that faced recent crises. “And I don’t know how you go much beyond that, because once you destroy that foundation, then it starts to affect the underpinning of all business relationships—which assume that contracts are enforceable.”

As the crisis has receded this year, the government has remained aggressive, seeking business outcomes it finds desirable with some apparent indifference to contractual rights. In Chrysler’s bankruptcy negotiations in April, for example, Treasury’s plan offered the automaker’s senior-debt holders 29 cents on the dollar. Some debt holders, including the hedge fund Xerion Capital Partners, believed they were contractually entitled to a much better deal as senior creditors holding secured debt. But four TARP banks—JPMorgan Chase, Citigroup, Morgan Stanley, and Goldman Sachs—which owned about 70 percent of the Chrysler senior debt at par (100 cents on the dollar), had agreed to the 29-cent deal. By getting these banks and the other senior-debt holders to accept the 29-cent deal and give up their rights to push for the higher potential payout they were entitled to, the government could give Chrysler’s workers, whose contracts were general unsecured claims—and therefore junior to the banks’—a payout far more generous than would otherwise have been possible or likely. Essentially, the government was engineering a transfer of wealth from TARP bank shareholders to auto workers, and pressuring other creditors to go along.

On April 30, when President Obama announced the bankruptcy, he forcefully stated the White House position: “While many stakeholders made sacrifices and worked constructively,” he said, “I have to tell you, some did not. In particular, a group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout. They were hoping that everybody else would make sacrifices, and they would have to make none. Some demanded twice the return that other lenders were getting. I don’t stand with them. I stand with Chrysler’s employees and their families and communities.”

In the face of this kind of political pressure, Perella Weinberg, the owner of Xerion, backed down. “In considering the President’s words and exercising our best investment judgment,” the firm said in a statement, “we concluded that the risks of potentially severe capital loss that could arise from fighting this in bankruptcy court far outweighed any realistic potential upside.” Tom Lauria, an attorney who was representing the firm during the negotiations, said in a May 1 radio interview that his client had been told by the administration that the White House press corps would destroy Perella Weinberg’s reputation if it continued to fight the deal. He later told ABC News that Treasury adviser Steven Rattner had made the threat. (The White House denied making any threats, and Perella Weinberg denied Lauria’s account of events, without elaboration.) Lauria said, in his radio interview, “I think everybody in the country should be concerned about the fact that the president of the United States, the executive office, is using its power to try to abrogate that contractual right.”

A somewhat similar story played out during GM’s bankruptcy—the government again put together a deal that looked to many like a gift to the United Auto Workers at the expense of bondholders, who were pressed hard to quickly take a deal that would leave them with 10 percent of the equity of the reorganized company (plus some out-of-the-money warrants) when they likely would have been able to negotiate for more in a less well-orchestrated bankruptcy proceeding. The Obama administration also famously browbeat AIG employees, who had a contractual right to some $165 million in bonuses, to void that right. (In the face of the government’s pressure and the public outcry, some 15 of the top 20 recipients of the retention bonuses agreed to give back a total of more than $30 million in payments.) Curiously, the government has put no pressure on Merrill executives to return their $3.6 billion in bonuses that were paid out in December 2008, even though the company had suffered those huge losses.

“The rules as to how the government will act are not what we learned,” explained Gary Parr, the deputy chairman of Lazard and one of the leading mergers-and-acquisitions advisers to financial institutions. “In the last 12 months, new precedents have been set weekly. The old rules often don’t apply as much anymore.” He said the recent examples of the government’s aggression are “a really big deal,” but adds, “I am not sure it is going to last a long time. I sure hope not. I can’t imagine the markets will function properly if you are always wondering if the government is going to step in and change the game.” One former Treasury official in the Bush administration told me he believes that the Obama administration has been disturbingly heavy-handed with the automobile companies and those who have lent to them. “It’s very easy, when you’re holding all the cards, to impose your will,” he said. “And when you are the only source of financing, forget it.”

It can be hard to find sympathy for some of the people now decrying the government’s actions. And surely, the fat cats who always seem to find a way of bending the system to their advantage should be expected to make concessions as we seek to right the economy—especially where bankruptcy and taxpayer bailouts are concerned. Many observers have argued that if anything, the government has not been aggressive enough in reforming the financial system. But there’s a difference between reform—the development and application of new, clear standards for the system as a whole—and ad hoc interference.

The pattern of government intervention in the past year is at times bewildering. Why did Paulson and Bernanke decide to save AIG and Merrill, but not Lehman? Why did they let Merrill pay $3.6 billion in bonuses but make a federal case out of the $165 million paid out to AIG’s professionals? How should businesses and investors think about bond purchases, mergers, compensation, and a range of other activities that are essential to a smoothly functioning economy, but now carry the uncertainty of potential government intervention? Creeping uncertainty of this sort would inevitably slow and distort the economy. It would also lead to charges of crony capitalism and favoritism—indeed, it already has.

The legacy of the crash and our response to it has yet to be fully written. And we will never—can never—know if the actions taken by Bernanke and Paulson in December prevented a meltdown many times worse than the one we experienced last fall. Given the gravity and the time pressure of the situation, it is perhaps best to give them the benefit of the doubt.

Yet the very success that Bernanke and Paulson (and later, the Obama administration) seem to have had in ameliorating the crisis may, over time, carry unintended consequences. Pressure for aggressive reform of the financial system appears to have waned in recent months. Meanwhile, the pressure applied on Bank of America and other private institutions, as it has come to light, has for the most part been met with a collective shrug (although some members of Congress, particularly Democrats Dennis Kucinich and Elijah Cummings, seem determined to get to the bottom of who did what to whom and why). This raises the possibility that Treasury and the Fed will continue to simply manage the financial industry informally for some years to come, confident in their ability to pull the right levers and twist arms when necessary behind the scenes. That’s a scenario that seldom ends well; we should hope it doesn’t come to pass.

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 Merrill Lynch, 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?

William D. Cohan is the author, most recently, of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street
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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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