The market’s case of nerves this week seems a tad more justified, given that the details of the Bank of America rescue plan are apparently out, Previous press reports suggested the Charlotte bank might need $8 to $10 billion of additional equity to compensate for losses related to the Merrill acquistion. Yes, as Senator Everett Dirksen said, a billion here, a billion there, and pretty soon you are talking real money, but an infusion of $10 billion or less, particularly after the bank trying to back out of the Merrill purchase, would not have been a catastrophic number.
But the level of support set forth in the Wall Street Journal belies the idea that BofA was a strong bank, able to absorb the risks of garbage barges like Countrywide and Merrill (in fairness, Merrill at least has some good franchises along with the junk on its balance sheet. We’ve long inveighed against the Countrywide acquisition). They were both known problem children, suitable only for a highly capitalized and capable institution. The latest turn of events raises considerable questions about Ken Lewis’ judgement as well as the health of the bank ex these turkey deals (and that should be no surprise either, given that BofA is a retail giant and consumer balance sheets are badly impaired).
From the Wall Street Journal:
Reeling from previously undisclosed losses from its Merrill Lynch & Co. acquisition, Bank of America Corp. received an emergency capital injection of $20 billion from the Treasury, which will also backstop about $118 billion of assets at the bank…
The developments angered some Bank of America shareholders, who began to question why Chief Executive Kenneth Lewis didn’t discover the problems prior to the Sept. 15 deal announcement. Many also wanted to know why he didn’t disclose the losses prior to their vote on the Merrill deal on Dec. 5, or before closing the deal on Jan. 1.
The situation put Treasury Secretary Henry Paulson in the position of negotiating to spend money destined for the Obama administration, a further reason for the poor regard in which the bailout is held in Washington….
Bank of America said it learned of Merrill’s losses after the Dec. 5 shareholder vote.
Yves here. Huh? The deal was agreed in mid-September. I ought to track down the merger agreement, but pretty much every deal has representations and warranties by the seller (for instance, that there have been no material adverse changes since the last financial save as disclosed). This was supposed to be a coup of sorts for BofA, rescuing bruised but not broken Merrill, but the apparent safeguards for the buyer even in a hastily brokered deal is more akin to a shotgun wedding.
And in the days following, both Federal Reserve Chairman Ben Bernanke and Mr. Paulson impressed upon Mr. Lewis the importance of closing the transaction for the firm’s own sake and also warned of the consequences for the country’s overall financial system, say people familiar with the discussions.
Bank of America spokesman James Mahoney said: “Beginning in the second week of December, and progressively over the remainder of the month, market conditions deteriorated substantially relative to market conditions prior to the Dec. 5 shareholder meetings. So Merrill wound up making adjustments for the quarter that were far greater than anticipated at the beginning of the month. These losses were driven by mark-to-market adjustments which were necessitated by changes in the credit markets, and those conditions change on a daily basis.”
At one point in December, Mr. Lewis even sent lawyers to New York to find out whether Merrill’s situation amounted to a material-adverse situation that might allow the bank to cancel the deal, according to a person familiar with the situation…..Merrill Lynch Chief Executive John Thain and Tom Montag, the firm’s global head of sales and trading, positioned these losses as ….”market related” and not out of step with the rest of Wall Street, according to attendees at these meetings….
Yves here, Reader reality testing would be useful here. “Material adverse change” means big time decay. I don’t follow the blow by blow in credit markets, but aside from a marked deterioration in commercial real estate, I was under the impression that conditions in the credit markets were generally improving in December. Treasury bond prices fell a bit (but from super high levels, and that would be a sign of willingness to move into riskier assets), mortgage spreads tightened, even junk bond prices improved. Back to the article:
Messrs. Bernanke and Paulson also urged Mr. Lewis to finish the deal and not invoke a material-adverse change clause, saying it was in his interest to finish the deal. If they walked away, it would reflect poorly on the bank and suggest it hadn’t done its due diligence and wasn’t following through on its commitments.
Yves here. True but irrelevant. You don’t compound an error (lack of due diligence and risk-shifting back to the seller where due diligence could not be done adequately) by proceeding with a turkey deal if you have a way to get out. The pretexts are irrelevant. Lewis was not willing to cross the Treasury and Fed in an environment like this when he’d almost certainly need their support at some point. Back to the piece:
The policy makers told Mr. Lewis that if conditions were really as bad as he believed, then the government could step in with a rescue similar to that used for Citigroup Inc. in November. In such an arrangement, the government would provide cash and guarantee against part of the firm’s losses.
In addition to a capital injection from the Treasury, the Fed, Treasury and FDIC are working on an asset-guarantee plan modeled after the Citi rescue. The government may backstop a figure of $115 billion to $120 billion in Bank of America assets, with BofA agreeing to take a portion of first losses, the Treasury and FDIC taking second losses, and the Fed backstopping a large chunk of the rest.
Some conspiracy-minded readers have suggested Merrill was not in as bad shape as portrayed, but served as a convenient pretext to give a lot of support to BofA in one fell swoop, which (in the long run) would go over better with the markets than the drip-drip-drip of quarterly writedowns and compensatory cash injections.
Update 1:40 AM: Some useful detail on how the dough for the deal was cobbled together from the WSJ Economics Blog. As we have noted, Treasury with the auto rescue plan relied on the notion that even though the TARP funds were very close to fully committed, quite a few of the payments had not yet been made.