Bob Ivry, Hugh Son and Christine Harper have written an article
that needs to be read by everyone interested in the financial crisis.
The article (available
here)
is entitled:
BofA Said to Split Regulators Over Moving Merrill
Derivatives to Bank Unit. The thrust of their story is that Bank of
America’s holding company, BAC, has directed the transfer of a large
number of troubled financial derivatives from its Merrill Lynch
subsidiary to the federally insured bank Bank of America (BofA). The
story reports that the Federal Reserve supported the transfer and the
Federal Deposit Insurance Corporation (FDIC) opposed it. Yves Smith of
Naked Capitalism has
written an appropriately blistering attack on this outrageous action, which puts the public at substantially increased risk of loss.
I write to add some context, point out additional areas of
inappropriate actions, and add a regulatory perspective gained from
dealing with analogous efforts by holding companies to foist dangerous
affiliate transactions on insured depositories. I’ll begin by adding
some historical context to explain how B of A got into this maze of
affiliate conflicts.
Ken Lewis’ “Scorched Earth” Campaign against B of A’s Shareholders
Acquiring Countrywide: the High Cost of CEO Adolescence
During this crisis, Ken Lewis went on a buying spree designed to
allow him to brag that his was not simply bigger, but the biggest. Bank
of America’s holding company – BAC – became the acquirer of last
resort. Lewis began his war on BAC’s shareholders by ordering an
artillery salvo on BAC’s own position. What better way was there to
destroy shareholder value than purchasing the most notorious lender in
the world –
Countrywide. Countrywide was in the midst of a death
spiral. The FDIC would soon have been forced to pay an acquirer tens of
billions of dollars to induce it to take on Countrywide’s nearly
limitless contingent liabilities and toxic assets. Even an
FDIC-assisted acquisition would have been a grave mistake. Acquiring
thousands of Countrywide employees whose primary mission was to make
fraudulent and toxic loans was an inelegant form of financial suicide.
It also revealed the negligible value Lewis placed on ethics and
reputation.
But Lewis did not wait to acquire Countrywide with FDIC assistance.
He feared that a rival would acquire it first and win the CEO bragging
contest about who had the biggest, baddest bank. His acquisition of
Countrywide destroyed hundreds of billions of dollars of shareholder
value and led to massive foreclosure fraud by what were now B of A
employees.
But there are two truly scary parts of the story of B of A’s
acquisition of Countrywide that have received far too little attention.
B of A claims that it conducted extensive due diligence before
acquiring Countrywide and discovered only minor problems. If that claim
is true, then B of A has been doomed for years regardless of whether it
acquired Countrywide. The proposed acquisition of Countrywide was huge
and exceptionally controversial even within B of A. Countrywide was
notorious for its fraudulent loans. There were numerous lawsuits and
former employees explaining how these frauds worked.
B of A is really “Nations Bank” (formerly named NCNB). When Nations
Bank acquired B of A (the San Francisco based bank), the North Carolina
management took complete control. The North Carolina management decided
that “Bank of America” was the better brand name, so it adopted that
name. The key point to understand is that Nations/NCNB was created
through a large series of aggressive mergers, so the bank had
exceptional experience in conducting due diligence of targets for
acquisition and it would have sent its top team to investigate
Countrywide given its size and notoriety. The acquisition of
Countrywide did not have to be consummated exceptionally quickly.
Indeed, the deal had an “out” that allowed B of A to back out of the
deal if conditions changed in an adverse manner (which they obviously
did). If B of A employees conducted extensive due diligence of
Countrywide and could not discover its obvious, endemic frauds, abuses,
and subverted systems then they are incompetent. Indeed, that word is
too bloodless a term to describe how worthless the due diligence team
would have had to have been. Given the many acquisitions the due
diligence team vetted, B of A would have been doomed because it would
have routinely been taken to the cleaners in those earlier deals.
That scenario, the one B of A presents, is not credible. It is far
more likely that B of A’s senior management made it clear to the head of
the due diligence review that the deal was going to be done and that
his or her report should support that conclusion. This alternative
explanation fits well with B of A’s actual decision-making.
Countrywide’s (and B of A’s)
reported financial condition fell
sharply after the deal was signed. Lewis certainly knew that B of A’s
actual financial condition was much worse than its reported financial
condition and had every reason to believe that this difference would be
even worse at Countrywide given its reputation for making fraudulent
loans. B of A could have exercised its option to withdraw from the deal
and saved vast amounts of money. Lewis, however, refused to do so.
CEOs do not care only about money. Ego is a powerful driver of conduct,
and CEOs can be obsessed with status, hierarchy, and power. Of course,
Lewis knew he could walk away wealthy after becoming a engine of mass
destruction of B of A shareholder value, so he could indulge his ego in a
manner common to adolescent males.
Acquiring Merrill Lynch: the Lure of Liar’s Loans
Merrill Lynch is the quintessential example of why it was common for
the investment banks to hold in portfolio large amounts of
collateralized debt obligations (CDOs). Some observers have jumped to
the naïve assumption that this indicates that the senior managers
thought the CDOs were safe investments. The “recipe” for an investor
maximizing reported income differs only slightly from the recipe for
lenders.
- Grow rapidly by
- Holding poor quality assets that provide a premium nominal yield while
- Employing extreme leverage, and
- Providing only grossly inadequate allowances for future losses on the poor quality assets
Investment banks that followed this recipe (and most large U.S.
investment banks did), were guaranteed to report record (albeit
fictional) short-term income. That income was certain to produce
extreme compensation for the controlling officers. The strategy was
also certain to produce extensive losses in the longer term – unless the
investment bank could sell its losing position to another entity that
would then bear the loss.
The optimal means of committing this form of accounting control fraud
was with the AAA-rated top tranche of CDOs. Investment banks
frequently purport to base compensation on risk-adjusted return. If
they really did so investment bankers would receive far less
compensation. The art, of course, is to vastly understate the risk one
is taking and attribute short-term
reported gains to the
officer’s brilliance in achieving supra-normal returns that are not
attributable to increased risk (“alpha”). Some of the authors of
Guaranteed to Fail call this process manufacturing “fake alpha.”
The authors are largely correct about “fake alpha.” The phrase and
phenomenon are correct, but the mechanism they hypothesize for
manufacturing fake alpha has no basis in reality. They posit honest
gambles on “extreme tail” events likely to occur only in rare
circumstances. They provide no real world examples. If risk that the
top tranche of a CDO would suffer a material loss of market values was,
in reality, extremely rare then it would be impossible to achieve a
substantial premium yield. The strategy would diminish alpha rather
than maximizing false alpha. The risk that the top tranche of a CDO
would suffer a material loss in market value was highly probable. It
was not a tail event, much less an “extreme tail” event. CDOs were
commonly backed by liar’s loans and the incidence of fraud in liar’s
loans was in the 90% range. The top tranches of CDOs were virtually
certain to suffer severe losses as soon as the bubble stalled and
refinancing was no longer readily available to delay the wave of
defaults. Because liar’s loans were primarily made to borrowers who
were not creditworthy and financially unsophisticated, the lenders had
the negotiating leverage to charge premium yields. The officers
controlling the rating agencies and the investment banks were complicit
in creating a corrupt system for rating CDOs that maximized their
financial interests by routinely providing AAA ratings to the top
tranche of CDOs “backed” largely by fraudulent loans. The combination
of the fake AAA rating and premium yield on the top tranche of
fraudulently constructed (and sold) CDOs maximized “fake alpha” and made
it the “sure thing” that is one of the characteristics of accounting
control fraud (see Akerlof & Romer 1993; Black 2005). This is why
many of the investment banks (and, eventually, Fannie and Freddie) held
substantial amounts of the top tranches of CDOs. (A similar dynamic
existed for lower tranches, but investment banks also found it much more
difficult to sell the lowest tranches.)
Merrill Lynch was known for the particularly large CDO positions it
retained in portfolio. These CDO positions doomed Merrill Lynch. B of A
knew that Merrill Lynch had tremendous losses in its derivatives
positions when it chose to acquire Merrill Lynch.
Given this context, only the Fed, and BAC, could favor the derivatives deal
Lewis and his successor, Brian Moynihan, have destroyed nearly
one-half trillion dollars in BAC shareholder value. (See my prior post
on the “Divine Right of Bank Profits…”) BAC continues to deteriorate
and the credit rating agencies have been downgrading it because of its
bad assets, particularly its derivatives. BAC’s answer is to “transfer”
the bad derivatives to the
insured bank – transforming (ala Ireland) a private debt into a public debt.
Banking regulators have known for well over a century about the acute
dangers of conflicts of interest. Two related conflicts have generated
special rules designed to protect the bank and the insurance fund. One
restricts transactions with senior insiders and the other restricts
transactions with affiliates. The scam is always the same when it comes
to abusive deals with affiliates – they transfer bad (or overpriced)
assets or liabilities to the insured institution. As S&L
regulators, we recurrently faced this problem. For example, Ford Motor
Company attempted to structure an affiliate transaction that was harmful
to the insured S&L (First Nationwide). The bank, because of
federal deposit insurance, typically has a higher credit rating than its
affiliate corporations.
BAC’s request to transfer the problem derivatives to B of A was a no
brainer – unfortunately, it was apparently addressed to officials at the
Fed who meet that description. Any competent regulator would have
said: “No, Hell NO!” Indeed, any competent regulator would have
developed two related, acute concerns immediately upon receiving the
request. First, the holding company’s controlling managers are a severe
problem because they are seeking to exploit the insured institution.
Second, the senior managers of B of A acceded to the transfer,
apparently without protest, even though the transfer poses a severe
threat to B of A’s survival. Their failure to act to prevent the
transfer contravenes both their fiduciary duties of loyalty and care and
should lead to their resignations.
Now here’s the really bad news:
First, this transfer is a superb
“natural experiment” that tests one of the most important questions
central to the health of our financial system. Does the Fed represent
and vigorously protect the interests of the people or the systemically
dangerous institutions (SDIs) – the largest 20 banks? We have run a
real world test. The sad fact is that very few Americans will be
surprised that the Fed represented the interests of the SDIs even though
they were directly contrary to the interests of the nation. The Fed’s
constant demands for (and celebration of) “independence” from democratic
government, combined with slavish dependence on and service to the CEOs
of the SDIs has gone beyond scandal to the point of farce. I suggest
organized “laugh ins” whenever Fed spokespersons prate about their
“independence.”
Second, I would bet large amounts of money that I do not have that
neither B of A’s CEO nor the Fed even thought about whether the transfer
was consistent with the CEO’s fiduciary duties to B of A (v. BAC). We
took depositions during the S&L debacle in which senior officials of
Lincoln Savings and its affiliates were shocked when we asked “whose
interests were you representing – the S&L or the affiliate?” They
had obviously never even considered their fiduciary duties or identified
their actual client. We blocked a transaction that would have caused
grave injury to the insured S&L by taking the holding company
(Pinnnacle West) off the hook for its obligations to the S&L. That
transaction would have passed routinely, but we flew to the board of
directors meeting of the S&L and reminded them that their fiduciary
duty was to the S&L, that the transaction was clearly detrimental to
the S&L and to the benefit of the holding company, and that we
would sue them and take the most vigorous possible enforcement actions
against them personally if they violated their fiduciary duties. That
caused them to refuse to approve the transaction – which resulted in a
$450 million payment from the holding company to the S&L. (I know,
$450 million sounds quaint now in light of the scale of the ongoing
crisis, but back then it paid for our salaries in perpetuity.)
Third, reread the
Bloomberg column and wrap your mind around the size
of Merrill Lynch’s derivatives positions. Next, consider that Merrill
is only one, shrinking player in derivatives. Finally, reread Yves’
column in
Naked Capitalism where she explains (correctly) that
many derivatives cannot be used safely. Add to that my point about how
they can be used to create a “sure thing” of record fictional profits,
record compensation, and catastrophic losses. This is particularly true
about credit default swaps (CDS) because of the grotesque accounting
treatment that typically involves no allowances for future losses.
(FASB: you must fix this urgently or you will allow a “perfect
crime.”). It is insane that we did not pass a one sentence law
repealing the
Commodities Futures Modernization Act of 2000. Between
the SDIs, the massive, sometimes inherently unsafe and largely opaque
financial derivatives, the appointment, retention, and promotion of
failed anti-regulators, and the continuing ability of elite control
frauds to loot with impunity we are inviting recurrent, intensifying
crises.
I’ll close with a suggestion and request to reporters. Please find
out who within the Fed approved this deal and the exact composition of
the assets and liabilities that were transferred.
