This is a tale of two deals.
Three years ago yesterday, Bank of America leapt into the maelstrom and bought Merrill Lynch for about $50 billion. Early the next morning, Lehman Brothers announced its bankruptcy filing. Lehman soon sold its investment banking and capital markets operations to Barclays for $250 million.
One of these deals has been a success. The other is questionable. The difference shows not only how chief executive hubris can destroy a company, but how three years later, the failure of the US treasury department, the Federal Reserve and the banks themselves to shrink the mortgage liabilities of the banks significantly still threatens our economy.
Of the two deals, the hands-down winner is the Lehman Brothers acquisition. Barclays paid anything but retail for Lehman and, in the process, acquired a powerful franchise in the US. Barclays is now the seventh largest US investment bank measured by revenue, according to Dealogic. The former Lehman bankers are competing strongly in some key areas. In advising on mergers and acquisitions in the US, Barclays was fifth in the first half of the year, according to Dealogic. Barclays was also the largest adviser on debt offerings in the world and third largest in the US.
At first blush, Merrill is also performing well, but, in a way, that highlights Bank of America’s scarily poor performance. The bank lost $8.8 billion in the second quarter after taking a $20.7 billion write-off for mortgage-related losses. It would have been worse without Merrill. Bank of America’s investment banking and wealth management operations, which are largely old Merrill operations, contributed $2.1 billion to Bank of America’s profits on $11.3 billion of revenue.
While Merrill is throwing a lifeline to its parent, Bank of America, Merrill has also contributed substantially to Bank of America’s problems. The Merrill acquisition added nearly $900 billion worth of assets to Bank of America’s balance sheet. With that, Merrill’s liabilities related to the mortgage crisis were assumed by Bank of America. It is unclear how big they are, but they total in the tens of billions. During the financial crisis, Merrill’s mortgage problems forced Bank of America to take an extra $20 billion in Troubled Asset Relief Program funds.
This is where the two deals truly differ. Barclays’ regulator stopped Barclays from buying Lehman before it declared bankruptcy. This was unbelievably lucky for Barclays. By buying Lehman out of bankruptcy, Barclays did not take on Lehman’s toxic assets. These consisted of more than $600 billion in debt. Barclays avoided liability for most of it.
In contrast, Bank of America plunged headlong into buying Merrill. The deal was driven by Bank of America’s former chief executive, Kenneth D. Lewis, who had lusted after Merrill Lynch for years. Bank of America paid a 70% premium three years ago for a bank that was worth far less and likely might have been insolvent. And, while Bank of America executives, a few months later, appeared to get cold feet, the federal government pushed them to close the deal.
Being as deeply in the mortgage market as Merrill was—if not more so—Bank of America should have been aware in September 2008 of the problems looming on the horizon. Yet Lewis’ eagerness to buy Merrill instead consumed all sober judgement. At the same time, blaming him alone is also simplistic. I wonder where the Bank of America board was in all of this. This is yet another example of a board failing in its responsibility to ask hard questions.
Things would have been different had Bank of America waited. It would at a minimum have paid a bargain basement price for Merrill, one that was tens of billions lower at least.
There is still some talk of spinning off Merrill Lynch. The operations of Merrill have already been combined with Bank of America, so a real separation would be complicated. And the recent reorganization of bank’s management—which puts Merrill Lynch’s wealth management business under David Darnell, the co-chief operating officer, but Bank of America-Merrill Lynch under the other chief operating officer, Tom Montag— also makes a split more difficult.
Ultimately, Barclays made a better deal by doing what should be done in an acquisition, carefully assessing the future liabilities and limiting them as best possible. But let’s be clear. Barclays did this only because it was forced to by the regulator.
The first lesson of Bank of America and Merrill Lynch is that impatience and chief executive hubris can lead to some very bad decisions. And regulators can sometimes stop these heady moves.
There is also a larger lesson here. In the case of Barclays, a regulator asserted that the liabilities could not be assumed. These had to be dealt with before the acquisition. The result was a messy and expensive bankruptcy process for Lehman, but one that has allowed the viable part of Lehman to prosper.
In contrast, Merrill was anything but a clean acquisition. Merrill’s toxic assets were put together with Bank of America’s and Countrywide’s toxic assets. While some argue that Merrill’s investment banking division is helping Bank of America, it ignores the fact that Merrill’s mortgage assets are now likely hurting the bank even more.
The ultimate lesson from these two deals is that taking your medicine early is worthwhile. Regulators and banks still have not come to terms with the mortgage debt on bank balance sheets left over from the financial crisis, let alone the liability these banks face for selling these mortgage to investors.
This is a problem concentrated in the large banks. As of the end of last year, the four biggest banks held 42% of then outstanding $950 billion in second-lien loans, according to the American Banker, which most banks have yet to write down. Bank of America alone held $136 billion of these loans as of the first quarter. Second-lien loans are the riskiest of mortgage assets because they are the most likely to be written down. According to CoreLogic, 23.1% of the nation’s mortgaged homes are underwater, their owners owing more than the home is worth. This means that there will be more pain for Bank of America and other large banks in the coming years.
Putting together Bank of America’s and Merrill’s bad assets has only kicked the can down the road. Three years after that fateful September weekend changed Wall Street, the same mortgage liabilities continue to haunt many banks. This is not a worry for Barclays, at least in the US. It made the better deal.
Steven M. Davidoff, a former corporate lawyer, is a professor at the Michael E. Moritz College of Law at Ohio State University.
©2011/The New York Times
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