Citigroup has been losing tens of billions of dollars over the past two years as the financial crisis has unfolded. If one considers the government capital that Citi has not paid back, the bank is clearly the weakest of the four largest legacy banking behemoths in the United States. Earnings results this year demonstrate that their raw earnings power is no match for the likes of JPMorgan Chase or Wells Fargo. Moreover, their capital base has been impaired, causing them to have to sell assets, reducing their earnings power further still.

Unless something miraculous happens over the next few years, they are not going back to the glory days of $20 billion yearly net income. That’s why their mountainous $38 billion deferred tax asset is a problem.

Reuters explains:

Citigroup has a roughly $38 billion deferred tax asset, which essentially represents expected cash flow from future tax benefits. Accounting expert Robert Willens said on a conference call late last month that he expects the bank to write the asset down by about $10 billion in the fourth quarter. That would represent about 7 percent of the bank’s net worth as measured by the reported value of the company’s shareholder equity.

What is going on here is a result of the fact that companies keep two sets of books – one for the taxman and one for public statements.  On the tax books, they pay more taxes upfront than we see in their public accounts (I know it sounds dodgy but I am sure a tax accountant can explain). By deferring the tax liability, companies reduce the net present value of the tax charges. Everybody wins except the taxman, right? 

Well, not exactly.  If Citigroup cannot make enough taxable income in future periods to cover these deferred tax assets, they are going to have to take a charge and write down the asset immediately. That is what Robert Willens is pointing to. If he is right, Citigroup would have $10 billion less capital as soon as Jan.1, 2010. And given they are perhaps the least well-capitalized of the stress test 19 except GMAC, that’s a problem.  It would certainly constrain their lending capacity.

But, of course, Citi officials have already come out to put any fears to rest.

"We are comfortable with the valuation," Kelly said, adding that the bank looks at its deferred tax asset at the end of each quarter. About $16 billion of the deferred tax asset must be realized by around 2016, and the rest has a much longer time frame, Kelly added.

Whew. For a second there, I was starting to think Citi needed another bailout.

By the way, Bank of America has a similar problem.  They have a huge net operating loss (NOL) carry-forward from their acquisitions of Merrill Lynch and Countrywide Financial. If BofA cannot make enough taxable income to use all of their NOLs which are now assets on their balance sheet, they too will have to take a ‘valuation allowance’ a.k.a a hit to earnings.  The net deferred tax assets at BofA (incl. NOLs) were $19.6 billion according to their 3Q 10-Q filing.  See the note below (click to expand).

As you would suspect, “The Corporation has concluded that no valuation allowance is required.”

Source

Bank of America SEC filings – BofA website

Related posts:

• Credit Suisse cautious on Citigroup due to regulatory hurdles
• How well capitalized is Citigroup?
• JPMorgan has record revenue and $2.7 billion in profit
• Is Citi being forced to downsize by Obama?
• Are Citi and BofA gaming the Geithner Plan already?

It seems that not a day goes by when you don’t hear about some asset sale in Citigroup’s far-flung empire. Of all the major too-big-to-fail institutions, it is easily the most troubled: the poster child for everything that is wrong in finance in America.

But, when President Obama’s Pay Czar Kenneth Feinberg stepped in to limit pay at Citi and six other failed institutions living off of taxpayer largesse, I noticed something that made me wonder if there was more going on than meets the eye at Citi.  I am starting to think Citigroup is being forcibly dismantled by the Obama Administration as a condition of its bailout. Could there be some bailout strings of which we are not yet aware?

Why is WFC not getting pay caps?

The thing I noticed was Wells Fargo’s name missing from Kenneth Feinberg’s list. The seven companies now subject to pay caps are: Citigroup, GMAC, American International Group, General Motors, Chrysler Group and Chrysler Financial. But, last time I checked, Wells Fargo was suckling from the government breast via a $25 billion TARP payment. What gives?

The only logical conclusion one can make is that the Obama Administration has excluded Wells Fargo because it is a healthier institution than the pay-cap seven. I agree with that assessment despite a downbeat post on Wells earnings last week. The headwinds from Wachovia are significant. But the underlying earnings power of Wells Fargo’s franchise is of a different caliber than Citigroup’s. If you saw Citi’s earnings report, it was a disaster in banking, credit cards, trading, you name it.  Everywhere, Citigroup was getting killed.

So clearly, in looking at the too big to fail banks, something quite awful is still amiss at Citi (and at BofA to a degree) that is not at Wells Fargo or JPMorgan Chase (Goldman and Morgan Stanley are not really banks).

Remember those stress tests?

The question then is: what do you (the government) do about the problems at Citi, and, to a lesser degree, Bank of America? Well, we have answer number one: pay caps for executives. And don’t think Ken Lewis left Bank of America on his accord, despite his huge golden parachute. We could be seeing some of his cash clawed back. I suspect, however, there is more for these multi-bailout offenders.

Think back to the bogus stress tests from this past spring and summer. I was pointing the finger at Citi and BofA then, saying these stress tests were just a cover-up to buy these organizations more time. If they weren’t able to make the grade in that time, more draconian action would be warranted. My logic was as follows:

The leaks about who failed the stress tests are already starting.  Who got a big fat ‘F’?  Apparently, Citi and BofA for starters.  But is that any surprise?…

See, the stress are just a scheme to make us think the Federal government is actually doing something about the under-capitalized banking system in the U.S.. In reality, the Obama Administration is just buying more time in order to let us grow our way out of this problem…

Based on what Summers is saying, the stress tests are not designed to really test anything. They are designed to make it seem like the government has things well in hand so that we can grow our way out of this crisis with the help of government stimulus and debt.

Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.

So, Geithner and Summers are hoping FDIC-subsidized funding, toxic asset removal, fiscal stimulus, quantitative easing and all the other measures now in place will kick in and provide a recovery – and solve the banking problem. However, if the problem is not solved, there is plan B – debt-for-equity swap, nationalization, or asset seizure.

In my view, we should be going to Plan B right from the start rather than going through this jerry-rigged sham of a stress test.

Everyone beat the clock… except Cit and BofA

Now, time is up. All of the big banks raised boatloads of capital months ago. If Citi and BofA aren’t ready to hand back TARP funds yet… then they may never be. It is time for Plan B.

Remember back in May when all the big banks ‘passed’ the tests and immediately went to the capital markets for more capital after their share prices had doubled, tripled and quadrupled? That whole process was by design. We were supposed to have some ‘stress tests,’ followed by a clean bill of health, all in an effort to get those stock prices up so the banks could sell shares to shore up their capital base (the exact same thing has just happened in Sweden, by the way. See here and here).

Every bank CEO which could escape TARP, ran as fast as he could away from the government and the TARP facility. Only the truly capital-constrained remained under TARP, namely Wells, BofA and Citi. Wells is going to earn their way out of this one (which George Soros feels is exactly what should happen). Obviously, Citi and BofA are a different story. Hence the pay caps. But, I suspect there is a lot more.

Citi pullback and asset sales

Let’s concentrate on Citi because I have written a lot about their asset sales over the last year. They are the big bank which is truly deleveraging the most. They are selling everything they can to raise cash. Here’s a short list. Please tell me ones I have missed.

• Sale of German retail bank (Jul 2008)
• Morgan Stanley-Smith barney deal (Jan 2009)
• Lending halt in Denmark (Feb 2009)
• Sale of Brazilian assets (Feb 2009)
• Sale of Japanese business Nikko (May 2009)
• Potential disgorgement in Mexico (Oct 2009)

I am sure there is a lot I am missing here. Nevertheless, it is clear that the Citigroup of 2011 or 2012 will be a shadow of its former self. I suspect the same is true for Bank of America as well.

But, it strikes me as likely that these sales – at least the ones in 2009 – are being dictated by the Obama Administration. Citibank may not be selling purely because they need the capital and it makes strategic sense to do so. The coercive power of government may be standing shotgun over this.  All of the chatter between big banks and government is being done behind closed doors, so we can’t know what the true pre-conditions of the BofA or Citigroup bailouts were.

My operating assumption to date is that the government recklessly gave the banks all of the bailout money and backstops, asking next to nothing in return – all largely because they are captured by the financial services lobby. But, I would like to think there were at least some strings attached and that we are now beginning to see what those strings are.

Related posts:

• JPMorgan has record revenue and $2.7 billion in profit
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• Ten big banks receive approval to repay TARP funds
• How is Citi going to deal with $38 billion in deferred tax assets?
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks

Below is a good video analysis by Jess Bravin of the Wall Street Journal on the BofA-Merrill Lynch saga.  Bravin discusses the recent rejection by Judge Jed Rakoff of the out-of-court settlement between the SEC and Bank of America (BAC) in which BofA was to pay a miniscule $33 million fine.

Rakoff’s decision to scupper this settlement stems from his understanding that BofA shareholders are the ones who have allegedly been harmed by BofA’s actions. Yet they are also the ones to pay the fine.  The SEC deal did not seek charges against bank management or lawyers. Management and attorneys were the alleged perpetrators of the false and misleading proxy statements that led to shareholder approval of the acquisition of Merrill Lynch. Bravin says Rakoff believes this may have been the result of collusion.

The settlement is a perfect example of regulatory capture and demonstrates why the financial system has failed.

Related articles

Andrew Cuomo’s Most Recent Letter To Bank Of America – Zero Hedge

Related posts:

• Judge stops BofA deal with the SEC
• Mea Culpa: I was too bullish on the BofA-Merrill deal
• BofA CEO confirms government coerced him into Merrill deal
• BofA CEO Lewis investigated by SEC
• BofA saga continues as John Thain calls Lewis a liar

Thank goodness someone has some sense. Manhattan Federal District Court Judge Jed Rakoff refused to approve Monday’s Bank of America’s deal with the SEC be cause it may be unfair to the public to accept the settlement.

Bank of America was accused by the SEC of lying to shareholders about its role in bonuses at Merrill Lynch.  Yet, inexplicably, the SEC decide to settle the case for $33 million, allowing Bank of America to release a statement saying it had not admitted any wrong doing.

Bank of America believes that the settlement, which it entered into without admitting or denying the SEC’s allegations, represents a constructive conclusion to this issue.

This deal is a travesty and has now been stopped.

"Despite the public importance of this case, the proposed consent judgment would leave uncertain the truth of the very serious allegations made in the complaint," Rakoff wrote in his two-page order.

"The proposed consent judgment in no way specifies the basis for the $33 million figure or whether any of this money is derived directly or indirectly from the $20 billion in public funds previously advanced to Bank of America as part of its ‘bailout,’" the judge added.

SEC spokesman John Nester declined immediate comment. Bank of America did not immediately return requests for comment.

The Wall Street Journal, citing company emails and people familiar with the situation, added that the Charlotte, North Carolina bank’s loss projections for Merrill bulged by nearly $2 billion two days before the takeover was approved by shareholders.

The bank’s executives, however, decided that the losses were not severe enough to be disclosed publicly before the vote, the paper said.

Good thing we have Judge Rakoff on our side because the SEC has not done right by taxpayers supporting Bank of America with tens of billions or by Bank of America shareholders who have lost considerable sums due to the events associated with the credit crisis.

Source

Judge won’t approve Bank of America, SEC settlement – Reuters

Related posts:

• Judge Rakoff says BofA-SEC deal suggests collusion
• SEC charges BofA of lying to investors over Merrill but settles
• Mea Culpa: I was too bullish on the BofA-Merrill deal
• Merrill – Bank of America deal
• BofA CEO confirms government coerced him into Merrill deal

Bank of America’s story in the BofA-Merrill saga has always sounded dubious at best.  Ken Lewis has always claimed he was doing what was right by shareholders and America, that Gentle Ben and Hammering Hank coerced him into the Merrill deal, that Merrill’s CEO John Thain was not completely above board.

All of this should be looked at with great suspicion, especially in light of the SEC’s charges against BofA for lying to investors about Merrill’s bonuses.  The Washington Post reports:

The Securities and Exchange Commission on Monday charged Bank of America with lying to investors about its plan to pay billions of dollars in bonuses to employees of Merrill Lynch.

Bank of America, which bought the ailing investment bank this year, agreed to settle the charges and pay a $33 million penalty, according to the SEC. The company did not admit or deny wrongdoing.

The agency alleged that Bank of America violated securities law by telling investors in a November 2008 filing that bonuses would not be paid without its consent.

"In fact, Bank of America had already contractually authorized Merrill to pay up to $5.8 billion in discretionary bonuses to Merrill executives for 2008," the SEC said in a statement. "The disclosures in the proxy statement were rendered materially false and misleading by the existence of the prior undisclosed agreement allowing Merrill to pay billions of dollars in bonuses for 2008."

This case represents one of the highest profile instances so far of legal fallout from the financial crisis. The Bank of America settlement involves a company in which the U.S. government owns a large stake, having provided tens of billions of dollars in emergency relief.

Bank of America bought Merrill Lynch for $50 billion under heavy pressure from the U.S. government.

"Bank of America believes that the settlement, which it entered into without admitting or denying the SEC’s allegations, represents a constructive conclusion to this issue," said a Bank of America spokesman, Scott Silvestri. "This is an important step forward for Bank of America and allows us to focus our energies on enhancing stockholder value by continuing to execute our strategies for the long-term success of our business."

He would say that, wouldn’t he?  Let’s rewind a bit, shall we?  Lewis claimed that John Thain gave out bonuses to Merrill employees in an unauthorized way.  He fired Thain and made his name mud in public.  At the time, I said:

As for John Thain, the man has been pilloried publicly, in particular because of the bonus scandal and the office re-design.  But, let me ask you this: was BofA going to underpay its vaunted Merrill money-makers in a one-off bonus round and risk their exiting the company?  No.  If you went to a Fortune 500 company with a new CEO, what would you guess the average amount spent for office renovations would be?

Now we learn the truth: BofA may have authorized $5.8 billion in bonuses all along as I suspected.  BofA will now pay a penalty to avoid having to admit guilt or admitting the allegations. Whether they admit guilt, one should certainly be suspicious.

In my view, Ken Lewis seems to have been self-dealing and empire building throughout this. Clearly he saw Merrill as a jewel in the crown he has been building for years.  When the deal started to go pear shaped, he started pointing his finger at others. I do not see him looking out for his investors. Is anyone going to take the blame for this public relations disaster and black eye at BofA?  Will Ken Lewis resign?  Doubtful.

And it is pretty pathetic that Bank of America gets off with a mere slap on the wrist after the billions in money taxpayers have ponied up for that organization.  There should be absolutely no deal.  We deserve to know exactly what happened.  If BofA has a reasonable defense – fine.  If not, force wrongdoers to resign and suffer the legal ramifications.

But, of course, that’s not going to happen.

Related posts:

• BofA saga continues as John Thain calls Lewis a liar
• Mea Culpa: I was too bullish on the BofA-Merrill deal
• Ken Lewis points the finger at Bernanke and Paulson
• Merrill – Bank of America deal
• BofA CEO confirms government coerced him into Merrill deal

While Citi and BofA are getting taken to the woodshed for double secret probation, JPMorgan Chase is showing record revenue of $25.6 billion and a large profit of $2.7 billion.  As profit is up 36% from a year earlier and 27% from just last quarter, you can see that JPM is now firing on all cylinders.

The contrast between the performance at JPMorgan Chase and Goldman, who reported Tuesday and the beating that BofA and Citi are taking at the hands of regulators demonstrates which big banks are weak and which are doing better.  Goldman and JPMorgan have already returned their TARP funds and are free to return to business as usual.  Goldman has increased risk to pre-crisis levels according to Value at Risk (VaR) measurements and are due to give out record bonuses.  Meanwhile, JPMorgan Chase saw its loan loss reserves fall 2% from Q1 to Q2.

Citi is up tomorrow. Expect a huge contrast to what we have seen from Goldman and JPMorgan Chase. 

Also expect some serious regulatory steps as well. As I indicated in April’s post “Stress tests reveal Citi and BofA need more capital, but you knew that already,” some banks were going to pass the stress test while others would fail. I also said then that debt for equity swaps, nationalization or FDIC seizure were going to be on the table, if the failing banks didn’t get the necessary capital from the private market. Citi and BofA have both failed the stress tests and have not gotten enough capital.  So the Feds are going to move in and take action- and we’ll get a sense of what kind of action tomorrow.

The only remaining question is Wells Fargo.  They have not paid back their TARP money but I still suspect they are doing better than Citi and BofA.

Related posts:

• JPMorgan: Beats expectations despite writedowns
• Is Citi being forced to downsize by Obama?
• Ten big banks receive approval to repay TARP funds
• Will banks exiting TARP take back their toxic waste now?
• How is Citi going to deal with $38 billion in deferred tax assets?

Congressman Darrell Issa (R-CA) claims to have evidence supporting Ken Lewis’ original contention that he as threatened by government officials for contemplating pulling out of the BofA-Merrill deal.  Let’s review.  Two weeks ago, Lewis pointed the finger at Paulson and Bernanke in testimony before Congress (see my post).  This came after claims of government coercion that Lewis made in a he said-she said drama between Lewis and John Thain, the former head of Merrill Lynch. Clearly, someone is lying and this drama has become a political football.  Translation: a scapegoat will be found – justifiably or not.

So, now we have Issa going after the Fed after Obama presents his banking reform package asking to increase Federal Reserve power.  The narrative against the Fed reads as follows:  first these guys were asleep at the wheel on regulation, allowing a mortgage bubble to spin out of control.  Then, they recklessly lower interest rates, encouraging speculation and making the bubble that much larger.  Now, we see the Fed strong-arming banks in a desperate attempt to clean up the mess they made. And, they are covering it up to boot.  Do you want these people to have more power?

This argument is coming to a TV screen near you very soon – and most of it is justified.

Below is the clip of Issa making his case that the Federal Reserve coerce Lewis and is now covering it up (By the way, I should point out that this doesn’t get Ken Lewis off the hook for potentially disregarding his fiduciary responsibilities).

Related posts:

• Ken Lewis points the finger at Bernanke and Paulson
• Is Bernanke Toast? If he is, Summers is a shoo-in
• The Federal Reserve bails out AIG
• BofA CEO confirms government coerced him into Merrill deal
• Countrywide is the real problem at Bank of America

The drama at Bank of America continues with Ken Lewis testifying before Congress today.  Most of the events surround claims by Lewis that he was coerced into doing the Merrill deal by Hank Paulson and Ben Bernanke.   I chronicled these events when they were made public back in April.

• BofA CEO confirms government coerced him into Merrill deal
• BofA CEO Lewis investigated by SEC
• BofA saga continues as John Thain calls Lewis a liar
• Bof A’s MAC clause was as porous as swiss cheese

Just yesterday, it was revealed that Fed officials called  Lewis “reckless” in internal e-mails.  The Republican party is running with this and looking to make trouble for Bernanke and the Fed.  Given the fact that Bernanke is up for re-appointment, these events could have a material impact on the Obama Administration’s desire to keep him on.  The last two Fed Chairmen, Greenspan and Volcker were appointed by a President of one party, but subsequently kept on by the next President of another party.  If Bernanke goes, we could expect Larry Summers to be a top candidate for the Fed Chairman role.

As for Lewis, he argues that the Countrywide and Merrill acquisitions were in the country’s and in Bank of America’s best interest.  Below is the video of Lewis on Capitol Hill making his opening statements before Congress.

My take here is that the Bank of America case has become very political – and that means the blame game is going to be played. Someone — Bernanke, Lewis, Thain or Paulson — is going to take the fall.  The knives are out.

Related articles

Lewis, Fed Face Anger on Hill – WSJ.com

Related posts:

• Throwing Bernanke under the bus
• BofA saga continues as John Thain calls Lewis a liar
• Is Bernanke Toast? If he is, Summers is a shoo-in
• Ken Lewis defends Bank of America’s stress test results
• BofA CEO confirms government coerced him into Merrill deal

Here is the SEC press release regarding the fraud and insider trader alleged to have been perpetrated at Countrywide Financial, now a part of Bank of America (emphasis added):

SEC Charges Former Countrywide Executives With Fraud

Former CEO Angelo Mozilo Additionally Charged With Insider Trading

FOR IMMEDIATE RELEASE
2009-129

Washington, D.C., June 4, 2009 — The Securities and Exchange Commission today charged former Countrywide Financial CEO Angelo Mozilo and two other former executives with securities fraud for deliberately misleading investors about the significant credit risks being taken in efforts to build and maintain the company’s market share. Mozilo was additionally charged with insider trading for selling his Countrywide stock based on non-public information for nearly $140 million in profits.

The SEC alleges that Mozilo along with former chief operating officer and president David Sambol and former chief financial officer Eric Sieracki misled the market by falsely assuring investors that Countrywide was primarily a prime quality mortgage lender that had avoided the excesses of its competitors.

Excerpts
of E-Mails From
Angelo Mozilo

The SEC’s enforcement action alleges that from 2005 through 2007, Countrywide engaged in an unprecedented expansion of its underwriting guidelines and was writing riskier and riskier loans, which these senior executives were warned might ultimately curtail the company’s ability to sell them. Countrywide was required to disclose these important trends to its investors in the Management Discussion and Analysis portion of its SEC filings, but failed to do so.

“This is the tale of two companies,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “Countrywide portrayed itself as underwriting mainly prime quality mortgages using high underwriting standards. But concealed from shareholders was the true Countrywide, an increasingly reckless lender assuming greater and greater risk. Angelo Mozilo privately described one Countrywide product as ‘toxic,’ and said another’s performance was so uncertain that Countrywide was ‘flying blind.’”

Rosalind Tyson, Director of the SEC’s Los Angeles Regional Office, added, “Angelo Mozilo had access to detailed and alarming information about Countrywide’s operations. He knew that Countrywide was gambling with increasingly risky mortgages and he kept those details from investors while he was actively taking his own chips off the table.”

---

Additional Materials

• Litigation Release No. 21068
• SEC Complaint

---

According to the SEC’s complaint, filed in federal district court in Los Angeles, Countrywide’s annual reports for 2005, 2006, and 2007 misled investors in claiming that Countrywide “manage[d] credit risk through credit policy, underwriting, quality control and surveillance activities.” Its annual reports for 2005 and 2006 falsely stated that the company ensured its “access to the secondary mortgage market by consistently producing quality mortgages.” The annual report for 2006 also falsely claimed that Countrywide had “prudently underwritten” its Pay-Option ARM loans.

The SEC alleges that Mozilo, Sambol, and Sieracki actually knew, and acknowledged internally, that Countrywide was writing increasingly risky loans and that defaults and delinquencies would rise as a result, both in loans that Countrywide serviced and loans that the company packaged and sold as mortgage-backed securities.

According to the SEC’s complaint, Countrywide developed what was internally referred to as a “supermarket” strategy that widened underwriting guidelines to match any product offered by its competitors. By the end of 2006, Countrywide’s underwriting guidelines were as wide as they had ever been, and Countrywide made an increasing number of loans based on exceptions to those already wide guidelines, even though exception loans had a higher rate of default.

The SEC’s complaint alleges that Mozilo believed that the risk was so high that he repeatedly urged that Countrywide sell its entire portfolio of Pay-Option loans. Despite these severe concerns about the increasing risks that Countrywide was undertaking, Mozilo, Sambol, and Sieracki hid these risks from the investing public.

The SEC further alleges that Mozilo engaged in insider trading of Countrywide stock that he owned. Mozilo established four executive stock sale plans for himself in October, November, and December 2006 while he was aware of material, non-public information concerning Countrywide’s increasing credit risk and the expected poor performance of Countrywide-originated loans. From November 2006 through August 2007, Mozilo exercised more than 5.1 million stock options and sold the underlying shares for total proceeds of nearly $140 million, pursuant to written trading plans adopted in late 2006 and early 2007.

The SEC’s complaint alleges that each of the defendants violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and aided and abetted violations of Sections 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder. The complaint further alleges that Mozilo and Sieracki violated Rule 13a-14 under the Exchange Act. The SEC’s complaint seeks permanent injunctive relief, officer and director bars, and financial penalties against all of the defendants and the disgorgement of ill-gotten gains with prejudgment interest against Mozilo and Sambol.

# # #

For more information, contact:

Rosalind R. Tyson
Regional Director, SEC’s Los Angeles Regional Office
(323) -965-3893

Michele Wein Layne
Associate Regional Director-Enforcement, SEC’s Los Angeles Regional Office
(323) 965-3850

John McCoy
Regional Trial Counsel, SEC’s Los Angeles Regional Office
(323) 965-3890

http://www.sec.gov/news/press/2009/2009-129.htm

Related posts:

• Countrywide: California sues too
• Ex-Countrywide CEO is the new Ken Lay
• Former Countrywide head Mozilo is charged by the SEC
• Florida sues Countrywide
• More reason BofA is crazy to take on Countrywide

Jim Cramer is not just calling a stock market bottom, but now he’s calling a housing bottom too.  In fact, he says go buy a house.  “Buy a house and buy Bank of America too?”  Cramer says: “This is patently obvious.”

Take a look and tell me what you think.  Personally, I know his stock picking record is dubious so I tend to dismiss this too. Hat tip Joe Weisenthal.

Related posts:

• Nationwide: U.K. house prices down 16.6%
• UK house prices up for third time in fourth month
• Nationwide: U.K. house prices rise for second time in three months
• Nationwide: U.K. house prices down 17.6% in year to Februay
• House prices in the U.K. up for first time since Oct 2007

Earlier today I posted an article about how accounting was favourable to banks in that it could help them weather the storm and appear well-capitalized until a recovery is underway.  Afterwards, a buoyant economy would increase earnings enough to allow the massive writedowns that need to flow through the income statement to be taken in stride.  As an addendum to the previous post, I added a note regarding how this turn-of-events can take place even though the housing market is considerably worse than most pundits felt it would be.

Calculated Risk has a story out (Revisiting the JPMorgan / WaMu Acquisition) which suggests that JPMorgan, if anything, under-provisioned for the eventual WaMu losses.  That would suggest a lot of writedowns over the life of the WaMu loans. This is an account that I would tend to believe as the housing market is worse than the baseline case JPMorgan presented after the acquisition (see my post "JP Morgan Chase buys WaMu out").  Again, I see WaMu as a bankrupt organization that was destined to fail.  Nevertheless, over the short-term, accounting from the transaction can be favourable to JPMorgan’s earnings – and I see that as a net positive for JPM.

I have another tack regarding bank earnings to share.  Feel free to express your agreement or doubt in the comments regarding this line of argument.  As a result of the securitization model of mortgage finance having replaced the traditional model, banks with large retail customer bases are geared to transactions and volume as a way of making money.  This means banks like high mortgage transaction volumes, whether through actual purchases or refinancing.  Some of the the banks geared in that direction include Wells Fargo and Wachovia, Bank of America and Countrywide Financial, and JPMorgan and Washington Mutual. All of these banks will benefit from having bought other bankrupt organizations with large mortgage operations. 

For example, say you buy a house in 2004 that is not underwater. Having seen your 5-year ARM reach the end of the ARM period, you are looking to refinance now in 2009.  Using some of the homeowner-oriented bailout schemes, your bank can lower your monthly payment but in return they get an incentive payment:

• A straight out cash incentive payment of say $1000 for doing a loan modification on a still current loan as the lender (say Wells Fargo) AND another cash payment as a servicer (say, Countrywide, now BofA).
• A amortized payment equal to half of the savings you just received (as long as you stay current, which 40% of loan-mods are not doing). So you save $100, but the bank gets $50 a month for the next five years as a lender. The servicer will get annual payments here as well.

Nice, huh?  Well read this from the Mortgage Bankers Association from last week’s Weekly Mortgage Applications Survey.  I have highlighted the points you should pay attention to.

The Mortgage Bankers Association (MBA) today released its Weekly Mortgage Applications Survey for the week ending May 15, 2009.  The Market Composite Index, a measure of mortgage loan application volume, was 915.9, an increase of 2.3 percent on a seasonally adjusted basis from 895.6 one week earlier.  On an unadjusted basis, the Index increased 2.0 percent compared with the previous week and increased 42.0 percent compared with the same week one year earlier.

The Refinance Index increased 4.5 percent to 4794.4 from 4588.6 the previous week and the seasonally adjusted Purchase Index decreased 4.4 percent to 254.0 from 265.7 one week earlier. 

The four week moving average for the seasonally adjusted Market Index is down 6.4 percent.  The four week moving average is up 0.1 percent for the seasonally adjusted Purchase Index, while this average is down 8.2 percent for the Refinance Index.

The refinance share of mortgage activity increased to 73.6 percent of total applications from 71.9 percent the previous week. The adjustable-rate mortgage (ARM) share of activity increased to 2.4 percent from 2.3 percent of total applications from the previous week.

The fact is bankers are looking to get A LOT of refinancing volume because both servicers and lenders stand to increase current net income significantly if refinancing volumes are high.  An increased refinancing transaction volume is a backdoor way of re-capitalizing banks.  Now, just in case you are interested, here is what the same MBA Weekly report looked like on Oct 8th, just after Lehman filed for bankruptcy.

The Mortgage Bankers Association (MBA) today released its Weekly Mortgage Applications Survey for the week ending October 3, 2008.  The Market Composite Index, a measure of mortgage loan application volume, was 465.5, an increase of 2.2 percent on a seasonally adjusted basis from 455.4 one week earlier.  On an unadjusted basis, the Index increased 2.2 percent compared with the previous week and was down 28.6 percent compared with the same week one year earlier.

The Refinance Index increased 0.9 percent to 1345.8 from the previous week and the seasonally adjusted Purchase Index increased 3.2 percent to 314.5 from one week earlier.  The Conventional Purchase Index increased 0.7 percent while the Government Purchase Index (largely FHA) increased 9.9 percent.
The four week moving average for the seasonally adjusted Market Index is down 1.4 percent.  The four week moving average for the seasonally adjusted Purchase Index is down 4.1 percent, while this average is up 1.8 percent for the Refinance Index.

The refinance share of mortgage activity decreased to 43.4 percent of total applications from 44.0 percent the previous week. The adjustable-rate mortgage (ARM) share of activity decreased to 2.3 percent from 2.5 percent of total applications from the previous week.

Clearly refinancing volume is through the roof as zero percent interest rates are an incentive for all mortgage-holders to refinance.  This increased volume of transactions will be very helpful to banks’ earnings over the near-term.  Notice that I haven’t mentioned Citigroup anywhere here because they lost out in the Wachovia transaction and they have a fairly small retail operation domestically.

Source

Mortgage Applications Increase in Latest MBA Weekly Survey: 20 May 2009 – MBA website

Mortgage Applications Increase Slightly In Latest MBA Weekly Survey: 8 Oct 2008 – MBA website

Related posts:

• More on Fannie and Freddie – Signs of life in the Refi Market?
• How much money is Wells Fargo really making?
• Fixed rate mortgages at a nine-month high
• Merrill – Bank of America deal
• WaMu: Mr. Smith goes to Washington and turns predatory

The following Bloomberg article points out why I have repeatedly argued that banks will be earning a lot of money, Meredith Whitney’s counter-arguments notwithstanding. It also points out why the likes of John Hempton believe that the FDIC ‘stole’ Washington Mutual from shareholders and awarded it to JPMorgan, a view I have not supported (hat tip Marshall Auerback).  For those of you who don’t think accounting matters tremendously in why banks are going to fare much better than anticipated, you need to read this article.  I have bolded the most significant parts

JPMorgan Chase & Co. stands to reap a $29 billion windfall thanks to an accounting rule that lets the second-biggest U.S. bank transform bad loans it purchased from Washington Mutual Inc. into income.

Wells Fargo & Co., Bank of America Corp. and PNC Financial Services Group Inc. are also poised to benefit from taking over home lenders Wachovia Corp., Countrywide Financial Corp. and National City Corp., regulatory filings show. The deals provide a combined $56 billion in so-called accretable yield, the difference between the value of the loans on the banks’ balance sheets and the cash flow they’re expected to produce.

Faced with the highest U.S. unemployment in 25 years and a surging foreclosure rate, the lenders are seizing on a four- year-old rule aimed at standardizing how they book acquired loans that have deteriorated in credit quality. By applying the measure to mortgages and commercial loans that lost value during the worst financial crisis since the Great Depression, the banks will wring revenue from the wreckage, said Robert Willens, a former Lehman Brothers Holdings Inc. executive who runs a tax and accounting consulting firm in New York.

“It will benefit these guys dramatically,” Willens said. “There’s a great chance they’ll be able to record very substantial gains going forward.”

When JPMorgan bought WaMu out of receivership last September for $1.9 billion, the New York-based bank used purchase accounting, which allows it to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent. Now, as borrowers pay their debts, the bank says it may gain $29.1 billion over the life of the loans in pretax income before taxes and expenses.

Basically, all of these banks acquired loan books that were marked down tremendously before they went on the books.  Now, they are going to use this to their advantage and run the ‘excess’ cash flow from these assets through the income statement.  John Hempton has been particularly vociferous about the purchase accounting in the WaMu deal.  Because I had puts on WaMu through August 2007, I tend to see Washington Mutual as a bankrupt organization that was destined to fail.  If you read Hempton’s account, he makes an argument for the opposite. It all boils down to purchase accounting.

Purchase Accounting

The purchase-accounting rule, known as Statement of Position 03-3, provides banks with an incentive to mark down loans they acquire as aggressively as possible, said Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine.

“One of the beauties of purchase accounting is after you mark down your assets, you accrete them back in,” Cassidy said. “Those transactions should be favorable over the long run.”

JPMorgan bought WaMu’s deposits and loans after regulators seized the Seattle-based thrift in the biggest bank failure in U.S. history. JPMorgan took a $29.4 billion writedown on WaMu’s holdings, mostly for option adjustable-rate mortgages and home- equity loans.

“We marked the portfolio based on a number of factors, including housing-price judgment at the time,” said JPMorgan spokesman Thomas Kelly. “The accretion is driven by prevailing interest rates.”

What about the other transactions: Wachovia, Lehman, Countrywide, Merrill?  I am sure you will find the same dynamic at work.  The article goes on to mention how many of these deals will also be favourable: at least over the short-term – and that  is what matters.  If the big banks can re-capitalize during this recession and we get a recovery, they are going to be able to take the eventual writedowns in stride as recovery will buoy their earnings potential.

Watch Q2 earnings at the banks, because Meredith Whitney and others are expecting a horrendous quarter.  I am not.  I think this accounting swag is going to be a positive for banks and may cause their shares, now under pressure to stabilize or rally.  Key names to watch: BAC, JPM, PNC, WFC, and COF, all of whom have benefitted from purchase accounting.  You should notice that Citigroup is not amongst these names.

The full story is linked below.

UPDATE 3:40PM: Calculated Risk has a story out (Revisiting the JPMorgan / WaMu Acquisition) which suggests that JPMorgan, if anything, under-provisioned for the eventual WaMu losses.  That would suggest a lot of writedowns over the life of the WaMu loans. This is an account that I would tend to believe as the housing market is worse than the baseline case JPMorgan presented after the acquisition (see my post “JP Morgan Chase buys WaMu out“).  Again, I see WaMu as a bankrupt organization that was destined to fail.  Nevertheless, over the short-term, accounting from the transaction can be favourable to JPMorgan’s earnings – and I see that as a net positive for JPM.

Update 540PM: Here is the associated viedo clip.

Source

JPMorgan $29 Billion WaMu Windfall Turned Bad Loans Into Income – Bloomberg.com

Related posts:

• JPMorgan: Beats expectations despite writedowns
• How refinancing helps the likes of Bank of America and Wells Fargo
• JPMorgan has record revenue and $2.7 billion in profit
• Regionals options suffer due to accounting rules
• WaMu on the brink of disaster: has agreement with regulators

In the CNBC video below, Ken Lewis defends his company’s performance on the stress test and answers some pointed questions in the John Thain – Ben Bernanke – Ken Lewis – Hank Paulson he said she said match.  He also details how Bank of America plans to raise the $34 billion in capital to deal with the government’s plans.  All in all, despite looking very stressed, it was a good performance from Lewis.  Take a look. By the way, Lewis says Countrywide “is on fire in a positive way.”

Related posts:

• Countrywide is the real problem at Bank of America
• Ken Lewis is out as Chairman of Bank of America
• Bank of America cuts its dividend
• Ken Lewis points the finger at Bernanke and Paulson
• Bank by bank breakdown of stress test results

If you haven’t noticed, the Treasury department seems to be leaking the results of the stress tests to reporters at the Wall Street Journal.  Richard Bove, a well-known bank analyst was on Bloomberg Radio this morning talking to Tom Keene and said he knows they have been leaking.  Yves Smith was on top of this a few days back.  With the results to be released tomorrow, we now pretty much know who the winners are and who the losers are.

The losers are Citigroup, Bank of America, Wells Fargo and GMAC. Bloomberg reports:

Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and GMAC LLC are among the companies judged to need additional capital according to results of regulators’ stress tests on the 19 largest U.S. banks.

Bank of America has the biggest shortfall, at $34 billion, according to people familiar with the matter. Citigroup’s requirement for deeper reserves to offset potential losses over the coming two years is about $5 billion, people with knowledge of that bank’s results said. Wells Fargo requires about $15 billion, while GMAC’s need is $11.5 billion, one person said.

Goldman Sachs Group Inc., Morgan Stanley, MetLife Inc., JPMorgan Chase & Co., Bank of New York Mellon Corp. and American Express Co. were deemed not to need additional funds, the results show.

Stocks rallied after the news, sending the Standard & Poor’s 500 Financials Index to its highest level in four months. The results are the culmination of weeks of investigations, led by the Federal Reserve, into the banks’ lending practices, funding strategies and securities and loan portfolios.

“The markets are telling us we’re in a recovery and the banks are beginning to heal,” William Isaac, former chairman of the Federal Deposit Insurance Corp., said in an interview today. The end of the stress tests after “three months of water torture” is providing investors some relief, he said.

The regulators put an emphasis in their reviews on tangible common equity. Citigroup’s assessment reflects the New York- based bank’s previously announced plan to convert some of its preferred shares into common stock.

Spokespeople for all of the 10 banks declined to comment.

It’s not as if any of these banks really are losers here.  This charade was pretty predictable. I said as much last week. 

Just one look at the credit ratings and stock prices of the 19 banks and financial institutions in the stress tests will tell you which are the weak institutions. So, why the charade?

Based on what Summers is saying, the stress tests are not designed to really test anything. They are designed to make it seem like the government has things well in hand so that we can grow our way out of this crisis with the help of government stimulus and debt.

Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.

Of those banks that need more capital, Bank of America was up 15%, Citi 14%, and Wells 13%.  Only GMAC suffered.  The word on the street is that investors are happy with the results and relieved that more capital is not needed. Congress and taxpayers won’t need to pony up either.  That’s a relief!

Bove doesn’t seem to think this is good news however.  Another Bloomberg story quoted him as seeing this as negative for expanding credit:

Forcing banks to boost capital in the midst of a recession will cripple lending and may delay a recovery, said Richard Bove, vice president and equity research analysts at Rochdale Securities in Lutz, Florida.

“How are they going to assist the American economy if they are shrinking?” Bove said today in an interview on Bloomberg Radio. “If you make all those banks shrink, which is what you’re really doing by forcing them to add capital, how are they going to lend money?”

Regulators determined Bank of America Corp. requires about $34 billion in new capital, the largest need among the 19 biggest banks subjected to government stress tests, according to a person with knowledge of the matter. Other institutions require capital as well.

“If you go beyond these 19 banks to the next 20, which is what they are going to do, you’re going to knock some of those banks out of business,” Bove said.

“By the time you finish, my guess is you will at least knock at least 150 banks out of business in the United States, shrinking the banking industry in the middle of a recession at a time when you want them to provide more lending to grow the economy,” Bove said. “It makes no sense at all.”

In theory, Bove is correct, but there have been significant reports that Bank of America is selling non-core assets and that they will convert all of their preferred stock into common in order to meet the tangible common equity guidelines laid out in the stress tests.  So, ultimately, even Bank of America, the most under-capitalized of the banks is not going to have to raise any outside capital.  This is why bank shares were up big-time.

But, wait a minute.  Isn’t the preferred, equity that Bank of America already has on its balance sheet?  Why is moving items around like a massive shell game going to make this organization better capitalized?  Paul Kasriel has the answer. It’s called accounting alchemy (pdf):

Congress currently is in no mood to authorize more funds to help recapitalize the financial system. The Treasury says this will not be a problem. If financial institutions need additional capital from the taxpayers to remain solvent, the Treasury will simply shift the preferred shares it already owns in financial institutions to common equity shares. Voila – capital adequate financial institutions! Really?

Consider Balance Sheet One of hypothetical Gotham City Bank. Assets equal liabilities plus common equity. That is good for starters.

But suppose the Treasury believes that Gotham should have a ratio of common equity to total assets of 10% rather than the 5% it currently has. No problem. Treasury will just convert $5 of the preferred shares it owns in Gotham to $5 of common equity. This is shown in Balance Sheet Two. Now Gotham is well capitalized, right? Wrong. The depositors and the bond holders always were in line in front of the preferred shareholders in case Gotham had to be liquidated. So, moving $5 from the preferred equity category to the common equity category does not make the depositors and bond holders any better off. Are taxpayers any worse off? Not really. If Gotham’s original $5 of common equity was not going to be enough of a cushion to protect depositors and bondholders, then taxpayers were not going to get all of their preferred-share holdings back anyway.

Now suppose that $30 of Gotham’s loans and investments become uncollectible, as shown in Balance Sheet Three. This means that all of Gotham’s common equity has been wiped out. In fact, Gotham now has an equity "deficiency" of $20. No problem, according to Treasury. It will simply convert its remaining $10 of preferred equity to common equity. That won’t cut it in this case. As shown in Balance Sheet Four, Gotham still has a common equity deficiency of $10. In other words, if Gotham were to be liquidated, there are only $70 of assets to pay off $60 of deposits and $20 of bonds. Either the Treasury would have to come up with $10 of new funds or bondholders would have to take a 50% haircut. If the Treasury wanted to keep Gotham open and with a ratio of common equity to total assets of 10%, Treasury would have to inject $17 of new funds, all of which would be common equity. In other words, Treasury, meaning us taxpayers, would own 100% of Gotham.

In sum, Treasury’s plan to enhance the capitalization of some financial institutions by beating preferred equity shares into common equity shares is accounting alchemy.

Problem solved. There will be no train wreck. Move along, nothing to see here.

Related posts:

• Bank by bank breakdown of stress test results
• At least six banks need more capital under stress tests
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• What the stress tests reveal about Obama’s thinking on banks
• GMAC has been nationalized

This is from BofA’s website:

Bank of America Corporation today announced the results of management and shareholder proposals at the company’s 2009 annual meeting…

All 18 directors were elected to the board by comfortable margins. In addition, management proposals regarding executive compensation and the retention of PricewaterhouseCoopers LLC as the company’s independent accounting firm were approved.

Seven shareholder proposals were not approved. An eighth shareholder proposal to change the company’s by-laws to require an independent chairman was narrowly approved. (For results see the table below).

At a meeting of the Board of Directors today, after a recommendation from the Governance Committee, Dr. Walter E. Massey was elected chairman. Kenneth D. Lewis will be president and chief executive officer. The board unanimously expressed its support for Lewis to continue in that role…

During the meeting, Lewis said the company’s long-term vision for profitable growth is being advanced by the acquisitions of Merrill Lynch & Co. and Countrywide Financial Corp. despite the challenging economic environment.

“We are building this company and managing for the long term,” Lewis told shareholders at the company’s annual meeting today. “I continue to believe we have built the best financial company in the industry, and that our results over the long term will bear that out.

“Let me acknowledge that 2008 was a very difficult year for the economy, for the financial services industry and for our company in particular,” Lewis said. “Our company’s shareholders have carried a heavy burden recently. We are doing everything within our power every day to fight through today’s adversity and drive toward tomorrow’s promise.

“Merrill will help the company move toward its goal of developing stronger, deeper and more profitable customer relationships over the long term through its leading positions in capital markets and wealth management,” Lewis said. “Countrywide helped Bank of America gain a high-quality franchise and customer base along with significant market share in mortgages – a cornerstone financial product,” he added.

“My strong feeling is that organizational integration – and a renewed focus on organic growth – will be the almost exclusive focus of our efforts in the coming years,” Lewis said.

Bank of America Chief Financial Officer Joe Price told shareholders the company’s core strengths in its business become more evident in challenging economic times.

“Our broad customer and client reach and geographic diversity form a powerful engine for revenue generation and earnings,” Price said. “Our business diversity is equally important, providing balance as some businesses perform well while others are confronted with challenges.”

With the earnings power added from recent acquisitions including Countrywide, Merrill, LaSalle Bank and MBNA, along with the cost savings opportunities, Price said although he can’t predict future results, he believes the company has the potential to produce approximately $30 billion in annual net income under more normal economic conditions.

“As demonstrated by our history of revenue and earnings, and despite today’s challenges, the model we have built is working, and we expect it to be even more powerful in the future,” Price said.

    Items of Business Voting Final Results

                    Directors                  % For        % Against

    William Barnet, III                         93.19           6.81
    Frank P. Bramble, Sr.                       78.32          21.68
    Virgis W. Colbert                           85.64          14.36
    John T. Collins                             93.32           6.68
    Gary L. Countryman                          87.33          12.67
    Tommy R. Franks                             93.43           6.57
    Charles K Gifford                           92.58           7.42
    Kenneth D. Lewis                            67.33          32.67
    Monica C. Lorenzo                           75.34          24.66
    Walter E. Massey                            92.72           7.28
    Thomas J. May                               93.32           6.68
    Patricia E. Mitchell                        87.92          12.08
    Joseph W. Prueher                           85.69          14.31
    Charles O. Rossotti                         86.37          13.63
    Thomas M. Ryan                              84.06          15.94
    O. Temple Sloan                             62.60          37.40
    Robert L. Tillman                           75.66          24.34
    Jackie M. Ward                              71.79          28.21

               Management Proposals            % For        % Against

    Ratification of Accounting Firm             96.70           3.30
    Executive Compensation (non-binding)        71.28          28.72

              Shareholder Proposals            % For        % Against

    Government Employment Disclosure             7.81          92.19
    Executive Compensation Advisory Vote        40.08          59.92
    Cumulative Voting                           37.78          62.22
    Special Stockholder Meetings                49.35          50.65
    Independent Board Chairman                  50.34          49.66
    Credit Card Practices                       33.38          66.62
    Healthcare Reform Principles                 7.52          92.48
    Limits on Executive Compensation            26.77          73.23

Related posts:

• Countrywide is the real problem at Bank of America
• BofA saga continues as John Thain calls Lewis a liar
• Ken Lewis defends Bank of America’s stress test results
• Denmark: Fionia Bank collapses
• The horrible self-dealing of Ken Lewis and the principal-agent problem

Over the past few days, I have written two posts regarding the increasingly acrimonious sparring surrounding Bank of America’s acquisition of Merrill Lynch.

• The horrible self-dealing of Ken Lewis and the principal-agent problem
• BofA CEO Lewis investigated by SEC
• BofA saga continues as John Thain calls Lewis a liar

The latest news is stunning: Bank of America’s MAC clause could probably never have been invoked because it had a specific exclusion for the deteriorating prices of legacy assets on Merrill’s books.

Here’s what it says. All you need to do is read the highlighted parts:

3.8 Absence of Certain Changes or Events. (a) Since June 27, 2008, no event or events have occurred that have had or would reasonably be expected to have, either individually or in the aggregate, a Material Adverse Effect on Company. As used in this Agreement, the term “Material Adverse Effect” means, with respect to Parent or Company, as the case may be, a material adverse effect on (i) the financial condition, results of operations or business of such party and its Subsidiaries taken as a whole (provided, however, that, with respect to clause (i), a “Material Adverse Effect” shall not be deemed to include effects to the extent resulting from (A) changes, after the date hereof, in GAAP or regulatory accounting requirements applicable generally to companies in the industries in which such party and its Subsidiaries operate, (B) changes, after the date hereof, in laws, rules, regulations or the interpretation of laws, rules or regulations by Governmental Authorities of general applicability to companies in the industries in which such party and its Subsidiaries operate, (C) actions or omissions taken with the prior written consent of the other party or expressly required by this Agreement, (D) changes in global, national or regional political conditions (including acts of terrorism or war) or general business, economic or market conditions, including changes generally in prevailing interest rates, currency exchange rates, credit markets and price levels or trading volumes in the United States or foreign securities markets, in each case generally affecting the industries in which such party or its Subsidiaries operate and including changes to any previously correctly applied asset marks resulting there from, (E) the execution of this Agreement or the public disclosure of this Agreement or the transactions contemplated hereby, including acts of competitors or losses of employees to the extent resulting therefrom, (F) failure, in and of itself, to meet earnings projections, but not including any underlying causes thereof or (G) changes in the trading price of a party’s common stock, in and of itself, but not including any underlying causes, except, with respect to clauses (A), (B) and (D), to the extent that the effects of such change are disproportionately adverse to the financial condition, results of operations or business of such party and its Subsidiaries, taken as a whole, as compared to other companies in the industry in which such party and its Subsidiaries operate) or (ii) the ability of such party to timely consummate the transactions contemplated by this Agreement.

(b) Since June 27, 2008 through and including the date of this Agreement, Company and its Subsidiaries have carried on their respective businesses in all material respects in the ordinary course of business consistent with their past practice.

(c) Since June 27, 2008 through and including the date of this Agreement, neither Company nor any of its Subsidiaries has (i) except for (A) normal increases for or payments to employees (other than officers subject to the reporting requirements of Section 16(a) of the Exchange Act (the “Executive Officers”)) made in the ordinary course of business consistent with past practice or (B) as required by applicable law or contractual obligations existing as of the date hereof, increased the wages, salaries, compensation, pension, or other fringe benefits or perquisites payable to any Executive Officer or other employee or director from the amount thereof in effect as of June 27, 2008, granted any severance or termination pay, entered into any contract to make or grant any severance or termination pay (in each case, except as required under the terms of agreements or severance plans listed on Section 3.11 of the Company Disclosure Schedule, as in effect as of the date hereof ), or paid any cash bonus in excess of $1,000,000 other than the customary year-end bonuses in amounts consistent with past practice and other than the monthly incentive payments made to financial advisors under current Company programs, (ii) granted any options to purchase shares of Company Common Stock, any restricted shares of Company Common Stock or any right to acquire any shares of its capital stock, or any right to payment based on the value of Company’s capital stock, to any Executive Officer or other employee or director other than grants to employees (other than Executive Officers) made in the ordinary course of business consistent with past practice under the Company Stock Plans or grants relating to shares of Company Common Stock with an aggregate value for all such grants of less than $1 million for any individual, (iii) changed any financial accounting methods, principles or practices of Company or its Subsidiaries affecting its assets, liabilities or businesses, including any reserving, renewal or residual method, practice or policy, (iv) suffered any strike, work stoppage, slow-down, or other labor disturbance, or (v) except for publicly disclosed ordinary dividends on the Company Common Stock or Company Preferred Stock and except for distributions by wholly-owned Subsidiaries of Company to Company or another wholly-owned Subsidiary of Company, made or declared any distribution in cash or kind to its stockholder or repurchased any shares of its capital stock or other equity interests.

Translation: If the market tanks and assets already on the books when this deal is consummated are marked down, then this is NOT grounds for Bank of America to renegotiate or pull out.

Look, here’s the story:

• Ken Lewis rushed into a terrible deal for Merrill Lynch at a grossly inflated price because he desperately wanted Bank of America to be a top notch franchise across the full spectrum of products.  Merrill has a very good franchise and had a good brand until recently.
• The deal terms specifically excluded poor market conditions as a MAC clause.  I should add that this is standard operating procedure in many mergers as I have been witness to countless MAC clauses with this very exclusion in mergers when I worked in Leveraged Finance and Corporate Development.
• John Thain was doing his duty in getting the best deal for his shareholders and protecting the 60,000 jobs of Merrill Lynch from a Lehman cataclysm. Ken Lewis was arguably not worried enough that he was overpaying and wasting shareholder money.

So, if Ken Lewis says that he told Hank Paulson and Ben Bernanke on December 21st that he was invoking the MAC clause, then this was a hollow statement because the MAC clause could not be invoked.  Whether Lewis knew/knows that is unclear.

As for John Thain, the man has been pilloried publicly, in particular because of the bonus scandal and the office re-design.  But, let me ask you this: was BofA going to underpay its vaunted Merrill money-makers in a one-off bonus round and risk their exiting the company?  No.  If you went to a Fortune 500 company with a new CEO, what would you guess the average amount spent for office renovations would be?

All of the Thain theatrics were bread and circuses, distracting us from the real issues: is our financial system safe yet and, if not, how can we most prudently ensure it is.

Source
Definitive Proxy Statement (Schedule 14A), Merrill Lynch – BofA Merger – SEC Website

Related posts:

• UBS woes with IRS have Swiss worried
• Creditors paid in full? No – try 6 cents on the dollar
• Are European banks sitting on 16.3 trillion in toxic assets?
• Bank failures to surge in coming years
• Structured Credit downgrades

The leaks about who failed the stress tests are already starting.  Who got a big fat ‘F’?  Apparently, Citi and BofA for starters.  But is that any surprise?

Regulators have told Bank of America Corp. and Citigroup Inc. that the banks may need to raise more capital based on early results of the government’s so-called stress tests of lenders, according to people familiar with the situation.

The capital shortfall amounts to billions of dollars at Bank of America, based in Charlotte, N.C., people familiar with the bank said.

Executives at both banks are objecting to the preliminary findings, which emerged from the government’s scrutiny of 19 large financial institutions. The two banks are planning to respond with detailed rebuttals, these people said, with Bank of America’s appeal expected by Tuesday.

The findings suggest that government officials are using the stress tests to send a tough message to struggling banks. Bank of America and Citigroup have been the highest-profile problem children in recent months, but it is unlikely that they are the only banks the Federal Reserve has determined might need more capital.

Just three months ago these two mega-banks were on the verge of collapse and needed yet more cash to sustain them.  So, the ’stress tests’ haven’t provided any new information.  But, ah, there’s that last sentence: “it is unlikely that they are the only banks the Federal Reserve has determined might need more capital.”  Who else might need more dosh?

Industry analysts and investors predict that some regional banks, especially those with big portfolios of commercial real-estate loans, likely fared poorly on the stress tests. Analysts consider Regions Financial Corp., Fifth Third Bancorp and Wells Fargo & Co. to be among the leading contenders for more capital. Wells Fargo declined to comment. Representatives of Regions and Fifth Third didn’t respond to requests for comment made late in the day.

Government officials say their meetings about the stress tests with bank executives over the past few days conveyed preliminary results and that discussions were expected to continue this week about specific findings. They also say that banks directed to raise more capital shouldn’t be viewed as insolvent.

Come again? Banks directed to raise more capital shouldn’t be viewed as insolvent? Then what is the purpose of the stress tests, pray tell?

Instead, the capital is intended to cushion the banks against potential future losses under dire economic conditions. Federal officials say they won’t allow any of the top 19 banks to fail.

Still, it is unclear how flexible the government will be about adjusting the results, especially as banks plead their cases individually. Banks have until the middle of this week to lodge their formal responses to the tests. Bankers expect that will set the stage for several days of intense negotiations between the banks and their examiners.

Ah, I see, it is all a sham.

It sounds a lot like a test where the student banks who just failed go to the teacher regulator with mommy and daddy bank lobbyists in tow to see if they can get their grades changed higher. See, the stress are just a scheme to make us think the Federal government is actually doing something about the under-capitalized banking system in the U.S.. In reality, the Obama Administration is just buying more time in order to let us grow our way out of this problem.

According to MIT Professor and former IMF Chief Economist Simon Johnson, this is very nearly what Larry Summers said in a Feb 24th speech at the Inter-American Development Bank. Summing up Summers’ statements, Johnson says:

Summers made five points that reveal a great deal about his personal thinking – and the structure of thought that lies behind most of what the Administration is doing vis-a-vis the crisis. Some of this we knew or guessed at before, but it was still the clearest articulation I have seen.

1. All crises must end. The “self-equilibrating” nature of the economy will ultimately prevail, although that may take massive one-off government actions. Such a crisis happens only ”three or four times” per century, so taking on huge amounts of government debt is fine; implicitly, we will grow out of that debt burden.
2. We will get out of the crisis by encouraging exactly the kind of behaviors that “previously we wanted to discourage” two years ago. It is “this insight, this view” particularly with regard to leverage (overborrowing, to you and me) that “undergirds the policy program in the United States.”
3. There is a critical need to support financial intermediation and to ensure it is adequately capitalized, with a view to the risks inherent in the current situation. He then said, with a straight face, that the current bank stress tests are designed with this in mind.
4. Growth in the 1990s and more recently was based too much on finance (this appears to be a relatively new thought for Summers). The high and rising share of finance in corporate profits “should have been a warning”. The next expansion should be based less on asset bubbles and more on investment in key public services.
5. The financial regulatory system “in fundamental respects has been a failure”. There have been too many serious crises in the past 20 years (yes, this statement was somewhat at odds with the low frequency of major crises statement in point 1).

Just one look at the credit ratings and stock prices of the 19 banks and financial institutions in the stress tests will tell you which are the weak institutions. So, why the charade?

Based on what Summers is saying, the stress tests are not designed to really test anything. They are designed to make it seem like the government has things well in hand so that we can grow our way out of this crisis with the help of government stimulus and debt.

Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.

So, Geithner and Summers are hoping FDIC-subsidized funding, toxic asset removal, fiscal stimulus, quantitative easing and all the other measures now in place will kick in and provide a recovery – and solve the banking problem. However, if the problem is not solved, there is plan B – debt-for-equity swap, nationalization, or asset seizure.

In my view, we should be going to Plan B right from the start rather than going through this jerry-rigged sham of a stress test.

Sources
Fed Pushes Citi, BofA to Increase Capital – WSJ
Larry Summers’ New Model – The Baseline Scenario

Related posts:

• BofA, Citi, Wells and GMAC biggest losers in stress test leaks
• At least six banks need more capital under stress tests
• Reinhart: Not everybody can be above-average in stress tests
• Ackman and Stigliz talk Stress Tests with Charlie Rose
• What the stress tests reveal about Obama’s thinking on banks

The Wall Street Journal is running a front-page story about John Thain today in which he  accuses Bank of America CEO Ken Lewis of lying about events surrounding the Bank of America – Merrill transaction and the ouster of Thain as a top Bank of America executive.  Thain spent most of his career at Goldman Sachs, but left to head the New York Stock Exchange when he was passed over at Goldman in 2003.

The key issue as far as John Thain is concerned has to do with the bonuses paid out to Merrill Lynch executives.  Ken Lewis says he was apoplectic that these bonuses were paid when Merrill lost $15 billion.

But Mr. Thain says that he and Bank of America Chief Executive Kenneth Lewis agreed in writing that the bonuses could be paid before Bank of America’s acquisition of Merrill closed, which led to the early payments. “The suggestion Bank of America was not heavily involved in this process, and that I alone made these decisions, is simply not true,” he says.

Bank of America has painted a different picture than Mr. Thain’s of critical decisions that were made last fall. It has cast him as the person responsible for distributing billions of dollars of bonus money despite Merrill’s huge losses. Before Mr. Thain’s recent discussions with the Journal, he had refrained from commenting in depth.

Edward here. Honestly, Ken Lewis does not have a lot of credibility here after details of a February deposition were revealed last week. In that deposition, Lewis admitted to consummating the merger with Merrill Lynch despite his own misgivings about the deal, apparently because his job was on the line. So we have to take Lewis’ statements with this in mind.

The Wall Street Journal article continues later with this:

According to the merger documents, many other compensation decisions at Merrill were to be made “in consultation” with Bank of America officials. Bank of America approved paying a portion of the bonuses in Bank of America stock and was involved in setting compensation for a number of Merrill executives, people involved in the matter say.

Within days of the takeover announcement, Bank of America’s transition team arrived at Merrill to begin figuring out how to combine the two companies. About 200 employees set up on one floor of Merrill’s headquarters, and Bank of America Chief Accounting Officer Neil Cotty moved into an office on the 32nd floor.

The group became involved in nearly every aspect of Merrill’s operations, with dozens of Bank of America employees tracking Merrill’s financial condition on a daily basis, according to people who work at the firm.

In October, Bank of America announced that Mr. Thain had agreed to become president of the combined company’s global banking, securities and wealth-management business once the acquisition was completed. A bank spokesman said there had been “no commitment about succession in Mr. Thain’s decision to stay.”

Mr. Thain says that in late September, over a dinner in Charlotte, Mr. Lewis told him he was the only real candidate in line to succeed him.

By the end of November, Merrill’s losses were ballooning because of deteriorating market conditions and write-downs on various mortgage-related investments. Still, the daily emails sent to executives at both companies summarizing the deal’s status said “status green,” according to Mr. Thain, signaling that the takeover was on track.

In early December, the compensation committee of Merrill’s board agreed to a bonus pool of $3.62 billion. On Dec. 11, Bank of America asked Merrill to increase the amount of cash to 70%, according to a letter reviewed by the Journal. The two companies agreed that the stock portion of Merrill’s bonuses would be paid in early January. Mr. Thain says the documents prove that Bank of America was actively involved in compensation decisions.

Some Bank of America executives have said that Mr. Lewis lost confidence in Mr. Thain when Mr. Lewis learned of the losses from the transition team. Mr. Lewis flew to Washington on Dec. 17 to tell federal regulators that he was considering abandoning the takeover. Two days later, Mr. Thain left for vacation in Vail, Colo., unaware that the regulatory showdown had happened. Messrs. Thain and Lewis both have said that Mr. Thain didn’t find out until Jan. 5.

What transpired is not entirely clear, but the following is a potential course of events:

• John Thain sees Merrill Lynch on the verge of failure on the weekend of Lehman’s demise and rings Ken Lewis, a man he hardly knows – after all Bank of America is not really a creature of Wall Street. John Thain and Merrill Lynch are.
• Thain wants to strike a deal – one that the Feds (read Paulson, Bernanke and Geithner) – facilitate (See Fed Chair Hoenig’s off-the-cuff remarks about this, which I first mentioned in March).
• Later, the banking industry gets hammered.  Anyone with a large prop desk (Goldman, Merrill, Deutsche, Morgan Stanley) suffers huge losses. Merrill is one of the worst hit.
• Now, remember Bank of America is NOT a Wall Street firm.  They are based in Charlotte.  They are a regional commercial bank (BofA is really Nations Bank/NCNB) with a very different culture to the likes of Merrill.  So they probably were shocked by the losses here – which I imagine they were kept abreast of on an ongoing basis.  In March, The FT has said BofA knew how Merrill’s books were being marked.
• The next part is tricky.  Did Lewis, a deal hound if there ever was one, want to back out at this point?  My gut says no.  Were they going to pay big bonuses to retain personnel at Merrill? Yes! Remember, they had just paid a monster $44 billion for Merrills.  They were not about to let the deal founder on a one-off bonus round.
• Things changed somehow by December as the losses mounted.  And I suspect there was a real culture clash as well.  Thain and Lewis started to get to know one another and it was not working.  From my perspective, it is irrelevant what really happened in December between Thain and Lewis.
• What is relevant is that Lewis and the board of directors of Bank of America allowed the Merrill Lynch transaction to take place knowing that huge bonuses had been paid out and huge losses had been sustained – making the Merrill franchise considerably weaker than it was in September.  The MAC clause is completely valid as a reason to pull out or change the terms of the deal. This is what I argued in a post yesterday about Lewis.
• Because BofA did not change the deal terms and was subsequently bailed out, we can only believe that there was a nod-and-wink deal made with Bernanke and Paulson that more funds would be coming to bolster BofA’s worsening balance sheet as the stock price cratered.

At the end of the day, none of this is beneficial to Bank of America shareholders, who have seen their shares fall from over $50 per share to as low as $3 before rebounding to over $10. They now trade for $9.10.

Just think back, before the Countrywide and Merrill acquisitions, Ken Lewis could have claimed to be a rival for king of the hill to JPMorgan CEO Jamie Dimon, who now touts his firm’s ‘fortress’ balance sheet. But, after two disastrous mergers, Bank of America is a shambles. The real losers in this he-said she-said saga of corporate executives managers and regulations are the owners of the business, the shareholders.

And yet, John Thain is the only one to have lost his job.

Source
Thain Fires Back at Bank of America – WSJ

Related posts:

• SEC charges BofA of lying to investors over Merrill but settles
• Mea Culpa: I was too bullish on the BofA-Merrill deal
• Ken Lewis points the finger at Bernanke and Paulson
• BofA CEO Lewis investigated by SEC
• Ken Lewis defends Bank of America’s stress test results

I don’t much like Ken Lewis. It should be fairly obvious to everyone that he is a man who has only his own interests at heart. But, his revelation that BofA bought Merrill Lynch for the agreed-upon September price, despite Merrill’s having an additional $7 billion in losses is grounds for legal action.

Let’s review the situation.

In September, Hank Paulson, Ben Bernanke, and Tim Geithner committed the financial blunder of the century in allowing Lehman to fail spectacularly without any contingency plan for the probable market fallout. (Yes, Tim Geithner was a principal actor in this fiasco.)  Now, there was nothing wrong in letting Lehman Brothers fail.  However, there was something very wrong with bailing out Fannie Mac and Bear Stearns and allowing everyone on Wall Street to believe Lehman was too big to fail.  And there was even more wrong in having no contingency plan for the fallout.

So as a direct result of that fallout, Merrill Lynch was poised to be the next to go under.  Enter Ken Lewis, our White Knight.  I have to admit to being idiot enough to have thought the Bank of America – Merrill deal was a good one.  It seemed all was well when Ken Lewis plunked down $44 billion in September (even though Barclays got much of the Lehman assets for a song days later).  But, as markets went into freefall, so too did Merrill Lynch, hemorrhaging losses.  So why did Ken Lewis buy the company without at least trying to negotiate a lower price tag?

Answer: self-dealing.

It was the real thing. The banker, as you may have guessed, is Ken Lewis, CEO of Bank of America. And the bad guys harassing him are Hank Paulson, then Treasury secretary, and Ben Bernanke, head of the Federal Reserve, aided and abetted by shadowy henchmen.

The script for this stranger-than-fiction melodrama was provided by that rabid (and fiercely ambitious) bulldog New York state attorney general, Andrew Cuomo. Mr. Cuomo, back in February, had been grilling Mr. Lewis on what his keen canine eye detected as another indignity — the awarding of $3.6 billion to employees of Merrill Lynch, the giant brokerage firm acquired by BofA on Jan. 1 of this year.

What had Mr. Cuomo frothing at the mouth was that the $3.6 billion was shelled out even though Merrill suffered losses upwards of $15 billion in 2008’s fourth quarter alone.

We must point out how fortuitous it was that losses had not reached, say, $30 billion, since by the peculiar calculus being used to reward red-ink, that would have boosted Merrill’s bonus tab to $7.2 billion. And enraging the chronically enraged Mr. Cuomo all the more was that the bonuses were distributed even while the losses manifested themselves but were not disclosed, least of all to the bank’s shareholders.

According to Mr. Cuomo’s dour narrative, the product of four hours of interrogation of Mr. Lewis, the merger with Merrill was proposed in September after two days of due diligence (sounds more like due negligence to us). It gained approval of shareholders of both companies on Dec. 5. Barely a week later comes the revelation: Merrill’s losses were spiraling ever higher, causing an increasingly frantic Mr. Lewis to weigh calling the marriage off.

He reckoned he could legally do so thanks to MAC (material adverse event), recognizing that $7 billion more in losses than had been projected when the merger was agreed to was a very big MAC, indeed. He diffidently informed the powers-that-were of his plan to nix the nuptials and was summarily summoned to powwow with them in Washington that very evening. And it was there that Messrs. Bernanke and Paulson put the screws to him to not break the deal lest he trigger a systemic calamity.

On Dec. 21, Mr. Lewis, still of a mind to ditch the merger, communicated his determination to Mr. Paulson, who bluntly warned that he would give the boot to Mr. Lewis and his board unless the acquisition went through. To that bald threat, Mr. Lewis’ retort was a resounding purr: “That makes it simple. Let’s de-escalate.”

And de-escalate he did. The merger became a done deal right on schedule. To help salve any hurt feelings, Bank of America got $118 billion in loan guarantees from rich Uncle Sam to absorb any potential losses from Merrill.

To me, this sounds like a deal was worked out whereby BofA got a bailout if it went through with the deal. But, it should be plain from the events above that Ken Lewis did NOT have his fiduciary responsibilities for his shareholders top of mind.

So, let’s recap.

• Paulson, Bernanke and Geithner blow Lehman up and everybody panics.
• Merrill looks ready to blow up and take the system down with it.
• Bank of America steps in – or better yet, is coerced in – and pays $44 billion for Merrill.
• But, the market freefall continues, taking WaMu, AIG and Wachovia down with it.  Merrill loses its shirt in this disaster.
• By December, Ken Lewis is ready to pull out of the deal, citing the MAC (material adverse change) clause as grounds.
• Paulson and Bernanke go ballistic (Geithner was prepping to be Treasury Secretary) and get Ken Lewis to do something he thinks is bad for shareholders
• By February, BofA needs to be bailed out again to the tune of tens of billions more government money from Tim Geithner.  BofA’s stock tanks – shareholders are looking at 90%+ losses.
• Now, the SEC is investigating.

This whole episode stinks to high heaven and Ken Lewis doesn’t even look the worst of the lot here. That honor goes to Paulson and Bernanke.

But, what about the shareholders? Oh, those people, right. Don’t they deserve better? Yes, they do. But, they are not going to get better because mega-corporations are run by managers who are in it for their own enrichment and shareholders have zero say. This is a classic principal-agent conflict.

The essence of the principal-agent problem comes when a principal (let’s call them the owners) hires an agent (we’ll call them the managers) to act on her behalf. Often times, one is just too busy – or too inexperienced – to manage a business or negotiate a contract or what have you. So, one hires a professional steeped in experience to do it.

For instance, sports agents, made famous by the film Jerry Maguire, are the classic agents to the sports stars principal. As it happens, the agent has his own agenda – and this may or may not be the same as the principal’s employing him. You will recall the 2007 incident when Alex Rodriguez negotiated his own contract with the New York Yankees baseball team in order to make sure the result was one that was most favorable to his wants and needs (See NY Times article here.)

In business, the same dynamic is at play. While a dry cleaner can be the owner-proprietor of his own store, he cannot run two stores or ten stores at the same time (think George Jefferson). George needs to hire managers to run those stores – and he better hope those managers don’t have their hand in the till.

In today’s age, corporations are absolutely enormous, globe-spanning enterprises whose owners – the shareholders – individually have no influence over decision-making. What’s more is, the larger the organization, the less likely anyone is to have sway over the company’s managers. Supposedly, that’s why there is a board of directors, right?

A board of directors is a body of elected or appointed persons who jointly oversee the activities of a company or organization. The body sometimes has a different name, such as board of trustees, board of governors, board of managers, or executive board. It is often simply referred to as “the board.”

A board’s activities are determined by the powers, duties, and responsibilities delegated to it or conferred on it by an authority outside itself. These matters are typically detailed in the organization’s bylaws. The bylaws commonly also specify the number of members of the board, how they are to be chosen, and when they are to meet.

In an organization with voting members, e.g., a professional society, the board acts on behalf of, and is subordinate to, the organization’s full assembly, which usually chooses the members of the board. In a stock corporation, the board is elected by the stockholders and is the highest authority in the management of the corporation. In a nonstock corporation with no general voting membership, e.g., a university, the board is the supreme governing body of the institution.

So, where was Bank of America’s Board of Directors? Didn’t they see that Merrill had imploded. Why did they allow this travesty to take place? Shareholders had approved the merger on 5 Dec 2008, 16 days BEFORE Ken Lewis had said he was willing to back out. So they obviously had no say here.

Only the board of directors could have stopped Ken Lewis consummating a merger that should never have taken place or that had been re-negotiated. You should notice that this is the exact same run of events that we witnessed in the Countrywide transaction as well.

But, in the end, the deal went ahead as planned and Bank of America shareholders got their clocks cleaned as a result.

Sources
Shareholders Be Damned! – Alan Abelson, Barron’s
Board of directors – Wikipedia

Related posts:

• BofA saga continues as John Thain calls Lewis a liar
• BofA CEO confirms government coerced him into Merrill deal
• Ken Lewis is out as Chairman of Bank of America
• Ken Lewis defends Bank of America’s stress test results
• Mea Culpa: I was too bullish on the BofA-Merrill deal

Ken Lewis, the embattled CEO of Bank of America, has recently admitted to being coerced by U.S. Government officials to consummate the Merrill Lynch acquisition. The problem for Lewis is he may have neglected his fiduciary responsibility to shareholders in bowing to this pressure. The SEC is now investigating. See the video below for details.

Related posts:

• BofA saga continues as John Thain calls Lewis a liar
• Ken Lewis defends Bank of America’s stress test results
• Ken Lewis points the finger at Bernanke and Paulson
• BofA CEO confirms government coerced him into Merrill deal
• The horrible self-dealing of Ken Lewis and the principal-agent problem

Bank of America CEO Ken Lewis is fighting to keep his job because earnings at his company have plummeted. BofA’s acquisition of Merrill Lynch has been a large part of the problem.  Now, understanding that he is being made out to be the fall guy, he has fessed up that BofA was coerced into the deal.

Federal Reserve Chairman Ben Bernanke and then-Treasury Department chief Henry Paulson pressured Bank of America Corp. to not discuss its increasingly troubled plan to buy Merrill Lynch & Co. — a deal that later triggered a government bailout of BofA — according to testimony by Kenneth Lewis, the bank’s chief executive.

Mr. Lewis, testifying under oath before New York’s attorney general in February, told prosecutors that he believed Messrs. Paulson and Bernanke were instructing him to keep silent about deepening financial difficulties at Merrill, the struggling brokerage giant. As part of his testimony, a transcript of which was reviewed by The Wall Street Journal, Mr. Lewis said the government wanted him to keep quiet while the two sides negotiated government funding to help BofA absorb Merrill and its huge losses.

Under normal circumstances, banks must alert their shareholders of any materially significant financial hits. But these weren’t normal times: Late last year, Wall Street was crumbling and BofA faced intense government pressure to buy Merrill to keep the crisis from spreading. Disclosing losses at Merrill — which eventually totaled $15.84 billion for the fourth quarter — could have given BofA’s shareholders an opportunity to stop the deal and let Merrill collapse instead.

“Isn’t that something that any shareholder at Bank of America…would want to know?” Mr. Lewis was asked by a representative of New York’s attorney general, Andrew Cuomo, according to the transcript.

“It wasn’t up to me,” Mr. Lewis said. The BofA chief said he was told by Messrs. Bernanke and Paulson that the deal needed to be completed, otherwise it would “impose a big risk to the financial system” of the U.S. as a whole.

Mr. Lewis’s testimony suggests how aggressively federal regulators have been willing to behave in their fight to fix the U.S. financial system. The testimony for the first time spreads some of the blame to Messrs. Paulson and Bernanke for Mr. Lewis’s decision to keep problems at Merrill under wraps.

“Everybody — Lewis, Paulson, Bernanke — eventually agreed that any public discussion of the situation at Merrill would have adverse consequences for the system,” according to an individual close to BofA.

A person in government familiar with Mr. Bernanke’s conversations with Mr. Lewis said Wednesday that the Fed chairman didn’t offer Mr. Lewis advice on the question of disclosure. Instead, Mr. Bernanke suggested Mr. Lewis consult his own counsel.

Mr. Paulson repeatedly told Mr. Lewis that “the U.S. government was committed to ensuring that no systemically important financial institution would fail,” according to his spokeswoman.

All of this should be quite alarming to American citizens because it demonstrates the lengths to which our government has gone to conceal the true nature of this financial crisis. I do want to point out that BofA was apparently coerced into the Countrywide deal as well as I said in a March post.

This past Monday, I posted an article about comments made by Kansas City Fed Chair Hoenig which have received zero press despite their significance.  Here they are (I have bolded the significant part):

“The Treasury Department, the Federal Reserve and other regulators have also arranged bailouts and mergers for large struggling or insolvent institutions, including Fannie Mae and Freddie Mac, Bear Stearns, WaMu, Wachovia, AIG, Countrywide, and Merrill Lynch. But other firms, such as Lehman Brothers, have been allowed to fail.”

Now, I don’t know about you, but I certainly do not remember hearing about the Bank of America transactions with Countrywide and Merrill Lynch as deals foisted upon BofA by the government.  In essence, Hoenig is suggesting that Bank of America is a US-equivalent of Lloyds Bank.

If you recall, HBOS, a very reckless lender in Britain, was on the verge of collapse after Lehman Brothers declared insolvency in September.  Gordon Brown, desperate to save his legacy as Chancellor during the asset bubble, coerced Lloyds into taking over HBOS without proper due diligence.  This deal has failed spectacularly as HBOS has many more writedowns than was anticipated and Lloyds has effectively been nationalized along with Royal Bank of Scotland (not before the executives involved came under criticism).

If one looks across the pond at Bank of America, Countrywide and Merrill Lynch, circumstances are not too dissimilar. To my mind, it makes sense that no one has gone to jail if the government basically foisted Countrywide and Merrill on to Ken Lewis and BofA in return for assurances down the line that the government would not make waves.

BofA is to Lloyds as Merrill and Countrywide are to HBOS. In both cases, the government was desperate to consummate a merger which prevented the collapse of a systemically-important financial institution. Unfortunately for shareholders of BofA and Lloyds, these mergers have been quite destructive to shareholder value. Ken Lewis’ revelations certainly demonstrate that BofA shareholders have reason to complain.

Source
Lewis Testifies U.S. Urged Silence on Deal – WSJ

Related posts:

• Mea Culpa: I was too bullish on the BofA-Merrill deal
• Ken Lewis points the finger at Bernanke and Paulson
• Throwing Bernanke under the bus
• SEC charges BofA of lying to investors over Merrill but settles
• BofA is nuts: still going to acquire Countrywide

Here we are just days out from the announcement by Treasury Secretary Tim Geithner that the Obama Administration will be buying up so-called toxic assets as originally planned by Henry Paulson during the Bush Administration.  The initial reaction has been one of euphoria as most asset markets responded positively to the news.

Now that the dust has settled somewhat, another reaction is taking place behind the scenes and it looks an awful lot like banks — specifically Citigroup and Bank of America — are gaming the system (hat tip Yves, Tom and Barry).  Note my highlighting:

As Treasury Secretary Tim Geithner orchestrated a plan to help the nation’s largest banks purge themselves of toxic mortgage assets, Citigroup and Bank of America have been aggressively scooping up those same securities in the secondary market, sources told The Post.

Both Citi and BofA each have received $45 billion in federal rescue cash meant to help prop up the economy and jumpstart the housing market.

But the banks’ purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults.

One Wall Street trader told The Post that what’s been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

The secondary market represents a key cog in the mortgage market, and serves as a platform where mortgage originators can offload mortgages in bulk that have been converted into bonds.

Yields on such securities can be as high as 22 percent, one trader noted.

BofA said its purchases of secondary-mortgage paper are part of its plans to breathe life back into the moribund securitization market.

“Our purchases in [mortgage-backed securities] increase liquidity in the mortgage market allowing people to buy a home,” said BofA spokesman Scott Silvestri.

A Citi spokesman declined to comment, though people familiar with the bank say it argues the same point.

You can read the rest of the Post article to see the full details. Of course, I am sceptical here. But, for the sake of argument, let’s assume Citi and BofA are telling us the truth as to their true motivations.

One must still ask the question: why are BofA and Citi, two of the weaker large banks in the U.S., aggressively buying up the same toxic assets which have already caused them huge writedowns? Here’s another one for you: if Citi and BofA are so bullish on these Mortgage-backed securities, why weren’t they buying them aggressively two weeks ago or last month? What’s changed between then and now?

I’ll tell you what has changed: the Geithner Plan. See, the U.S. government has pledged to purchase these toxic assets from banks like Bank of America and Citigroup. That means Citi and BofA know full well that they aren’t going to be holding these assets for long. So why are they buying? A couple of reasons:

1. The Geithner Plan effectively pledges to insure the purchases of these assets against downside risk.  This implicit put option means the sale price will be higher than a free-market transaction.  In essence, this is a transfer of money from taxpayers to both the selling and investing organizations.  Therefore, it behooves sellers to sell more assets.
2. The auction process is non-binding meaning the selling organizations do not have to sell if they don’t like the price offered.  In effect, this means the sellers have yet another option: the right but not the obligation to sell at a specific price.  This is the definition of a put option.  That means sellers are going to transact only if the sale does not force them to writedown the assets too much. Of course, they have received this option free of charge.  

Now, if you were Citi or BofA, wouldn’t you be looking to get the most out of this process as well? Their actions are wholly predictable. Nevertheless, their actions demonstrate the problems with this plan i.e. that we are about to see a massive transfer of money from taxpayers to banks. The interesting thing about all of this is that most Americans won’t necessarily know that these implicit options are embedded in the transaction structure unless they are familiar with derivatives.

My take on this is similar to Barry’s: Citi and BofA’s actions demonstrate yet again why the government must take control of the organization and get rid of existing management. Neither the Bush Administration nor the Obama Administration has been willing to do so.

For more on embedded options in the Geithner plan see Steve Waldman’s piece, Degrees of recourse.

UPDATE 1150AM ET: The Economist has this to say:

These assets can’t be comparable to ones for which the Geithner plan is designed, because that plan is designed for assets for which no secondary market exists. If a secondary market does exist, then presumably there’s no need to discover prices—we can just look at them—and there’s no question about which banks are solvent. I don’t see how Bank of America can go out and by a bunch of MBS on the market, then turn around and auction them based on the idea that they don’t know what they’re worth.

Right? What am I missing?

Source
Citi, BofA buying back laundered loans at lower rates – NY Post

Related posts:

• Roubini: Nationalization “fully on the table” in Geithner’s Plan
• Is Citi being forced to downsize by Obama?
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• S&P downgrades BofA
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks

Last summer, as a number of sinister revelations were made about the goings-on in the financial services sector, I speculated that we would definitely see the government going after individual executives for illegal activities. I saw Angelo Mozilo, the man with a tan, as the most likely scapegoat – a mortgage industry Ken Lay, if you will (see my August post “Ex-Countrywide CEO is the new Ken Lay“).  In August, it seemed perp walks were imminent. Yet, none of this came to pass.

Now, mind you, we have busted a few executives on Wall Street.  And we just got a conviction on Bernard Madoff for the world’s biggest financial fraud.  But, there have really been few convictions of the nature of Ken Lay, Jeffrey Skilling, Bernie Ebbers, Joseph Naccio or any of the others convicted after the tech bubble burst.  I have my ideas as to why.  Let me make my case here.

This past Monday, I posted an article about comments made by Kansas City Fed Chair Hoenig which have received zero press despite their significance.  Here they are (I have bolded the significant part):

“The Treasury Department, the Federal Reserve and other regulators have also arranged bailouts and mergers for large struggling or insolvent institutions, including Fannie Mae and Freddie Mac, Bear Stearns, WaMu, Wachovia, AIG, Countrywide, and Merrill Lynch. But other firms, such as Lehman Brothers, have been allowed to fail.”

Now, I don’t know about you, but I certainly do not remember hearing about the Bank of America transactions with Countrywide and Merrill Lynch as deals foisted upon BofA by the government.  In essence, Hoenig is suggesting that Bank of America is a US-equivalent of Lloyds Bank.

If you recall, HBOS, a very reckless lender in Britain, was on the verge of collapse after Lehman Brothers declared insolvency in September.  Gordon Brown, desperate to save his legacy as Chancellor during the asset bubble, coerced Lloyds into taking over HBOS without proper due diligence.  This deal has failed spectacularly as HBOS has many more writedowns than was anticipated and Lloyds has effectively been nationalized along with Royal Bank of Scotland (not before the executives involved came under criticism).

If one looks across the pond at Bank of America, Countrywide and Merrill Lynch, circumstances are not too dissimilar. To my mind, it makes sense that no one has gone to jail if the government basically foisted Countrywide and Merrill on to Ken Lewis and BofA in return for assurances down the line that the government would not make waves.

Nevertheless, two questions remain unanswered.  First, why has the Obama Administration not shown prosecutorial zeal with financial executives for alleged wrongdoings?  I would have anticipated that Eric Holder at the Justice Department  would have  signalling to the American public that the new administration was breaking with the old – that Barack Obama wanted to at a minimum investigate wrong-doing.

I foresaw the new Administration making a big to-do about this.  But, it has not. To my mind, this makes political sense and would certainly give Barack Obama more political capital with a rightly indignant American public.  It would certainly make bailouts at Citgroup and Bank of America more palatable.

Second, why is Hoenig coming out proclaiming that Countrywide and Merrill were government-enabled deals?  Was there a deal — and, if so, what were the terms of that deal?  I reckon the American public has a right to know, just as it should know who is getting money in deals with AIG and what kind of assets the Federal Reserve is now accepting as collateral.

My understanding is that investigations regarding criminal activity are indeed ongoing, especially at AIG.  However, I am still puzzled as to whether the Obama Administration is more interested in burnishing its populist pro-Main Street credentials or its business pro-Wall Street ones.

Related posts:

• BofA CEO confirms government coerced him into Merrill deal
• BofA is nuts: still going to acquire Countrywide
• Mea Culpa: I was too bullish on the BofA-Merrill deal
• Too big has failed
• Countrywide is the real problem at Bank of America

This news comes via Reuters:

Bank of America Corp is carrying loans on its balance sheet marked at more than $44 billion above their fair value, the company said in its annual report filed with U.S. regulators on Friday.

The bank said it ended 2008 with $886.2 billion in loans, but estimated the fair value — or market price — for these loans as $841.6 billion.

In a related Bloomberg article, an analyst from Friedman, Billings & Ramsey gets right to the point:

“That’s the heart of why these companies are trading where they are,” Friedman Billings Ramsey & Co. analyst Scott Valentin said in an interview. “Technically, if you mark-to- market the entire balance sheet, most of these banks are insolvent.”

Sources
Bank of America SEC Filings
Bank of America Loans Valued at $44 Billion Less Than Books Say – Bloomberg.com
BofA carries loans $44 billion above market value – Reuters

Related posts:

• FASB: Mark all financial assets at fair value
• $35 billion in missing writedowns
• Fannie reports $171 billion in non-performing loans
• JPMorgan’s $29 Billion windfall
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks

Chris Whalen, a well-regarded bank analyst, ran an interview piece with Nouriel Roubini on Barry Ritholtz’s site. The conversation was very illuminating and I highly recommend reading the whole post linked below. However, I wanted to point out a quote from Chris in the piece that I find significant in light of the recent dividend cut by JPMorgan Chase.

The difference between BAC and WFC, and JPM on the other hand, is that Jamie Dimon, who we like more and more, bought WaMu for three cents on the dollar of assets. WFC bought Wachovia whole, without a resolution. So JPM does not have to soft-pedal on foreclosures, despite what you read in the newspaper, and they don’t have to write anything down. WFC and BAC are choking on their acquisitions because they were not restructured first.

I am very impressed by Jamie Dimon. He has been as cautious as any of the big bank CEOs as evidenced by the lower writedowns at JPM and the firesale acquisition prices. Even the pro-active dividend cut smacks of prudent foresight. If any big bank can survive this mess, it will be JPMorgan Chase.

Sources
Now What for the Big Banks?: Interview with Nouriel Roubini – Chris Whalen, The Big Picture

Related posts:

• Quote of the day: “Jamie is always hanging around the hoop”
• Jamie Dimon: November was terrible, December is terrible
• Industrial & Commercial Bank of China
• Jamie Dimon on the economy
• Jamie Dimon: ‘we don’t need’ your money