Cynical View Of BofA-Merrill Lynch Merger

Maybe I am too much of a cynic, but as I look back at the details of the BofA/Merrill merger, things appear a bit strange.

First, BofA agreed to acquire Merrill Lynch without any government backing for $50 billion, or $29 per share,  a 70% premium over the closing stock price.  This was the same weekend in September of 2008 that Lehman failed and other investment banks were under a lot of pressure.  Many people thought Merrill would collapse as well and many people thought John Thain (CEO of Merrill) was brilliant in selling Merrill to BofA for such a high price.

Fast forward to December of 2008 and, all of a sudden, BofA threatens to pull out of the deal unless the federal government guarantees a bunch of Merrill Assets, up to 100 billion dollars, and gives BofA $20 billion in cash to make the deal happen.  The subsidy suddenly needed to make the deal happen is blamed on “sudden large losses in the December quarter”.  (Subsidy  = transfer of wealth from future taxpayers to BofA/Merrill shareholders, but sadly this is nothing new)

Below is one article that describes the “surprising loss”:

Even with those details, mystery still shrouds the epic write-downs: It’s not at all clear why more than half the losses occurred in December, when the credit markets were calmer than they were in October and November.

Here we see that BofA was very much involved with Merrill finances:

In October, BofA installed its chief accounting officer as Merrill’s acting CFO. It had access to Merrill’s daily profit-and-loss statements and all its trading positions.

What is interesting is that in December of 2008, miraculously Merrill’s  earnings collapsed to the surprise of BofA, even though BofA accountants and risk managers were on site at Merill.  Then we hear that even though Merrill supposedly lost billions in its final quarter and now needs government help to be bought by BofA, the folks at Merrill are still getting large year end bonuses anyway?

My theory about what really happened is this:

1. Mr. Lewis realized he overpaid for Merrill as the crisis got worse and as he dug into Merrill’s books.  He needed to offset some of that purchase price to taxpayers, and if other companies were getting government bailouts, why not BofA?
2. At the end of the December quarter, Merrill probably did fine and did not have a large loss.  BofA decided to create  a large loss at Merrill by massively writing down hard to value illiquid assets, by telling the accountants they were being “conservative” in their valuations.

We should note that none of the other investment banks had substantial losses, so it was unclear what happened to Merrill in December.  At this point Merrill was operating under the conservative BofA management direction, had ex Goldman traders working for them recruited by Thain, and per above, in December the credit markets were very calm.

Thinking about the incentives for the parties involved, having Merrill show a slight profit or slight loss in the December quarter was the worst possible outcome for BofA at the time – because it does nothing to benefit BofA management or BofA shareholders.  However, if Merrill marks down assets like crazy and shows a big loss, BofA gets two large and immediate benefits:

1. BofA can force the government to hand over money (20 billion in cash, 100 billion in guarantees to make the deal happen)
2. In future quarters when these same hard to value asset values that they have artificially written down inevitably rise again, these “new found” earnings will now be a part of combined BofA, which will make the stock price go up and executive bonuses get awarded to BofA management – for higher earnings per share numbers.  BofA management would not get any executive bonuses if Merrill did fine in it’s last quarter as a separate company.

Keep in mind also that Mr. Lewis was under pressure for paying too much for Merrill.  It’s pretty clear from above why BofA needed Merrill to have as large of a loss as possible in December.

The only problem with the above scenario is that the employees who ended up doing a decent job at Merrill are now not getting their bonus money.  No worries, Mr. Thain and the board (with BofA acknowledgment) “surprisingly” allows Merrill to pay out those bonuses because they knew the Merrill losses were not real.  Everything was going according to plan, except the media and taxpayers found out about the bonuses and obviously got very upset.  However, at the end of the day Mr. Thain, who is already worth millions, took the fall and everybody at Merrill got their bonuses paid out anyway.

So long story short, the taxpayers transferred wealth to BofA and Merrill Lynch shareholders, and we got some Kabuki theatre with Mr. Lewis from BofA getting mad at Mr. Thain for the “bonus mess” and “surprising loss” and firing him.  Is the sudden loss in the December quarter really that shocking if we are talking about 120 billion dollars in government subsidies and higher future profits and bonuses on the line, or am I just being cynical?