Back then, I assumed that the surprise Merrill “loss”  was probably overstated.  The reasons for Bank of America to overstate the losses at Merrill Lynch in Q4 of 2008 were to get the government aid, and also to push profits into 2009, where these profits w0uld then be recognized as part of the combined Bank Of America/Merrill Lynch.

Today, Bank of American released their earnings in which they reported a net profit of 4.2 billion.  Of this profit:

Non Interest income included $2.2 billion in gains related to mark-to-market adjustments on certain Merrill Lynch structured notes as a result of credit spreads widening.

Again, maybe I am being too cynical, but it seems like 50% + of the Q1 profit was from the gain on mark to mark adjustments at Merrill Lynch.  One could also assume that the surprising “loss” at Merrill in Q4 has now become a gain in Q1, and I would also assume that this “gain” will continue in future periods, helping Bank of American show higher profits in 2009.

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?

Our fist stop is with Madoff, below is an excerpt from the now famous Henry Markopolous, who had sent letters to the SEC about Madoff:

16. Red Flag # 20: Madoff is suspected of being a fraud by some of the world’s largest and
most sophisticated financial services firms. Without naming names, here ’s an
abbreviated tally:

A. A managing director at Goldman, Sachs prime brokerage operation told me that
his firm doubts Bernie Madoff is legitimate so they don’t deal with him.

And again here:

3. Red Flag # 27: Several equity derivatives professionals will all tell you that the split-strike
conversion strategy that BMruns is an outright fraud and cannot possibly achieve 12% average
annual returns with only 7 down months during a 14 % year time period. Some derivatives
experts that the SEC should call to hear their opinions of how and why BM is a fraud and for
some insights into the mathematical reasons behind their belief, the SEC should call:

a. Leon Gross, Managing Director of Citigroup’s world-wide equity derivatives research unit; 3^rd Floor, 390 Greenwich Street; New York, NY 10013: Tel# 800.492.9833 or 212.723.7873 or leon.i.gross@citigroup.com [ Leon can't believe that the SEC hasn't shut down Bernie Madoff yet. He's also amazed that FOF's actually believe this stupid options strategy is capable of earning a positive return much less a 12% net average annual return. He thinks the strategy would have trouble earning 1% net much less 12% net. Leon is a free spirit, so if you ask him he'll tell you but you'd understand it better if you met him at his workplace in a private conference room and tell him he won't need to have Citigroup lawyers present, you're just there for some friendly opinions. He talks derivatives at a high level, so ask simple "yes or no" type questions to start off the interview then drill down.]

b. Walter “Bud”Haslett, CFA; Write Capital Management, LLC; Suite 455; 900
Briggs Road; Mount Laurel, NJ 08065; Tel#: 856.727.1700 or
bud.haslett@writecapital.com www.writecapital.com [ Bud's firm runs $
hundreds of millions in options related strategies and he knows all of the math. ]

c. Joanne Hill, Ph.D.; Vice-President and global head of equity derivatives research,
Goldman Sachs (NY), 46^th Floor; One New York Plaza, New York, NY 10004;
Tel# 212.902.2908 [ Again, make sure she doesn't lawyer up or this conversation
will be useless to you. Tell her you want her opinion and no one will hold her to
it or ever tell she gave the SEC an opinion without legal counsel present. ]

It sounds like most of Wall St knew Madoff was a scam.  Henry Markopolous pretty much proved it in these letters.  I don’t have much finance knowledge, but reading over this letter clearly something was very wrong with Madoff’s operations. Yet the SEC did nothing for years.  However, nobody at the SEC has been fired for this – and there have been no negative repercussions to this federal agency so far.  Why not?  I don’t expect the SEC to have a perfect record, but this case is an incredible failure because of the size and all the warnings the SEC received.

Our next stop is AIG, which had a AAA ultra safe rating until 2008.  Goldman Sachs received a large amount of money from AIG during the last round of bailouts, and people were upset that at the end of the day taxpayers are shoveling billions to firms like Goldman. What was interesting to me was Goldman’s CFO on a conference call:

-On paper,investment bank Goldman Sachs (GS) had around $10 billion of derivatives contract exposure to American International Group’s (AIG) troubled Financial Products Group as the company began to falter sometime in 2007.

But its true exposure was much less, due to collateral it had forced AIG to post on contracts and through offsetting contracts it wrote with other banks to cover its exposure to AIG when it became “concerned enough to make sure that we were fully hedged” by sometime in 2007, David Viniar, Goldman’s chief financial officer, said on a conference call Friday.

In the end, Goldman got every dollar it was owed by AIG without having to call on any of its offsetting derivatives contracts. It even made a profit as AIG used some of its federal bailout money to cover its debt while collateral Goldman had gotten from AIG covered the rest.

In the conference call, Viniar argued that the company was too sophisticated a trader to allow itself to be materially exposed to one institution, even then triple-A-rated AIG.

What is interesting here is that even in 2007, Goldman knew there were issues with AIG and it’s AAA rating, and they took steps to hedge all of their bets with AIG with other firms.  I would not be suprised if other firms did the same. Even if AIG went belly up, Goldman would have been paid out by other companies they had bought insurance from. They did not really care if the government rescued AIG or not, but of course Goldman will take the money if it is offered to them by the government backing a contract they signed.

One final stop is a Scott Polakoff, the acting director of the Treasury Department’s Office of Thrift Supervision in testimony to congress:

HENSARLING: I believe I heard in an earlier answer to one of the questions, I believe I heard you say that OTS in 2004 should have stopped the book of business that I think you were alluding to to CDS and the AIG securities lending commitments. Did I understand you correctly?

POLAKOFF: Yes, sir.

HENSARLING: So if you said you should have stopped it in 2004, that implies you could have stopped it in 2004. Is that correct?

POLAKOFF: Yes, sir.

HENSARLING: So there were not limits on your power. Perhaps, there were limits on your knowledge or insight, but there was not limits on your power to stop what you cite, as I believe AIG’s liquidity — I’m reading from your testimony — was the result of AIG’s business lines.

So you did have the power to stop those business lines. Is that correct?

POLAKOFF: Yes, sir.

HENSARLING: I read on your Web site that, quote, OTS has supervisory and enforcement authority over the entire corporate structure. The scope of this authority includes the savings association, its holding company, and other affiliates and subsidiaries of the savings association.

I continue to quote, These supervisory tools allow OTS to obtain a complete picture of the interrelationship and risks throughout the savings and loan holding company enterprise regardless of its size and complexity.

Again, it appears, if this is correct, it was not a lack of supervisory authority that caused you not to take action with respect to these two lines. Is that correct?

POLAKOFF: Yes, sir.

HENSARLING: And I think I also heard you say in your testimony that you did not have sufficient* manpower and expertise. Is that correct?

POLAKOFF: Yes, sir.

HENSARLING: So, again, in retrospect, it wasn’t the lack of authority. It wasn’t the lack of resources. It wasn’t the lack of expertise. You just flat made a mistake. Is that a correct assessment?

POLAKOFF: In 2004, we failed to assess how bad the mortgage economy, the real estate economy would become in 2008. Yes, sir.

HENSARLING: I see my time is expired.

My point here is that the government had the power to stop AIG and it’s risk taking ways, but it failed to foresee what the risks were – just like Lehman and Bear failed.  The government is not some omnipotent power that knows all, but just a bunch of people which can be paid off by special interests and can make the same mistakes private businesses do.

To imagine that smart regulators would rather work for the government than make millions in the finance industry just does not make any sense.   In the case of Madoff and AIG, private corporations like Goldman that were risking their own money saw the risks much faster then the government did.  In the case of Madoff, the people that trusted the government regulators without checking for themselves were the ones that lost the most money.

For AIG, there are lessons to be learned and new regulations to be put in place.  However, the government should make clear that the counter parties will take losses in the future.  My concern is that there will be some new regulations, and with it new ways to game the system a couple of years from now.  When the next downturn happens, will the government have to bail everybody out again because it had “better” regulations – but they still failed?

The key is both – having the new regulations to fix the old issues, but also to make the market self-regulate as well, so that counter parties don’t enter into trades if they think they might not get fully paid back.  These counter parties should know upfront that the government will not bail them out next time around, and what the process will be if these institutions fail.  The counter parties should not think that because of  these new regulations, the US government is going to back them up in the future if the other party cannot pay up.