Who Framed Ken Lewis?

I wrote earlier today about the astonishing deposition of B of A CEO Ken Lewis. As a reminder, here's what the Wall Street Journal reported:

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.

Lewis did as he was told and B of A went through with the transaction, with disastrous financial results. Why would someone like Lewis, a CEO who understands full well his fiduciary duty to all the stakeholders at B of A, do this?

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.

When the story first broke, a lot of people wondered what exactly Lewis meant when he said "it wasn't up to me." Now we know. New York Attorney General Andrew Cuomo has released a letter detailing Lewis's deposition (PDF format) and the answer is quite clear. Paulson and Bernanke made an offer that Lewis couldn't refuse.

Lewis had learned from his CFO that Merrill's financial situation was even worse than initially understood and Lewis now sought to get out of the deal because the financial deterioration represented a "material adverse event." No dice, said Henry Paulson. AG Cuomo's letter picks up the story:

Immediately after learning on December 14, 2008 of what Lewis described as the "staggering amount of deterioration" at Merrill Lynch, Lewis conferred with counsel to determine if Bank of American had grounds to rescind the merger agreement by using a clause that allowed Bank of America to exit the deal if a material adverse event ("MAC") occurred. After a series of internal consultations and consultations with counsel, on December 17, 2008, Lewis informed then-Secretary Henry Paulson that Bank of America was seriously considering invoking the MAC clause. Paulson asked Lewis to come to Washington that evening to discuss the matter.

At a meeting that evening Secretary Paulson, Federal Reserve Chairman Ben Bernanke, Lewis, Bank of America's CFO, and other officials discussed the issues surrounding invocation of the MAC clause by Bank of America. The Federal officials asked Bank of America not to invoke the MAC until there was further consultation. There were follow-up calls with various Treasury and Federal Reserve officials, including with Treasury Secretary Paulson and Chairman Bernanke. During those meetings, the federal government officials pressured Bank of America not to seek to rescind the merger agreement. We do not yet have a complete picture of the Federal Reserve's role in these matters because the Federal Reserve has invoked the bank examination privilege.

Emphasis mine. So what was the pressure that Bernanke and Paulson brought to bear on Lewis and the rest of the honchos at B of A?

Bank of America's attempt to exit the merger came to a halt on December 21, 2008. That day, Lewis informed Secretary Paulson that Bank of America still wanted to exit the merger agreement. According to Lewis, Secretary Paulson advised Lewis that, if Bank of America invoked the MAC, its management and Board would be replaced:

[W]e wanted to follow up and he said, 'I'm going to be very blunt, we're very supportive of Bank of America and we want to be of help, but' -- as I recall him saying 'the government,' but that may or may not be the case -- 'does not feel it's in your best interest for you to call a MAC, and that we feel so strongly,' -- I can't recall if he said 'we would remove the board and management if you called it' or if he said 'we would do it if you intended to.' I don't remember which one it was, before or after, and I said, 'Hank, let's deescalate this for a while. Let me talk to our board.' And the board's reaction was of 'That threat, okay, do it. That would be systemic risk."

Again, emphasis mine. I don't know what you call it when the Chairman of the Fed and the Treasury Secretary make a threat of that sort. In the real world, I'd call it extortion. It's a hell of a charge for Lewis to make. And it turns out it's true. Returning to AG Cuomo's letter:

In an interview with this Office, Secretary Paulson largely corroborated Lewis's account. On the issue of terminating management and the Board, Secretary Paulson
indicated that he told Lewis that if Bank of America were to back out of the Merrill Lynch deal, the government either could or would remove the Board and management. Secretary Paulson told Lewis a series of concerns, including that Bank of America's invocation of the MAC would create systemic risk and that Bank of America did not have a legal basis to invoke the MAC (though Secretary Paul's basis for the opinion was entirely based on what he was told by Federal Reserve officials).

Again, emphasis mine. Do we know if this opinion has any validity? Hard so say, because as you'll recall, the Fed ain't talking. How convenient.

So the bottom line was this: you had two powerful government officials, including one (Bernanke) who isn't really accountable to anyone, essentially holding a gun to Lewis's head. Nice.

Now you might be thinking to yourself, "why didn't Lewis just fall on his sword? That would have been the honorable thing to do and it might have saved B of A shareholders from suffering huge losses." And you know what? It probably would have been the right thing to do for those reasons and one other -- it would have exposed for all to see what the entire TARP bailout program really was about. But hindsight is always 20/20. And had I been in Ken Lewis's shoes, I sure the hell don't know what I would have done.

There's one other thing: Lewis had a duty to disclose to his shareholders what the impact of this transaction would be. According to Cuomo, Lewis wanted to do the right thing. So how did that one play out? Let's go back to Cuomo:

Despite the fact that Bank of America had determined that Merrill Lynch's financial condition was so grave that it justified termination of the deal pursuant to the MAC clause, Bank of America did not publicly disclose Merrill Lynch's devastating losses or the impact it would have on the merger. Nor did Bank of America disclose that it had been prepared to invoke the MAC clause and would have done so but for the intervention of the Treasury Department and the Federal Reserve.

Lewis testified that the question of disclosure was not up to him and that his decision not to disclose was based on direction from Paulson and Bernanke: "I was instructed that 'We do not want a public disclosure.'"

Gee, I wonder why that is.

The whole thing stinks to high heaven, of course. It was bad enough that the federal government had spread moral hazard in a systemic manner throughout the housing boom by implicitly guaranteeing Fannie Mae and Freddie Mac. But now, the feds have given everyone associated with B of A a crap sandwich to eat. On a personal level, I have a number of friends who worked for B of A who have lost their jobs this year. It's possible that they might have lost those jobs anyway, but it's easy to suspect that Henry Paulson and Ben Bernanke were the ones who made their suffering possible.

Me, I'm having a hard time blaming Lewis and the B of A board for their actions. They had a choice: fall on the sword or march into a bayonet. They have chosen the bayonet. If there's a lesson to be learned in this sordid tale, it's this: you would be well advised to stay away from any industry that could fall under government control. The next bayonet may have your name on it.