The Great Read-cession, Part VIII

Crash of the TitansOn the eighth day, John S reviewed two more books of the financial crisis, including the final report of the Financial Crisis Inquiry Report.

Crash of the Titans: Greed, Hubris, The Fall of Merrill Lynch, and the Near-Collapse of Bank of America

by Greg Farrell 2010


Having read accounts of the failures of Bear Stearns and Lehman Brothers, it seemed appropriate to read a book about the third investment bank claimed by the financial crisis: Merrill Lynch. Of course, Merrill Lynch didn’t fail outright—it was sold to Bank of America, making the story slightly more complex. Greg Farrell’s book, Crash of the Titans, is really a soap opera about how two banks ended up in a reluctant and unhappy marriage.

The first step towards this malignant matrimony was the downfall of Merrill Lynch. Merrill Lynch occupied an odd position on Wall Street. On the one hand, it’s probably the investment bank normal people are the most familiar with, thanks to its “thundering herd” of brokers. On the other hand, it suffered from a clear inferiority complex for not being as profitable or as elite as Goldman Sachs or Morgan Stanley.

In its quest to catch Goldman Sachs, Merrill Lynch became one of the leaders in the CDO market, holding more CDO assets than any other bank. As the housing bubble inflated, this led a streak of immense profitability, but the lust for profits blinded many Merrill executives to the risks they were exposed to.

When Merrill had to pick a new head of fixed income trading in 2006, then-CEO Stanley O’Neal opted for the young salesman, Osman Semeci, over the more prudent choice of Jeff Kronthal, who understood risk. Semeci was flashier and, more importantly, he had a better history of generating revenues and more familiarity with the firm’s bigger CDO position. Though some opposed the pick at the time, like company president Greg Fleming, O’Neal went with revenues over risk.

Of course, that decision backfired. Semeci, either knowingly or unknowingly, misled the firm about the extent of Merrill’s exposure to the subprime housing market, insisting that the firm’s $30 billion position was safe. Once O’Neal* realized how wrong those assurances were—and how precarious the firm’s financial situation now was—he reached out to Bank of America about a possible sale of the company. Unfortunately, he neglected to mention this potential sale to his board of directors, and was fired for it when they found out.

*Stanley O’Neal is an intriguing figure. In Farrell’s book, he is portrayed as ruthless and vindictive. His most impressive feat seems to have been ascending to CEO without a single friend on Wall Street. Though this of course may be due to Farrell’s choice of sources, it is more or less corroborated by O’Neal’s depiction in other books, like Sorkin’s.

But while O’Neal deserves much of the blame for letting the CDO position get so out of hand, he at least deserves a modicum of credit for grasping the problem almost immediately. Once he actually started looking into the CDO situation, he seemed to realize that Merrill Lynch would need a buyer, something that of course proved true in time. Had O’Neal’s talks panned out in 2007, Merrill investors likely would have ended up with a better deal than they ultimately got.

Enter John Thain. Thain, who had worked under Paulson at Goldman Sachs and then served as CEO of the New York Stock Exchange, was perceived as a kind of superhero of Wall Street. He had helped turn around the NYSE after years of mismanagement, and his experience at Goldman lent him a lot of credibility. Merrill threw money at Thain—a $15 million signing bonus, $33 million in stock, and another $34 million in options—to get him as O’Neal’s replacement in December of 2007.

Much of Farrell’s book, though, is devoted to documenting just how Thain soured his warm welcome at Merrill Lynch. There was, famously, the $1.2 million he spent redecorating his office (including a $35,000 commode), as well as problems with his communication style.  And then there were things like the outsiders he hired from his days at NYSE and Goldman.

But, overall, it’s hard to blame Thain for as much as Farrell wants to. Yes, $1.2 million is a lot to spend on an office, but lavish spending on Wall Street is hardly new, and considering how much money Merrill spent on Thain’s salary, its hardly worth noting. And any new boss is likely to have an adjustment period; it’s just that Merrill Lynch went into freefall before Thain’s adjustment period ended.

A lot of the problems seemed to come from animosity between Thain and Fleming, who had acted as Merrill’s CEO between O’Neal’s resignation and Thain’s hiring. The two did not get along and, since Fleming seems to be one of Farrell’s main sources, Thain does not come off well in the telling (Fleming also comes off as kind of annoying, but he’s in many ways the “hero” of the book).

On the other hand, it’s hard to see much good in how Thain handled the crisis. He did not raise sufficient capital in early 2008 and, when the time came to talk about a sale, Thain resisted it until the last possible moment. When he did relent to a sale, he tried to get Goldman to bid on Merrill, even though doing so would possibly jeopardize negotiations with Bank of America.

All these things, taken together, make some sense from Thain’s perspective. The new office, the eagerness to be done with capital raising,* and his reluctance to sell all make sense for someone who had just gotten the job of a lifetime and wanted to actually do it for the long haul. But Thain’s refusal to acknowledge how bad the crisis was almost cost his firm.

*CEOs, for obvious reasons, hate having to raise capital, since it means they have to limit their spending and sell off assets. A new CEO, who might be eager to make a splash, would obviously hate it even more.

In one particularly absurd scene, when Bank of America and Merrill Lynch began negotiating in earnest in 2008, Fleming went to meet with Greg Curl, BofA’s chief risk officer. Although Merrill shares were trading then at only $17 per share, Bank of America offered to pay $29. Fleming was ecstatic to get such a premium, but when he told Thain the number, Thain asked him to go back and ask for $30. Thain was willing to jeopardize the deal to get a nice round number.

The deal was finalized at $29 per share, but Bank of America seemed to regret it almost immediately, leading to the final two showdowns that Farrell documents. The first is the story of the MAC clause, or the “material adverse claim” clause. This clause, apparently standard in acquisitions like this, essentially said that if things got much worse at Merrill Lynch, Bank of America could opt out of the deal.

Things did get much worse: losses at Merrill swelled to $22 billion. Although MAC clauses are incredibly hard to invoke, Bank of America’s CEO, Ken Lewis, likely thinking he had spent too much on Merrill Lynch, tried to back out of the deal.

Of course, by this point, Bank of America had run into trouble of its own. It had already received $15 billion in TARP money, and it would ultimately receive another $30 billion (not to mention various backdoor bailouts from the Fed, investigations of fraud, etc.). When Lewis mentioned wanting to back out of the deal to Hank Paulson, “Paulson warned Lewis that such a move would demonstrate a lack of judgment so severe that he would use it as grounds to fire Lewis and remove his entire board of directors.”

Now, this, strictly speaking, is not what the Constitution allows. The government is not supposed to fire CEOs. It would be one thing if Paulson were merely acting in his new capacity as part-owner of Bank of America (the TARP bailouts had made the government “non-voting shareholders” in the banks), but that’s obviously not what was going on. Paulson wasn’t worried on behalf of his Bank of America stock (which had gone down since the deal was announced), but by what such an announcement would mean for the markets in general. Paulson had worked diligently after Lehman’s failure to make sure every investment bank had capital or a buyer, so that the market would stabilize. Now Bank of America was threatening to undo that.

Of course, Lewis backed down and the deal went through, but a clear line had been crossed by the federal government.

The other big story of the merger, and the one Farrell devotes most of his time to, is the culture clash between Bank of America, which was headquartered in Charlotte, and Merrill Lynch. It might seem like a bank’s a bank, but there was a clear distinction between the Main Street style of B of A, and the Wall Street style of Merrill. The most interesting illustration of this clash is the story John Thain’s vanishing bonus.

At the end of 2008, Merrill’s compensation committee met with Bank of America to arrange early bonuses, to be paid before the merger was official. It also suggested a bonus of $40 million for Thain, and similar bonuses for other high-ranking executives. But people at Bank of America recoiled at the idea of paying $40 million to the CEO of a company that had just lost over $22 billion. So Merrill Lynch said the bonuses should be thought of as “success fees” for those who had successfully negotiated the merger. But Thain assured those at Bank of America that he wouldn’t mind taking a smaller fee. He was selfless like that…

Eventually, Thain requested a mere $20 million, and then going as low as $10 million (he was presumably willing to eat out less, or shop at Goodwill). But before he could make his request to the board, word was leaked to the press, and there was public outcry about the CEO of a bailed out firm getting a bonus. As a result, John Thain and his fellow executives withdrew their requests for bonuses, but only at the urging of the Bank of America board. Even then, Thain tried to negotiate a “retention package.”*

*This leads a major question that stumped me while reading the book: Why did John Thain care so much about his bonus? Farrell includes scene after scene of him practically begging those at Bank of America for a bonus, quibbling over an extra million dollars like he’s a sentenced criminal begging the Governor for clemency.

But it’s not like Thain was hurting for money. He had been paid handsomely throughout his career, most obviously when he took the Merrill job (though admittedly much of his stock lost value in the deal with Bank of America). And all his kvetching only hurt his standing at Bank of America, ultimately leading to his departure from the bank he had hoped to lead one day.

So what was in it for him? Did he really need the extra few million dollars that badly? It’s more likely that Wall Street fosters a culture in which bonuses and massive compensation are really just a personal scoreboard. The value of one’s bonus is not just a financial compensation, but a psychological one, a way of validating someone’s performance.

And from Thain’s perspective, he had done a good job. Merrill Lynch avoided the fate that had befallen Lehman Brothers and Bear Stearns, and the toxic CDOs that doomed Merrill had been obtained before Thain got there. Not getting a bonus was akin to overlooking those facts.

Of course, to most people outside of Wall Street, even those at a commercial bank as big as Bank of America, looking for an eight figure bonus after losing billions of dollars is nothing but greed.

Ultimately, with the news of the bonuses in the press, and Merrill announcing a $3 billion loss in the fourth quarter of 2008, Thain was let go from the newly combined Bank of America. Though the stated reasons were the poor performance, the culture clash seemed to play as big a role as anything.

Farrell’s book, overall, is big on culture and short on finance. There are big personalities and vivid depictions of feuds, but the book is not exactly brimming with details about the CDO market or the housing bubble. This may be a good thing, particularly if you are intrigued by the culture of Wall Street, but overall it’s relatively light on substance. Though the book is a soap opera with historic consequences, it is still just a soap opera.


Financial Crisis Inquiry ReportThe Financial Crisis Inquiry Report

by The Financial Crisis Inquiry Commission 2011


If you need proof of my dedication to this project, look not further than the fact that I read the Financial Crisis Inquiry Commission’s final report. If you are not familiar with the FCIC, it was the bipartisan commission put together by Congress to investigate the crisis, in the mode of the 9/11 Commission or, going way back, the Pecora Commission on the Great Depression.

The hope was that the Commission could both explain the crisis and offer some common sense solutions that might prevent such a crisis from reoccurring. In a development as predictable as it was disappointing, the Commission ended up splitting along party lines, with those members appointed by Democratic leadership issuing their report, and those appointed by Republicans dissenting.

Even worse, the “conclusions” offered by the concurring Commission members are so vague and obvious that they have hardly any value. The Commission concluded that the crisis was “avoidable,” that “widespread failures in financial regulation and supervision proved devastating,” that “the government was ill prepared for the crisis,” and that “there was a systemic breakdown,” among other similar conclusions. It does not seem like it should have taken hundreds of interviews and 19 days of public hearings to reach these conclusions.

This is not to say that the FCIC and its report were of no value. For one, there is almost always a value to public hearings about a crisis of this magnitude—at the very least the FCIC got primary figures to comment on the record.

Also, the report is a trove of data. It is full of precise information on, say, the amount of household debt that was held by banks, or the number of CDO tranches that were sold to other CDOs, or the number of AAA-ratings issued by Moody’s. So much data goes a long way toward providing a depiction of what was going on in the financial industry, though it’s not as good at identifying what exactly are the causes and what are merely symptoms of a larger problem.

One of the most effective criticisms in the minority dissent is that the report, in stressing so many possible causes, fails to pinpoint exactly which were real. In this respect, the gag order imposed by the FCIC, which limited each dissenting commissioner to just ten pages, actually worked in the dissent’s favor. The dissent’s brevity makes it much more cogent than the report itself, which stretches for over 400 pages.

For example, the dissent places the American crisis in the context of the global panic, pointing out that, although other countries did not have the same securitization fever that American banks had, there was a similar credit bubble across almost all of the developed world. As such, the dissent persuasively argues that the housing bubble was really more of a symptom of a larger credit bubble, and not merely the result of new derivatives.

Another crucial point in the dissent* is the response to the argument against bailouts. It’s easy to argue against bailouts, but the calculus to a policymaker strongly favors them. Since the consequences of a bank’s failure were potentially so dire, it’s hard to allow it to happen, even if one opposes bailouts in principle. As the dissent puts it, “it should be easy to see why policymakers favored action—there was a chance of being wrong either way, and the costs of being wrong without action were far greater than the costs of being wrong with action.” Of course, the dissent also endorses Treasury’s stated position that “there was no buyer” for Lehman, so it’s not perfect.

*There are actually two different dissents to the report. Three of the commission members—Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas—combined their ten page allotment to issue a cogent critique of the report. Peter Wallison wrote his own dissent, of which only the ten-page introduction is included with the book (the rest is online). Wallison’s dissent, though, is essentially just a partisan attack on Fannie Mae and Freddie Mac, blaming the government for causing the crisis in the face of all evidence to the contrary. It is hardly worth discussing.

The report itself, though, is better at showcasing the perverse relationship between banks and their regulators. For one, there is the way banks effectively shopped for the most lenient regulators. There are at least half a dozen regulators of the finance industry: the Federal Reserve, the SEC, the OCC, the CFTC, the OTS, etc. Each of them is responsible for a different aspect of the banking industry, but it’s not always clear where one agency’s jurisdiction ends and another begins. As a result, banks would try to find guidelines from whichever agency was the most lenient. In many cases, federal agencies preempted state regulations. That is, when several states tried to crack down on predatory lending, the OTS and OCC issued rules saying national banks were not subject to the state’s laws.

One grotesque result of this was that the “rules” imposed by federal regulators were often not rules at all. Often the federal government would tell states that national banks had to be regulated by national agencies—and then insist, either because the federal government did not have the resources, expertise, or foresight to regulate the banks, that it would actually be better if banks just regulated themselves. In other words, the federal government would wave off states by claiming to be a stricter, more stable authority, and then refuse to actually exercise that authority. Alan Greenspan was notably famous for his insistence that self-regulation would be most effective, though he now concedes there might be “a flaw” in this thinking.

With so many turf wars going on between the regulators, it wasn’t always clear what a regulator’s job was. A particularly interesting revelation in the report is that the SEC knew of Lehman’s “disregard of risk management” and that it had “increased and exceeded risk limits.” In other words, the SEC knew Lehman was exposing itself to the fragile housing market, and didn’t act. It’s easy to criticize the government for this inaction, but then again, this wasn’t really in the SEC’s jurisdiction. The SEC had been set up to regulate the stock market—enforcing fraud laws, or insider trading, or other securities law. It was not established to manage risk for the banks.*

*Of course, the SEC probably could have used this information in other ways, like, say, revoking Lehman’s leverage exemption, which it had granted in 2004 to allow the company to increase its leverage beyond the 12-to-1 limit (that is, 12 borrowed dollars for every dollar of capital) the SEC had imposed. Lehman’s leverage ratio was about 30-to-1 by 2007. Whether or not this would have prevented Lehman’s failure is debatable, but it seems prudent, if you know a firm is exceeding risk limits, to pressure it to raise its capital.

This is just one example of the nebulous powers of federal regulators. It’s not really surprising, given how murky the role of regulators is, that they tend to be so deferential to Wall Street—it can sometimes seem like the main role of regulators is to do what Wall Street needs.

In some cases, the banks actually asked to be regulated, as Chuck Prince, then CEO of Citigroup, did in 2007. Recognizing the dangers in the liquidity market, but claiming, “it was not credible for one institution to unilaterally back away from this leverage lending business,” Prince asked regulators to force the banks not to leverage so much. Of course, Prince’s advice was not heeded, so I suppose regulators are not ALWAYS deferential…

The last thing worth pointing out about the report is the sheer quantity of testimony from people who admit to being wrong in very big ways about very important things. Greenspan admits to “a flaw” in his way of thinking about regulation, Paulson admits he was “naïve” about the effects of his actions on the market, the CEO of Freddie Mac admits to not being able to foresee the market, etc. While it’s nice of these people to admit their flaws, it’s worth pausing to recognize how much power we’ve bestowed on people who, it turns out, don’t know what they are doing.

If the FCIC’s report doesn’t really provide concrete solutions or answers as to how the crisis could have been avoided, it is likely because, as this example shows, the changes necessary were not as simple as passing a law or two, or reversing some decisions. There was an entire culture of fraud, irrationality, and dependency on the government that was running rampant at virtually every institution involved in the crisis. Even Treasury’s ad hoc response to the crisis has to be examined in light of this cozy relationship between Wall Street and Washington. Though the report may not succeed in offering prescriptions for how to undo this, it at least offers an in-depth look at exactly what was going on.

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