David Dayen did a good blog on how BoA moved it’s risky derivatives to a subsidiary with deposits insured by the FDIC. Now here is a break down of the how and why of it by Bill Back of the S&L investigations fame. I am going to jump around here a bit and give you first some background info on BoA. It’s not your grandfathers BoA.

B of A is really “Nations Bank” (formerly named NCNB).  When Nations Bank acquired B of A (the San Francisco based bank), the North Carolina management took complete control.  The North Carolina management decided that “Bank of America” was the better brand name, so it adopted that name.  The key point to understand is that Nations/NCNB was created through a large series of aggressive mergers…..

Now here is the nitty gritty of it all.

During this crisis, Ken Lewis went on a buying spree designed to allow him to brag that his was not simply bigger, but the biggest.  Bank of America’s holding company – BAC – became the acquirer of last resort.  Lewis began his war on BAC’s shareholders by ordering an artillery salvo on BAC’s own position.  What better way was there to destroy shareholder value than purchasing the most notorious lender in the world – Countrywide.  Countrywide was in the midst of a death spiral.  The FDIC would soon have been forced to pay an acquirer tens of billions of dollars to induce it to take on Countrywide’s nearly limitless contingent liabilities and toxic assets.  Even an FDIC-assisted acquisition would have been a grave mistake.  Acquiring thousands of Countrywide employees whose primary mission was to make fraudulent and toxic loans was an inelegant form of financial suicide.  It also revealed the negligible value Lewis placed on ethics and reputation.

But Lewis did not wait to acquire Countrywide with FDIC assistance.  He feared that a rival would acquire it first and win the CEO bragging contest about who had the biggest, baddest bank.  His acquisition of Countrywide destroyed hundreds of billions of dollars of shareholder value and led to massive foreclosure fraud by what were now B of A employees.

What this all means is that BoA’s problems began with it’s acquisition of Countrywide whose financial deals or mis-dealings and fraud were much worse than what anyone was lead to believe at the time. And that the acquisition was driven by ego as much as greed.

But there are two truly scary parts of the story of B of A’s acquisition of Countrywide that have received far too little attention.  B of A claims that it conducted extensive due diligence before acquiring Countrywide and discovered only minor problems.  If that claim is true, then B of A has been doomed for years regardless of whether it acquired Countrywide.  The proposed acquisition of Countrywide was huge and exceptionally controversial even within B of A.  Countrywide was notorious for its fraudulent loans. There were numerous lawsuits and former employees explaining how these frauds worked. [emphasis mine]

………..

The acquisition of Countrywide did not have to be consummated exceptionally quickly.  Indeed, the deal had an “out” that allowed B of A to back out of the deal if conditions changed in an adverse manner (which they obviously did).  If B of A employees conducted extensive due diligence of Countrywide and could not discover its obvious, endemic frauds, abuses, and subverted systems then they are incompetent.  Indeed, that word is too bloodless a term to describe how worthless the due diligence team would have had to have been.  Given the many acquisitions the due diligence team vetted, B of A would have been doomed because it would have routinely been taken to the cleaners in those earlier deals.

That scenario, the one B of A presents, is not credible.  It is far more likely that B of A’s senior management made it clear to the head of the due diligence review that the deal was going to be done and that his or her report should support that conclusion.  This alternative explanation fits well with B of A’s actual decision-making.  Countrywide’s (and B of A’s) reported financial condition fell sharply after the deal was signed.  Lewis certainly knew that B of A’s actual financial condition was much worse than its reported financial condition and had every reason to believe that this difference would be even worse at Countrywide given its reputation for making fraudulent loans.  B of A could have exercised its option to withdraw from the deal and saved vast amounts of money.  Lewis, however, refused to do so.  CEOs do not care only about money.  Ego is a powerful driver of conduct, and CEOs can be obsessed with status, hierarchy, and power.  Of course, Lewis knew he could walk away wealthy after becoming a engine of mass destruction of B of A shareholder value, so he could indulge his ego in a manner common to adolescent males.
In other words Lewis and the top management knew all along that they were getting crap but did it anyway for some big ego strokes. Now enter Merrill Lynch.
Merrill Lynch is the quintessential example of why it was common for the investment banks to hold in portfolio large amounts of collateralized debt obligations (CDOs).  Some observers have jumped to the naïve assumption that this indicates that the senior managers thought the CDOs were safe investments.  The “recipe” for an investor maximizing reported income differs only slightly from the recipe for lenders.

1. Grow rapidly by

2 .Holding poor quality assets that provide a premium nominal yield while

3. Employing extreme leverage, and

4. Providing only grossly inadequate allowances for future losses on the poor quality assets

Investment banks that followed this recipe (and most large U.S. investment banks did), were guaranteed to report record (albeit fictional) short-term income.  That income was certain to produce extreme compensation for the controlling officers.  The strategy was also certain to produce extensive losses in the longer term – unless the investment bank could sell its losing position to another entity that would then bear the loss.

The optimal means of committing this form of accounting control fraud was with the AAA-rated top tranche of CDOs.  Investment banks frequently purport to base compensation on risk-adjusted return.  If they really did so investment bankers would receive far less compensation.  The art, of course, is to vastly understate the risk one is taking and attribute short-term reported gains to the officer’s brilliance in achieving supra-normal returns that are not attributable to increased risk (“alpha”).  Some of the authors of Guaranteed to Fail call this process manufacturing “fake alpha.

…………….

Merrill Lynch was known for the particularly large CDO positions it retained in portfolio.  These CDO positions doomed Merrill Lynch.  B of A knew that Merrill Lynch had tremendous losses in its derivatives positions when it chose to acquire Merrill Lynch.

Given this context, only the Fed, and BAC (Bank of America’s holding company), could favor the derivatives deal

Lewis and his successor, Brian Moynihan, have destroyed nearly one-half trillion dollars in BAC shareholder value.  (See my prior post on the “Divine Right of Bank Profits…”)  BAC continues to deteriorate and the credit rating agencies have been downgrading it because of its bad assets, particularly its derivatives.  BAC’s answer is to “transfer” the bad derivatives to the insured bank – transforming (ala Ireland) a private debt into a public debt.

So what we have here is a case where BoA knows that sooner or later they will go belly up and so they are making damn sure the investors will get the life boats first and damn the depositors.   With BoA in this situation, it kind of makes you wonder about the others. Like the saying goes. “Like picking up a hay stack and having three needles drop at your feet, it’s a pretty safe bet that the thing is stiff with needles.”

Isn’t it any wonder that these banks are going ape shit over people closing their accounts ? The same accounts they are planning to use to cover their asses.

cmaukonen

cmaukonen

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