Sunday, February 01, 2009

The sorrows of Bank of America

Bank of America CEO Ken Lewis

Like most bloggers with "day jobs", I avoid commenting about my own particular work environment and generally have avoided writing about even former employers. But after I read the article about Bank of America in the current Business Week, I decided to make an exception.

I worked for BofA for several years until 2000. I've had no business connection beyond personal checking and savings accounts since then, so don't expect any hot stock tips here. I was part of the previous (original) BofA that was acquired by NationsBank in 1998. The merged bank took the name Bank of America, though the management was very much that of the former NationsBank, then led for CEO Hugh McColl.

Like a lot of the employees of the old BofA, I always had, shall we say, restrained enthusiasm for the new top management. I'm going to refrain from any of my favorite illustrative anecdotes on that point. But NationsBank had been, in my way of thinking, not so much a bank as a bank acquisition company. Whatever his other faults, McColl was spectacularly successful at that.

Acquisitions provide some advantages for a company seeking, as they all do, to put the best face on their operations. As one example, you can set up very conservative reserves against risks in the merger transition. That gives the company the ability to release reserves later when the risks look smaller, which boosts earnings and pleases stock analysts. The Sarbannes-Oxley rules enacted after Enron's implosion reduced the latitude for game-playing with merger accounting. But it still offers advantages.

Another advantage is that mergers mean reorganizing the businesses, which means that senior managers often don't leave a consistent track record. If you move senior managers from division to division, reorganize frequently and do even more mergers, stock and business analysts have a harder time getting a clear idea of which managers, divisions and lines of business are strongest and most profitable. This gives the company enhanced ability to control their messaging. A huge downside is that it can also deprive the company itself of knowing which parts of its business are the most profitable and which managers are the most capable. That in turn puts a premium on "politics" in selecting managers for other senior positions.

The 1998 NationsBank/BofA merger did offer strategic advantages to both companies. No other two banks at the time would have had the combined nationwide reach that the new BofA had. BofA also had strong and profitable international operations. The name "Bank of America" was thought to be a significant brand benefit abroad because it created an impression that the US government stood behind the bank. And, as we've seen in recent months, that perception was not at all entirely wrong.

The old BofA was also developing an investment banking capability that was more extensive that what NationsBank had.

Yet the new BofA under its Charlotte (North Carolina) leadership wasn't especially interested in those two advantages. The one time I heard Hugh McColl live and in person, he was speaking to a group of mostly people from the "old" BofA. Someone asked him a question about international operations and he outright sneered at it. He said we didn't make any money off international operations. Anyone at all familiar with the old BofA's international business was probably at least as shocked as I was to hear him say that. But corporate habits generally discourage anyone from from telling the CEO in a public meeting that he's not only wrong but sounds totally clueless about what he's talking about. And of course, no one did.

Okay, one anecdote. I asked a good friend of mine who had been a senior computer programmer in the international division and who had worked a lot with programmers from Charlotte on the merger how well she thought the Charlotte people were picking up the international business. This was around two years after the merger. She said, "Well, even now when I'm working with programmers from Charlotte, I get questions like, 'Why is there a currency field in this program?'"

But one immense advantage of which the new BofA made good use was the gigantic deposit base the former BofA had built up in California. The original BofA more-or-less invented consumer banking in the early decades of the twentieth century. And the fact that they had and still have a huge customer base with checking accounts at BofA means that they had big cash reserves on which to draw and also that they don't have to borrow as much money from other financial institutions to make loans, because they have so much deposit money to loan out.

Without going too much into how earnings on deposits and favorable credit costs work, let's just say that the deposit base kept the old BofA afloat in the 1980s when they were hammered by bad loans to energy firms, agriculture and underdeveloped countries. And I'm guessing that the deposit base has covered quite a few management "sins" over the last 10 years, as well.

Until now. If the Business Week article is correct, BofA looks like an excellent candidate for full nationalization. The article in question is The Federal Bailout Hasn't Fixed Bank of America by David Henry, Matthew Goldstein and Roben Farzad 01/28/09. It's accompanied by a somewhat mysterious graphic showing a huge spider with the head of ski-masked bandit looming over a little guy with an aerosol spray can.

Knowing from experience what Charlotte's pre-merger "due diligence" can be like, it's not surprising to me to hear that they promiscuous merger activity has finally caught up with them. This past year, they acquired the remains of Countrywide and Merrill Lynch:

History shows that BofA's diligence was less than what was due. [CEO Ken] Lewis' advisers inside and outside the company expressed doubts about the Merrill deal, then valued at $50 billion—far more than its $27 billion market value at the time. But Lewis was ultimately swayed by his director of corporate planning and strategy, Gregory L. Curl, the architect of previous transactions. By the time the deal closed, Merrill's market price was less than $20 billion. A BofA spokesman says the due diligence on the Merrill transaction was adequate, noting that losses grew dramatically in December because of "market phenomena."

Now the hastily arranged deal is laying bare a host of problems. Investors are growing impatient: Since October, shares of BofA have fallen by around 70%. And some insiders are losing faith in Lewis and his senior management team. Employees on the trading floor are riffing on Lewis' dictatorial style, referring to the CEO as Kim Jong Il, the North Korean leader. On Jan. 28, BofA's directors issued a statement backing Lewis. [my emphasis]
Sloppy due diligence is nothing new, and not unique to BofA. It's notorious that the worst deals that corporations do are often arranged between the CEOs at the country club or somewhere with little real analysis. (You didn't really believe all that stuff about the ruthless rationality of business decision-making imposed by the famous invisible hand of the all-wise "free market", did you? If so, you're going to be very disappointed to hear the truth about Santa Claus and the Easter Bunny.)

By the way, one of the failings of the business press is that when companies are doing well on the surface, they usually don't publish things like the fact that people are referring to the CEO as "Kim Jong Il" or some other uncomplimentary name. Until things turn bad, they are captains of business with charming personal quirks. This is also not surprising to me. Even people from the old BofA, which was certainly not into some kind of loose hippie management style, were surprised at the degree of deference NationsBank people showed toward their management.

A previous Business Week article from just before BofA released its recent dismal quarterly earnings gave us a glimpse at this side of Lewis, Why Banks Still Won't Lend by Mara Der Hovanesian and Christopher Palmeri 01/07/09. The Bush administration injected billions of in banks on the justification that recapitalizing them would unfreeze credit by allowing banks to resume lending to businesses and consumers. But, being the Cheney-Bush administration, that didn't actually require the banks to do any such thing:

The industry is getting flak for hunkering down. After all, the Treasury has injected $187.5 billion into the nation's largest banks, including Citigroup (C), Bank of America (BAC), and JPMorgan Chase (JPM). The recipients of taxpayer money, say critics, should be required to open up their coffers. "The bad news [is] Treasury has no way to measure whether taxpayer funds are being used to increase lending," Representative Barney Frank (D-Mass.), chairman of the House Financial Services Committee, said in December. "The much worse news [is that Treasury] does not even have the intention of doing so."

Banking chiefs defend their position. They argue that the government funds are designed to shore up capital and support lending, but that they have no obligation to make new loans. "It's not a one-to-one relationship," says BofA CEO Kenneth D. Lewis. "We don't write $15 billion in loans because we got $15 billion from the government." [my emphasis]
It sounded bad enough that Lewis was taking such a dismissive attitude toward legitimate public policy concerns when his bank had gotten only the amount of public money injected up until that point. But he must have known even then that they were going to need more public funds to keep them afloat and to complete their ill-conceived acquisition of Merrill Lynch. You would have thought he might want to sound less arrogant and dismissive. Especially since there would soon be an administration in power not committed to sniveling to every demand of corporate CEOs.

His statement was also strange apart from the apparent arrogance of it. In retrospect, he may have been thinking that saying that was better than saying that his company was tanking and would soon be back in Washington, hat in hand for more public assistance.

But according to the assumptions behind the fall bailout, his statement is downright weird. Assuming everything else in the company isn't getting worse, $15 billion in new capital should have resulted in much more than $15 billion in new lending. If you assume that the bank is holding 20% in reserves against loan risks - a very conservative assumption - having $15 billion in additional capital should have allowed them to make five times that amount in loans, or $75 billion.

Now we know that in reality, they needed that capital and more just to survive. They weren't really in condition to expand lending by any large amount.

The more recent article paints a dire picture of BofA's current state:

With so many dubious assets on the bank's balance sheet, there are growing concerns about whether it is effectively, if not technically, insolvent. At last count, Bank of America's assets exceeded its liabilities by about $210 billion, or roughly 10%. A financial institution is considered insolvent when its assets don't cover its liabilities - and a regulator can take over a bank even before that happens. "We are a very liquid bank," says BofA spokesman Robert Stickler.

But there are questions on both sides of the ledger. A small decline in the price of the company's assets could bust the bank. The liabilities may also be understated: The tally doesn't include BofA's obligations to preferred shareholders, an increasingly large group. Already, Wall Street is questioning whether BofA is actually worth the $210 billion on its books. The stock recently traded at 7.35, which puts the company's value at roughly $47 billion.

Time is running out for BofA. Top talent is fleeing, not only legacy bankers from the commercial bank but also top Merrill brokers. Some employees are even volunteering for layoffs, so skeptical are they of the bank's future. Now, critics inside and outside the company wonder if Lewis' days are numbered. Says FBR's Paul Miller: "If there are any other big surprises - another big loss - I think the wall of protection will crumble around Lewis."

Regardless of Lewis' future, one thing is certain: The government can no longer afford to take half-measures or move slowly to prop up BofA and other banks. [my emphasis]
I'm not a real fan of the idea that's being much discussed of the government setting up a "bad bank" to take over the bad loans that are dragging down lending institutions like BofA. That approach leaves the public with the losses while bailing out stockholders and many of the senior managers who let their institutions get to that point in the first place.

An approach similar to what was used to clean up the last great Republican financial disaster - the Resolution Trust Corporation (RTC) set up to deal with the savings-and-loan disaster after St. Reagan's and Old Man Bush's deregulation efforts - would be more appropriate.

Nationalize the banks that are "too big to fail" but failing anyway. Clean them up, then re-privatize them as healthy companies.

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