September 22, 2023

DealBook: The Merrill Lynch and Lehman Deals, 3 Years Later

Harry Campbell

This is a tale of two deals.

Three years ago today, Bank of America leapt into the maelstrom and bought Merrill Lynch for about $50 billion. Early the next morning, Lehman Brothers announced its bankruptcy filing. Lehman soon sold its investment banking and capital markets operations to Barclays for $250 million.

One of these deals has been a success. The other is questionable. The difference shows not only how a chief executive’s hubris can destroy a company, but how three years later, the failure of the Treasury Department, Federal Reserve and the banks themselves to shrink significantly the banks’ mortgage liabilities still threatens our economy.

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Of the two deals, the hands-down winner is the Lehman Brothers acquisition. Barclays paid anything but retail for Lehman, and in the process acquired a powerful franchise in the United States. Barclays is now the seventh-largest American investment bank measured by revenue, according to Dealogic. The former Lehman bankers are competing strongly in some crucial areas. In advising on mergers and acquisitions in the United States, Barclays was fifth in the first half of the year, according to Dealogic. Barclays was also the largest adviser on debt offerings in the world and third-largest in the United States.

At first blush, Merrill is also performing well, but in a way that highlights Bank of America’s scarily poor performance. The bank lost $8.8 billion in the second quarter after taking a $20.7 billion write-off for mortgage-related losses. It would have been worse without Merrill. Bank of America’s investment banking and wealth management operations, which are largely old Merrill operations, contributed $2.1 billion to Bank of America’s profits on $11.3 billion of revenue.

While Merrill is currently throwing a lifeline to its parent, Bank of America, Merrill has also contributed substantially to Bank of America’s problems. The Merrill acquisition added nearly $900 billion worth of assets to Bank of America’s balance sheet. With that, Merrill’s liabilities related to the mortgage crisis were assumed by Bank of America. It is unclear how big they are, but they total in the tens of billions. During the financial crisis, Merrill’s mortgage problems forced Bank of America to take an extra $20 billion in Troubled Asset Relief Program money.

This is where the two deals truly differ. Barclays’s regulator stopped Barclays from buying Lehman before it declared bankruptcy. This was unbelievably lucky for Barclays. By buying Lehman out of bankruptcy, Barclays did not take on Lehman’s toxic assets. These consisted of more than $600 billion in debt. Barclays avoided liability for most of it.

In contrast, Bank of America plunged headlong into buying Merrill. The deal was driven by Bank of America’s former chief executive, Kenneth D. Lewis, who had lusted after Merrill Lynch for years. Bank of America paid a 70 percent premium three years ago for a bank that was worth far less and might have been insolvent. And while Bank of America executives a few months later appeared to get cold feet, the federal government pushed them to close the deal.

Being as deeply in the mortgage market as Merrill was — if not more so — Bank of America should have been aware in September 2008 of the problems looming on the horizon. Yet Mr. Lewis’s eagerness to buy Merrill consumed all sober judgment. At the same time, blaming him alone is also simplistic. I wonder where the Bank of America board was in all of this. This is yet another example of a board failing in its responsibility to ask hard questions.

Things would have been different had Bank of America waited. It would at a minimum have paid a bargain basement price for Merrill, one that was tens of billions lower at least.

There is still some talk of spinning off Merrill Lynch. The operations of Merrill have already been combined with Bank of America, so a real separation would be complicated. And the recent reorganization of the bank’s management — which puts Merrill Lynch’s wealth management business under David Darnell, the co-chief operating officer, but Bank of America-Merrill Lynch under the other chief operating officer, Tom Montag — also makes a split more difficult.

Ultimately, Barclays made a better deal by doing what should be done in an acquisition, carefully assessing the future liabilities and limiting them as much as possible. But let’s be clear. Barclays did this only because it was forced to by the regulator.

The first lesson of Bank of America and Merrill Lynch is that impatience and a chief executive’s hubris can lead to some very bad decisions. And regulators can sometimes stop these heady moves.

There is also a larger lesson here. In the case of Barclays, a regulator asserted that the liabilities could not be assumed. These had to be dealt with before the acquisition. The result was a messy and expensive bankruptcy process for Lehman, but one that has allowed the viable part of Lehman to prosper.

In contrast, Merrill was anything but a clean acquisition. Merrill’s toxic assets were put together with Bank of America’s and Countrywide’s toxic assets. While some argue that Merrill’s investment banking division is helping Bank of America, this ignores the fact that Merrill’s mortgage assets are now most likely hurting the bank even more.

The ultimate lesson from these two deals is that taking your medicine early is worthwhile. Regulators and banks still have not come to terms with the mortgage debt on bank balance sheets left over from the financial crisis, let alone the liability these banks face for selling these mortgages to investors.

This is a problem concentrated in the large banks. As of the end of last year, the four biggest banks held 42 percent of the $950 billion in second-lien loans then outstanding, according to The American Banker, which most banks have yet to write down. Bank of America alone held $136 billion of these loans as of the first quarter. Second-lien loans are the riskiest of mortgage assets because they are the most likely to be written down. According to CoreLogic, 23.1 percent of the nation’s mortgaged homes are underwater, their owners owing more than the home is worth. This means that there will be more pain for Bank of America and other large banks in the coming years.

Putting together Bank of America’s and Merrill’s bad assets has only kicked the can down the road. Three years after that fateful September weekend changed Wall Street, the same mortgage liabilities continue to haunt many banks. This is not a worry for Barclays, at least in the United States. It made the better deal.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

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Wall Street Banks Bracing for Drop in Trading Revenue

As if the troubles in Europe were not enough, two months of the most turbulent markets in decades are expected to seriously damp trading results for the nation’s largest banks.

In a bellwether for other large financial firms, JPMorgan Chase warned that third-quarter trading revenue was likely to fall about 8 percent from a year ago. Investment banking income is also expected to drop by one-third from a year earlier, as corporations get cold feet about acquisitions as well as stock and debt offerings.

“I think you can safely expect a decline in our markets revenue,” Jes Staley, the head of JPMorgan’s investment bank, said in remarks at the Barclays financial services conference on Tuesday.

There are still 13 trading days left in the third quarter ending Sept. 30, and Wall Street firms will not release their final numbers until the middle of next month. But a sharp fall-off in summer trading seems poised to weigh heavily on the banks’ earnings — and perhaps accelerate another round of layoffs expected in the coming months.

After helping lift Wall Street’s results during the financial crisis, trading revenue is projected to fall for a second straight quarter. On average, it is expected to be down by about 7 percent from a year ago, according to Credit Suisse research. Bank of America, Citigroup, Goldman Sachs and Morgan Stanley are also expected to have weak third-quarter results.

Investors shrugged off the latest bad news as shares of the biggest banks rose slightly on Tuesday in relatively calm trading. But bank stocks have been pummeled recently. The KBW index, a widely cited gauge of the banking sector, has fallen more than 28 percent since January.

Although Wall Street firms can land windfalls making speculative bets with the banks’ own capital, the bulk of their trading revenue comes from transactions made on behalf of clients.

But with the heightened volatility over the summer, many companies and investors remained on the sidelines — causing a significant slowdown in trading activity.

The lackluster trading results come at a bad time for the industry, when profits and revenues have slipped to the levels attained before the housing boom. Many are bracing for a slowdown in lending, as consumers grow nervous about their job prospects and businesses put off expansion plans. Banks still face an endless stream of legal headaches and litigation fees from the foreclosure mess.

In addition, new regulation has ratcheted up compliance costs and caused once-lucrative income streams, like debit card swipe fees and overdraft charges, to vanish. And all that is not counting the impact of the Federal Reserve’s pledge to keep interest rates low for the next two years — a move that will erode lending profit margins in the months ahead.

In anticipation of leaner times ahead, banks are looking to cut costs and streamline their operations. On Monday, Bank of America announced plans to cut about 30,000 jobs across the company, or nearly 10 percent of its work force. Citigroup, Goldman Sachs, Barclays, Credit Suisse and UBS are among the major Wall Street firms that have started laying off employees in the last few months.

JPMorgan’s investment bank is more than halfway through a five-year plan to save about $1.3 billion a year by consolidating its trading operations — a move that will involve shedding as many as 3,000 workers, some of whom will be employed elsewhere in the bank.

But so far, Mr. Staley said the bank does not anticipate a major round of layoffs beyond those previously announced. “We have had a very good first half of the year,” he said at a banking conference in Frankfurt last week. “We will see how this plays out.”

Still, the numbers at JPMorgan may foreshadow more pain ahead. JPMorgan was among the first major banks to sound the alarm bells over souring subprime mortgage loans in early 2007. In 2008, the bank flagged concerns about ballooning losses on its large portfolio of home equity loans ahead of many competitors and has moved quickly to shore up its reserves against legal claims stemming from the mortgage mess.

In his remarks, Mr. Staley said investors could expect equity and fixed income trading revenues to decline about 30 percent from the second quarter, putting them at about $3.85 billion. Investment banking fees are expected to fall to about $1 billion, down from $1.9 billion in the second quarter. He also said that the bank’s private equity business would face a “moderate loss” of about $100 million and that its asset management business would see trading-related declines.

Other banks may see a similar fall-off in trading. Citigroup, which has a giant fixed-income business, could see core trading revenue drop 47 percent from a year ago, according to Credit Suisse research. Overall trading revenue at Morgan Stanley is expected to fall about 1 percent from a year earlier, while revenue at Bank of America is expected to rise about 11 percent. Both banks had relatively weak third-quarter results in 2010.

Meanwhile, Goldman Sachs’s trading income is expected to fall about 7 percent from a year ago, according to Credit Suisse. But that may not represent the full extent of the declines it can expect.

Richard Staite, an analyst at Atlantic Equities, wrote in a recent report that the bank could face more than $3.2 billion in losses tied to its investment and lending businesses, which include private equity and other investments made with the bank’s own capital. That is because it must adjust its accounting to reflect the market’s recent round of wild swings.

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Bucks: Private Offerings Come With Many Caveats

Paul Sullivan’s Wealth Matters column this week makes the point that some investors are not any more aware of the risks involved in private equity and debt offerings than they were nearly three years ago, in the depths of the recession. The biggest risk is that they will lose all their money. That is probably not as big a deal for the wealthy as it is for those who aspire to be rich.

And that’s the point: Investors in private placements should not be dazzled by the lure of huge returns. Instead, experts say, they should expect the worst and hope for the best.

Have you had experience — or know someone who has — with these types of investments? Please tell us below what happened.

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