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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
Boost M&A outcomes with less risk by learning from mistakes of the past Material Adverse Change will help you close more successful mergers and acquisitions by analyzing the common root causes of deal failures from before the Great Recession to today. The time between signing and closing a deal is a particularly risky period where the buyer has committed to purchase the company, but the seller continues to operate it while waiting for regulatory approval or funding to close out the deal. A Material Adverse Change clause allows the buyer to back out of the transaction if certain adverse events occur during this period. By designing this safety net into the contract, you're free to take the time to examine records, meet with employees, and fully understand the legal issues at hand. If the target loses value during that time, in certain cases, you're free to walk away. This book explores the full power of the Material Adverse Change clause, and today's M&A in general. You'll dig into the real causes of M&A failure, and discover the traits and practices that lead to poor results as you learn how to avoid these common mistakes and drive more successful deals. Recent case studies highlight common mistakes made--and propagated--by otherwise intelligent people, so you can identify and eliminate these practices within your own organization. A large acquisition is already a delicate balancing act. Why complicate it with the exponential risk by not doing your homework? This book shows you how to apply best practices to increase your chances of successful deals and avoid potentially career ending mistakes. * Explore the true root causes of M&A failures of the past * Analyze the personality traits that drive suboptimal outcomes * Implement new practices to avoid mistakes and close successful deals * Learn why common-sense errors are repeated over and over again The M&A market has grown to become a major factor in the global economy, yet many buyers do less investigation than consumers making everyday purchases. Material Adverse Change shows you how to slash risk and improve your chances of completing better deals.
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Seitenzahl: 348
Veröffentlichungsjahr: 2018
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Table of Contents
Cover
Title Page
Introduction: The Risks and Opportunities of Doing a Deal
NOTES
CHAPTER 1: Why Bad Deals Happen
A PRACTICAL APPROACH TO MERGERS AND ACQUISITIONS
A CASE STUDY: RBS BUYS ABN AMRO
MOTIVATIONS FOR DEALS
A CASE STUDY: BANK OF AMERICA BUYS MERRILL LYNCH
USING M&A TO DIVERT ATTENTION
USING M&A TO GROW QUICKLY
USING M&A TO SOLVE PROBLEMS
HORIZONTAL AND VERTICAL MERGERS
CONCLUSION
NOTES
CHAPTER 2: Buy or Build?
A CASE STUDY: COMMERCE BANK
A CASE STUDY: METRO BANK
IS THERE ANYTHING IN BETWEEN?
A CASE STUDY: DOW CORNING JOINT VENTURE
A CASE STUDY: BUCKNELL INDUSTRIES
CONCLUSION
NOTES
CHAPTER 3: Let the Buyer Beware
WACHOVIA BUYS GOLDEN WEST
AOL TIME WARNER MERGER
WELLS FARGO BUYS WACHOVIA
NOTES
CHAPTER 4: The Opportunities and Risks of Expanding Your Business Globally
TELENOR INDIA JOINT VENTURE
TELENOR'S GLOBAL STRATEGY OVER TIME
TELENOR EXPANDS INTO EASTERN EUROPE
TELENOR PUSHES INTO ASIA
THE TELENOR UNITECH JOINT VENTURE
POSTMORTEM ON THE TELENOR UNITECH JOINT VENTURE
LESSONS LEARNED
TRENDS FOR THE FUTURE
NOTES
CHAPTER 5: Culture Is Critical
A CASE STUDY FROM CHINA
A CASE STUDY FROM JAPAN
A SUMMARY OF OTHER BEST PRACTICES
CHAPTER 6: Who Is Behind the Curtain?
A CASE STUDY: LLOYDS HBOS
A CASE STUDY: KRAFT BUYS CADBURY
NOTES
CHAPTER 7: Is It Too Late to Back Out?
CASE STUDY ONE: BANK OF AMERICA PURCHASES MERRILL LYNCH
CASE STUDY TWO: AT&T/T MOBILE
CASE STUDY THREE: VERIZON BIDS FOR YAHOO
CONCLUSION
NOTES
CHAPTER 8: How to Negotiate a Better Deal
TEN BEST PRACTICES FOR EFFECTIVE NEGOTIATION
CHAPTER 9: Making It Right
BACKGROUND
BE STRATEGIC
MAINTAIN A RATIONAL ORGANIZATIONAL STRUCTURE
STRUCTURE THE DEAL PROPERLY
RECOGNIZE THE IMPORTANCE OF BRAND
EFFICIENT DISTRIBUTION
BEWARE OF CULTURE
HAVE FINANCING LINED UP IN ADVANCE
ESTABLISH AN APPROPRIATE M&A APPROVAL PROCESS
INTEGRATE EARLY AND OFTEN
CLEAR LEGAL AND REGULATORY PROCESS
DON'T OVERPAY
CONTINUOUS LEARNING
A CASE STUDY: J.P. MORGAN BUYS BEAR STEARNS
CONCLUSION
NOTES
CHAPTER 10: Where Do We Go from Here?
HOW FAST WE FORGET
NOTES
APPENDIX A: Trinity International/American Public Media Group
NOTE
APPENDIX B: Bank of America/Merrill
NOTE
About the Author
Index
End User License Agreement
Guide
Cover
Table of Contents
Begin Reading
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Material Adverse Change
Lessons from Failed M&As
ROBERT V. STEFANOWSKI
Copyright © 2018 by Robert V. Stefanowski. All rights reserved.
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Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data
Names: Stefanowski, Robert, author.
Title: Material adverse change : lessons from failed M&As / by Robert V. Stefanowski.
Description: Hoboken, New Jersey : John Wiley & Sons, Inc., [2018] | Includes index. |
Identifiers: LCCN 2017049041 (print) | LCCN 2017050859 (ebook) | ISBN 9781118222430 (pdf) | ISBN 9781118236383 (epub) | ISBN 9781118066898 (cloth)
Subjects: LCSH: Consolidation and merger of corporations—United States.
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For my mom, I miss you.
Introduction: The Risks and Opportunities of Doing a Deal
Did any board member suggest that Bank of America should go ahead and invoke the MAC?
No, not at that point…most people thought the severity of the reaction meant that they (i.e., U.S. Federal Reserve and Treasury) firmly believed it was systemic risk.
—Ken Lewis, former chairman and CEO of Bank of America during U.S. Attorney Deposition on Executive Compensation February 26, 20091
On October 8, 2002, Fred Goodwin, then CEO of Royal Bank of Scotland (RBS), outbid Bob Diamond, the head of Barclays Capital, to conclude his long quest to purchase ABN AMRO Bank for $96.5 billion. Goodwin had built RBS from a small regional bank to a global powerhouse that was one of the largest banks in the world. For his efforts, Goodwin was voted “Businessman of the Year” by Forbes magazine in 2002. He had earned the name “Fred the Shred” for his ability to ruthlessly take out people while reducing the cost of operating the companies he acquired. Forbes proclaimed, “In a tough era for lenders, Fred Goodwin has built his bank into the world's fifth largest with a market cap of $70 billion.”2 Goodwin had a pragmatic approach to acquisitions, leveraging his instinct and experience running businesses to buy and transform companies.
Five years later, this jewel of an acquisition did not live up to expectations. Credit losses in the ABN loan book, key employee departures, an inability to integrate the complex ABN AMRO computer systems, and an overall downturn in the economy drove RBS's stock price from a high of over £7.00 per share ($4.2 per share) to a low of less than 50 pence per share (31 cents per share). Material adverse events in the company proved that a purchase price of close to $100 billion was more than ABN AMRO was truly worth.
With the continued deterioration of the economy and the rising of a Great Recession, the issues surrounding this deal became more and more apparent. Indeed, by the time of the depths of the recession in December 2007, for the same $100 billion that RBS used to buy ABN AMRO, an investor could have purchased 100 percent of Goldman Sachs, RBS, General Motors, Citibank, Deutsche Bank, and Merrill Lynch all together.3
What Can You Get for $100 Billion?
General Motors
$ 1 billion
Deutsche Bank
$25 billion
Goldman Sachs
$36 billion
Citibank
$ 8 billion
RBS
$12 billion
Total
$82 billion
Despite his best intentions and a desire to enhance the value to RBS shareholders by purchasing an exciting new business, this unfortunate acquisition cost Fred Goodwin his job. Thousands of shareholders who had invested in RBS stock lost all of their value. Goodwin was summarily dismissed from RBS, villainized by the press, and received threats on his personal safety. He was forced to leave his home and retreat to a friend's Majorcan Villa to avoid the press and an angry public. It was not until May 2016, over eight years after the fateful acquisition, that Goodwin was finally cleared of all criminal charges relative to the RBS deal.
This book is not intended to cast blame on CEOs, investment bankers, or other advisors unfortunate enough to be involved in failed transactions. I have found these constituencies to be hardworking and largely interested in the success of the companies they work for. Rather, it is to probe why deals don't work and the risks implicit in major transactions such as RBS paying close to $100 billion to purchase ABN AMRO. Through a review of past failures and the reasons behind these failures, we can better anticipate the potential pitfalls of future deals and avoid the disruption to a company and destruction of wealth to shareholders when deals don't work.
In the mergers and acquisitions (M&A) profession, due diligence is defined as the work accountants, lawyers, human resources, risk departments, senior executives, and other key personnel of the buyer complete prior to agreeing to purchase a company. Take the analogy of a newly married couple who wish to buy their first house; we will call them the “Wilsons.” The Wilsons typically look through the real estate listings, talk to a realtor, visit several properties, and narrow the search down to one house. At this point they will do a more detailed review of the property, looking for areas that may be damaged and in need of repair or replacement, or areas that the seller should correct before he sells the house. The Wilsons will likely hire outside experts such as an inspector to examine the house, an appraiser to verify the home's market value, a lawyer to help negotiate terms, and so forth. In essence, the Wilsons will want to be more than comfortable with the home before they commit money to purchase it.
Similarly, in successful acquisitions, a corporate or financial buyer of a company will analyze the financial position of the target, meet with key management, review the operations, update the company's financial projections, and investigate legal liabilities, all to determine if the company is worth the price being paid. Deal teams will hire consultants, lawyers, and accountants to help them with this process. Once complete, the buyer will sign a contract to purchase the company at a specified price over a certain time period.
In larger M&A deals, there is normally a time period between actual agreement to purchase (signing) and the completion of the transaction (closing). This time is used to satisfy contingencies such as government approval for the deal to happen, shareholder consents, employee union agreements, or agreements from other parties who need to consent to the transaction. Once all of these have been satisfied, the buyer and seller will move toward final closing of the transaction. It can take months to close a deal after contracts have been signed. This time between signing and closing is one of the most risky parts of the entire M&A process.
Take the example of the Wilsons, who now own the perfect home (as a result of completing very good due diligence!) and decide they need a car to go with it. They decide to buy a used car to save money and enter into a contract to purchase the car on Monday (signing). During the week they will withdraw the cash, arrange for financing and insurance, and then pay for and take possession of the car on Friday (closing). The Wilsons will absolutely want the car to be in the same condition on Friday that it was on Monday when they agreed to purchase it. But what if the owner decided to drive across the country from Tuesday to Thursday? What if the car was in an accident on Wednesday? Clearly the Wilsons will want some protection that the car will be in the same condition on Friday as it was when they agreed to purchase it on Monday if not to be able to walk away from the purchase.
Buyers in the M&A world face the same challenges. The target continues to function between signing and closing and is subject to the external risks of the business, the economy, and other acts beyond its control. Therefore, a buyer is at risk as they have agreed to purchase the company at signing, but the existing management team continues to run the company on a daily basis, hopefully well, for the buyer. A legal clause referred to as a material adverse change (MAC) has been crafted by attorneys to protect the buyer during this period between signing and closing.
An MAC allows the buyer to walk away from the deal if the target does not continue to run the company effectively or the firm incurs material changes that make the company less valuable. Attorneys have made the MAC clause much more complicated over the years. For example, years ago MAC clauses allowed buyers to walk away from transactions for the occurrence of natural disasters, acts of war, or terrorism. Unfortunately, due to the turmoil in the world since then, such events are no longer infrequent and these are no longer legitimate reasons for a buyer to walk away from a deal. But the concept remains the same. The buyer can back out of the deal if certain other bad things happen between signing and closing
The combination of due diligence and an MAC provision sounds perfect. In theory, the buyer gets to spend as much time as they want reviewing the corporate records; meeting with key employees; understanding the legal, environmental, and risk issues; and gaining an overall comfort with the target operations before agreeing to the purchase. Further, the MAC clause allows the buyer to walk away if material unusual events occur after they have agreed to buy in concept, but before they make final payment.
But many CEOs of major corporations do not exercise these rights as buyers or do enough due diligence to fully understand what they bought. Whether it is RBS's purchase of ABN AMRO or Bank of America's purchase of Merrill Lynch, these mistakes can have dramatic impacts for their company, their shareholders, and their careers. But bad deals continue to happen time after time. What are the factors motivating CEOs to put their careers on the line to acquire large companies? Why does this continue to happen despite highly publicized acquisition failures and the potential civil and criminal liability for the individuals involved? Why are successful companies not satisfied with where they are, pursuing a logical and orderly method of organic growth to improve their performance?
This book attempts to answer these questions. Whether you are a corporate CEO, an investment banker directly involved in M&A, an attorney, a human resources executive, a CFO, or a casual reader of business books, it will provide guidance on how to avoid these mistakes going forward. Landmark M&A case studies, such as Bank of America's purchase of Merrill Lynch and Kraft's purchase of Cadbury, will be used to answer these questions and provide hard evidence as to why these errors that defy common sense continue to be committed by well-established, successful, and highly intelligent businesspeople.
NOTES
1
. U.S. Legal Support Inc., Examination of Kenneth Lewis, taken at the State of New York of the Attorney General, February 26, 2009.
2
.
Forbes,
December 22, 2002.
3
. Based on total market capitalization of the firms as of 12/31/08 as listed in Fact Set.
CHAPTER 1Why Bad Deals Happen
This really is a merger of equals. I wouldn't have come back to work for anything less than this fantastic opportunity. This lets me combine my two great loves—technology and biscuits.
—Lou Gerstner, former chairman and CEO, IBM, commenting on Cisco's proposed acquisition of Nabisco from Kraft Foods
A PRACTICAL APPROACH TO MERGERS AND ACQUISITIONS
What do you look for when deciding on a bank to deposit your money? Given the recent large bank failures, the financial strength of the bank is certainly one main consideration. You may also be interested in the bank's customer service, checking account options, hours of operation, and so on. More financially experienced individuals will try to find the bank with the highest interest rates paid on customer deposits. For the most part, choosing a bank is a purely fact-based, rational decision.
Now assume that you are the CEO of a global company and are trying to decide what company to buy. Criteria will include the company strategy, quality of personnel, and of course the rate of return and profit you can earn. So it should be easy. Rank the companies for sale by their level of return and pick the highest one. For those of you who took business in college, remember the concept of net present value? You calculate the expected cash flows of the company and discount them by your firm's weighted average cost of capital. The project with the highest internal rate of return1 (IRR) is the one you choose.
Many of the university students I teach assume that this simple, scientific, and straightforward approach is how it works in the real world. This is the way the math works. This is how it was explained in the college corporate finance classes.
My professor is a brilliant person—it must be right. It takes a long time to convince students that the real world is much more complicated than this. Subjective judgments, personal agendas, egos, and a whole host of other human emotions often have more impact on these decisions than the pure numbers suggest.
In my experience, a purely academic approach to mergers and acquisitions is rarely the best way to make a decision. For example, an absolute comparison of returns versus cost of capital may have been a primary driver at the start of Royal Bank of Scotland's (RBS's) process to purchase ABN AMRO. However, as the auction went along and competition for ABN intensified between RBS and Barclays bank, it became less about the numbers and more about the softer items such as each firm's reputation, the impact to stock price of winning or losing the auction, public perception of the deal, and the attitudes of employees and customers.
A CASE STUDY: RBS BUYS ABN AMRO
Many postmortems have been written on Fred Goodwin's relentless pursuit of ABN AMRO. Early in the process, several internal and external RBS constituencies began to question the true motivations around this acquisition. One RBS analyst said at the time, “Some of our investors think Sir Fred is a megalomaniac who cares more about size than shareholder value.”2 But either these concerns never filtered up to the boardroom or, more likely, they were discussed and discounted; the momentum of a deal and commitment toward closing can often override very legitimate issues.
It must have been difficult to justify the ultimate purchase price of $96.5 billion when the initial bid from RBS in March 2008 was $92.4 billion. Did the fundamental operations and value of ABN AMRO improve by over $4.0 billion in the span of six months? In reality, a combination of poor integration, unrealistic projections, and a softening economy drove a significant loss in the value of ABN operations during this six-month period, and the price should have gone down, not up. An RBS trader commented at the time that “once you started to look around ABN's trading books, you realized that a lot of their businesses, where valuations were based on assumptions, were based on forecasts that were super-aggressive.”3
In hindsight, losing this deal may be the best thing that ever happened to Barclays and the CEO of Barclays Capital Bob Diamond. RBS never recovered from difficulty in integrating ABN AMRO, the poor asset quality, and the massive losses it incurred. In June 2007, RBS raised £12 billion of capital by issuing new shares in a rights offering to try to save the company from the massive overpayment and operating losses resulting from the ABN acquisition. At the time, this rights offering was the largest fundraising in the history of the British public equity markets; however, it still proved to be insufficient.
News of the serious issues associated with the acquisition of ABN was leaking to the market and the firm's capitalization decreased by more than a quarter—more than the total amount of capital raised by the rights offering itself. By October 7, 2008, RBS, its management team, its shareholders, and the U.K. government all realized that it was too late. The U.K. Treasury Select Committee started to provide emergency liquidity to RBS; in effect U.K. taxpayers were becoming the major shareholders in the new RBS.
In contrast, Barclays went on to be very successful. The bank has had some more recent issues, but Barclays had a strong enough balance sheet to withstand the Great Recession without bailout support from the government. Bob Diamond was ultimately promoted from the head of Barclays Capital to succeed John Varley as the head of the entire bank. While Diamond was dismissed from his post in 2012 for issues related to the LIBOR scandal, he was fortunate enough to have prolonged his tenure at Barclays by avoiding a disaster deal in ABN. In the world of M&A, winning the deal is not always the best outcome. The party that wins a competitive auction for a company is normally the party that is willing to pay the most! While this works out fantastically in some cases, it can cause problems for the buyers. As we saw with RBS, winning a deal may be the biggest curse of all.
MOTIVATIONS FOR DEALS
RBS's purchase of ABN AMRO seems truly illogical in hindsight. So why did it happen? Simple human nature is involved in all of these deals. It is easy to lose perspective, to forget the facts, and to become emotionally vested in the purchase. Many people can sympathize with this phenomenon. Have you ever paid more than you should have for a new home, a car, or a designer handbag because you became emotionally invested and just had to have it? Marketers all over the world depend on this human trait to sell product. As we see time and time again, it is no different in the “scientific” world of corporate finance.
Many CEOs are “Type A” personalities who like being in charge and enjoy the spotlight of the press. The battle for ABN was covered daily in the national press. While not intentional, it could be that the competitive nature of each CEO had as much to do with the rising price for ABN as the detailed acquisition models used to derive a fair price. In fact, by the time the purchase price rose to $96.5 billion, I imagine that the internal rate of return of the escalating bids for ABN AMRO was largely ignored while many of the softer issues were driving the ultimate decision.
A CASE STUDY: BANK OF AMERICA BUYS MERRILL LYNCH
The merger between Bank of America (BofA) and Merrill Lynch in September 2008 is another high-profile example of this phenomenon. Bank of America, headquartered in Charlotte, North Carolina, operated retail bank branches throughout the United States and the rest of the world. Originally founded in 1904, BofA had grown to be the largest retail bank in the United States.
Ken Lewis grew up in the southern United States, graduated from Georgia State University, and joined North Carolina National Bank in 1969. He became CEO of the successor organization, Bank of America, in 2001 upon the retirement of Hugh McColl. Lewis was admired for his strategic vision, execution of acquisitions, and ability to improve the operations of companies he acquired. By the mid-1990s, BofA had become a premier retail bank and Lewis was awarded “Banker of the Year” by American Banker in 2008 (American Banker, October 2008).
However, as a retail bank based in the southern United States, BofA did not have the prestigious reputation of the high-powered investment banks on Wall Street that were advising on multibillion-dollar acquisitions. Although widely respected, BofA was a large retail bank that took in consumer and corporate deposits and lent them out for car loans, home mortgages, leveraged loans, and other financing to individuals and corporations. BofA was headquartered in North Carolina, not New York City. Their core business was not as sexy as the billion-dollar transactions and initial public offerings being negotiated by investment banks making millions of dollars in fees for their firms and for themselves. While Lewis ran a first-class organization in its own right, it was and would always be considered second-tier to the global investment banks on Wall Street.
Merrill Lynch was a venerable investment bank on Wall Street with a heritage dating back to the early twentieth century. Founded by Charles Merrill and Edmund Lynch, Merrill became one of the leading providers of wealth management, securities, trading, corporate finance, and investment banking. The reputation Merrill held was very different from that of BofA. As a full-service investment bank headquartered on Wall Street, Merrill was absolutely included in the Wall Street elite. Over the years, Merrill's investment bank directed some of the largest and most visible transactions in the world of global financial services. Merrill's equity division had taken some of the most famous companies in the world public via initial public offerings. Merrill was able to attract the best recruits out of top colleges while improving the quality of management by tempting senior players from other Wall Street firms with employment contracts worth tens of millions of dollars.
In the late 2000s, Merrill decided to quickly expand its mortgage operations via internal growth and the acquisition of 12 major mortgage originators. The number of mortgage loans had exploded with the continued rise in the U.S. housing market. Merrill viewed mortgage lending as a way to diversify from its core M&A and equity underwriting business and bring in new revenue streams. A large part of this mortgage business included “subprime” mortgages, or mortgages made to borrowers with poor credit histories. These loans were attractive to Merrill because the bank could charge these customers a higher interest rate. Some of these borrowers had nowhere else to go and had to pay higher rates to secure financing. Many banks were worried about lending to these customers who had not paid back other loans, or historically paid loans late, resulting in a poor credit rating. However by 2006, over 20 percent of mortgage loans were to consumers considered to be subprime.
To manage exposure and generate fee income, the mortgages were packaged together into a pool and securitized to other investors. In other words, hundreds of mortgages were grouped into one pool of assets. Individual securities were then created that represented a percentage ownership in this broad pool of mortgages. An investor in one of these securities held a fraction ownership in the entire pool, enabling the investor to share in the risks and rewards of owning mortgage loans.
Financial professionals spoke about a “new paradigm” of risk. No one bank held the liability for the entire pool of mortgages any more. Rather, ownership of the individual securities was distributed among hundreds, if not thousands, of individual investors all over the world. The new theory was that if the pool of assets went bad and the mortgages were not repaid, it would not be a major global economic problem because the risk for any individual security holder was small. This eliminated the systematic risk posed by large borrowings to subprime mortgage holders held by one large bank because the securities were distributed in smaller sizes to multiple investors.
Securitization of mortgages became a massive business on Wall Street. Investment banks earned large fees by originating these loans or purchasing them from other borrowers and selling off the securities to others in the secondary market. Securitizations for other types of loans soon surfaced, such as automobile loans, corporate loans, credit card debt, and so on. These securities were called collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), depending on the type of loan pool.
As the global housing market boomed, banks started to lend more and more aggressively to weaker credits. This created more residential loans to supply the insatiable demand in the CDO market. It got to the point where “liar loans” were created that allowed individuals to take out home mortgages with no written evidence at all. In other words, a homebuyer could walk into a bank and list his net worth, level of income, and ability to pay back the mortgage. The mortgage broker would ask a few questions, but not require any documentation supporting the representations of the applicant. They trusted the applicant to not lie about his financial position.
Lenders started to loan up to 110 percent of a home's market value (i.e., more than the home was worth when the loan was taken out). This allowed a buyer to purchase a home without any of her own money committed. To make matters worse, the homeowner then received another 10 percent in addition to this amount and was allowed to keep the cash. The bank's theory was that home prices never came down. Given the escalation in home values, the loan would be worth more than the mortgage again after several months when the always-rising home prices would make the loan secure over time. This had become a very profitable business for Merrill Lynch and others on Wall Street.
All of this worked well until the housing bubble burst in late 2006. Individuals were no longer able to afford the significant mortgage payments they had signed up for in the boom years. The stock of homes for sale and foreclosed homes grew exponentially, further driving down values. As a result, banks holding large portfolios of subprime CDO assets started to incur defaults on their payments as the quality of the loan portfolios plummeted. As one of the largest holders of subprime assets, Merrill Lynch was hit particularly hard by the abrupt change in the economy. In October 2007, Merrill Lynch announced a $7.9 billion write-down resulting from exposure to CDOs. This produced Merrill's largest quarterly loss, $2.3 billion, in the history of the firm.
As a result of this crisis, CEO Stan O'Neal was replaced by John Thain, then CEO of the New York Stock Exchange, in October 2007. With an MIT and Harvard education and a prior job as president and co–chief operating officer of Goldman Sachs, Thain was the quintessential Wall Street executive, a stark contrast to Ken Lewis, the southern, state university–educated retail banking head based in North Carolina.
Earlier in 2007, the U.S. economy had suffered several severe shocks. Bear Stearns was a global investment bank founded in 1923. In March 2008, the Federal Reserve Bank of New York provided an emergency loan to try to save Bear from losses stemming from its own CDO business. However, the company could not be saved and was sold to JP Morgan Chase for $10 per share. This was up from the original offer from JP Morgan Chase of $2 per share, but still sharply below Bear's 52-week-high share price of $133. The Federal Reserve also guaranteed up to $30 billion of troubled mortgage and all other assets that got Bear Stearns into trouble.
In mid-September, the U.S. Federal Reserve had to step in and bail out yet another Wall Street firm. This time it was American International Group (AIG), with an $85 billion credit facility that entitled the U.S. government to a 79.9 percent equity ownership in the company. AIG also had a distinguished history. An insurance company and bank founded in 1919 with more than 88 million customers in 130 countries, by 2000 AIG was listed as the twenty-ninth largest public company in the world. The fall of AIG was set in motion by a credit downgrade for the company from AAA to AA. This caused counterparties to various complex financial instruments to insist on AIG posting additional collateral or settling the contract immediately. AIG did not have sufficient cash capacity to deal with all of these contracts at once, resulting in the need for an emergency loan from the U.S. government.
Finally on the weekend of September 12, 2002, this sequence of severe economic events came to a head. Lehman Brothers was the next largest Wall Street firm on the brink of bankruptcy due to massive losses in the existing portfolio. Founded in 1850, Lehman had grown to be the fourth largest investment bank in the United States behind only Goldman Sachs, Morgan Stanley, and Merrill Lynch. With over 26,000 employees, a Lehman failure would add considerable systematic risk to an already fragile economy.
However, the Federal Reserve had seen enough. They were concerned about the moral hazard of continuing to bail out financial institutions that had taken imprudent amounts of risk. If bankers were confident that the government would always bail them out for mistakes, there was incentive to take as much risk as possible. If the risks turned out well, bankers would be handsomely rewarded. If the trades went bad, the government would step in to pick up the losses. The banks could not lose, no matter how aggressive they became. The U.S. Federal Reserve believed that they had to set a precedent. They had to show Wall Street banks that executives were going to start taking accountability for their mistakes—both for their banks and for themselves.
By Friday, September 12, 2008, most expected that Lehman would not have enough cash to open for business on Monday morning. At 6:00 P.M. on Friday evening, an emergency meeting was called for the most powerful CEOs on Wall Street at the Federal Reserve Building in New York. The government urged these bank leaders to find a solution to prevent a potential global economic meltdown on Monday morning if Lehman did not open its doors. Each CEO claimed that their bank was not at fault for the problems encountered by Lehman, and they could not justify spending their own shareholders' money to bail out a competitor. The government stressed that it was in the best interest of the shareholders of all banks in the room to stabilize the U.S. economy as soon as possible.
Negotiations continued throughout the weekend, but no solutions emerged. With the possibility of a Lehman Brothers' bankruptcy growing more likely by the minute, Merrill became worried about its own survival. At 6:30 A.M. on Saturday morning, John Thain received a call from his COO suggesting they call Ken Lewis at Bank of America for help. Thain initially resisted. He insisted that Merrill could survive as an independent bank if they could sell off non-core assets to raise cash quickly. However, as discussions continued through Saturday morning, Thain relented and asked for a meeting with Ken Lewis. But he could not bring himself to make the call to Lewis personally. After pressure from his legal counsel, Thain again relented and agreed to make the call to Lewis directly.
Lewis immediately traveled to New York City and met Thain at the BofA corporate apartment in the Time Warner Center. Thain opened the conversation bluntly: “I'd like to explore whether you would have an interest in buying 9.9 percent of our company and providing a large liquidity facility.”4 Lewis countered that he was not really interested in buying 9.9 percent of the company—he wanted to buy the whole bank.
Negotiations became tense. As the day progressed, it became apparent that the only way discussions would proceed would be if BofA were allowed to buy 100 percent of Merrill. BofA initially took the position that they needed $70 billion in government guarantees to proceed with the purchase. They did not have time to adequately assess the assets over the weekend. They were being pushed by the government to close before Monday morning to avoid economic chaos. Merrill Lynch insisted on a purchase price of $30 per share. At 8:00 A.M. on Sunday, Thain and Lewis met again. Thain tried to make the case for a high valuation of Merrill, despite the fact that Merrill's stock price was in a downward spiral.
As Sunday went on, the pressure from the government to do a deal continued to increase. Thain became more and more concerned that Merrill would not survive the next week without a deal in some form. The balance of negotiating power was slowly moving from Merrill to BofA. Late on Sunday, BofA agreed to $29 per share for Merrill stock. This was equivalent to a 70 percent premium over Merrill's stock closing price on Friday. Further, the federal government refused to provide any support to backstop failed assets. BofA shareholders were taking 100 percent of the risk associated with the Merrill portfolio while paying a 70 percent premium to the market value of the company!
The deal was announced on Monday, September 15. BofA agreed to purchase Merrill for approximately $50 billion with each Merrill shareholder receiving .8595 shares of BofA stock for each share of Merrill they held. BofA shares immediately fell 21 percent on the announcement, and Merrill's shares rose to $17 per share, still a massive discount to the amount BofA had agreed to pay. Clearly, the market was not a big fan of this deal. While Thain had saved his company, Lewis had entered into a huge transaction with many unknown risks that put his own shareholders in danger. As we will see later in this book, the ultimate outcome of the transaction was materially worse than the negative market sentiment on that Monday.
So why did Lewis go forward with the deal? Unlike his highly levered peers on Wall Street, BofA was in very good condition relative to the rest of the market in this unstable environment. As investment banks only, Merrill, AIG, and Bear Stearns relied purely on the capital markets for funding. When this capital dried up along with the economy, they had nowhere to turn other than the federal government. Alternatively, BofA had a huge retail base to fall back on. Retail and corporate deposits at the bank provided BofA with billions of dollars of liquidity to wait out the financial crisis.
Lewis forged ahead. He effectively had one weekend to complete due diligence on a massively complicated, global investment bank. He put himself, his company, and his shareholders at a massive risk. What was driving Lewis forward? Had he lost his perspective? Was Lewis trying to protect the global economy? Or did he actually think that the troubled Merrill operations were worth $50 billion?
