Merrill Writedowns: The Plot Thickens

An interesting tidbit in the Financial Times: Bank of America was not blindsided by the Merrill writedowns (although Ken Lewis no doubt still wanted to walk from the deal). Its CAO was deeply involved in making them (boldface ours):

Bank of America was directly involved in markdowns that contributed to Merrill Lynch’s $15.3bn loss in the last quarter of 2008, its final reporting period before the Wall Street bank was acquired by BofA, sources familiar with the matter say.

Mounting losses at Merrill during December almost derailed the acquisition. Ken Lewis, BofA’s chief executive, threatened to walk away from the deal unless the US government provided $20bn in extra capital. The deal closed on January 1 after federal officials pledged their support.

People familiar with the matter said BofA had dispatched Neil Cotty, its chief accounting officer, during the fourth quarter to work with Merrill’s finance team. They said Mr Cotty played an active role in preparing accounts, wielding influence with Merrill executives who were set to report to him and other BofA officials after the deal closed.

With Mr Cotty’s involvement in December, the people familiar with the matter said, Merrill took a fourth-quarter writedown of $1.9bn in leveraged loans and a $2.9bn reserve against an exposure to derivatives linked to asset-backed securities.

Mr Cotty also gave his blessing to a $1bn writedown of credit default swaps involving investment grade companies. The markdown of a position on the “high vol 4” index transformed a gain of $100m into a loss of $900m….

Mr Cotty said: “While BofA had access to Merrill’s financial information in the fourth quarter and had input into many accounting policy and valuation issues, Merrill management was responsible for these decisions regarding the marks and other valuations.” There are two ways to look at this, neither of them pretty.

One is that Bank of America pushed for the most aggressive (meaning least favorable) writedowns on positions so that when it closed the deal, Merrill would be as clean as possible. The problem is that writedowns sufficient to do that (presuming that was BofA’s plan all along) left the bank looking like it had badly overpaid. Thus the threat to walk from the deal was a bit of a ruse, since the losses were at least in part the result of over-reserving (or hedging against positions BofA could not assess).

The second is that many (most? all?) of the BofA imposed writedowns were legitimate and called for. The implication would be that Merrill for some time had been making overly optimistic marks on its dodgy positions. And it might also imply that Merrill’s practices were not out of line with the industry (remember, Bank of America, unlike JP Morgan and Citigroup, is not a big player in exotic debt products). That in turn would suggest the financial reports of other big capital markets players (Goldman, Morgan Stanley, JPM, UBS) could also be more than a tad generously valued.

Of course, these possibilities are not mutually exclusive.

Informed reader comment encouraged, particularly on “high vol 4” index.


Originally published at Naked Capitalism and reproduced here with the author’s permission.