BofA Merrill Who Pays FLS2017 Copy INS184-PDF-ENG

INS184
Bank of America Acquires

Merrill Lynch: Who Pays?
04/2013-5824
This case was written by Robert Crawford under the supervision of N. Craig Smith, the INSEAD Chaired Professor of
Business Ethics and Corporate Responsibility. It is intended to be used as a basis for class discussion rather than to
illustrate either effective or ineffective handling of an administrative situation.
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On February 5, 2010, New York Attorney General Andrew Cuomo filed civil charges against
Bank of America Corp. (BofA) and Ken Lewis, its former CEO. To purchase Merrill Lynch,
Cuomo charged, BofA had misled shareholders not only about the dire financial condition of
Merrill Lynch, but also the bonuses paid to investment bankers who had structured the deal.
Public outrage was running high.1
Lewis’ tenure at BofA had been tumultuous. From a high of $54.85 in the fall of 2006,
BofA’s stock had fallen to $3.14 per share soon after the Merrill Lynch purchase, later
rebounding to the mid-teens. Moreover, though he was not entitled to severance pay, Lewis
would exit the firm with $53.2 million in pension benefits and nearly $82 million in stock and
other compensation that he had been awarded during his career. Moreover, BofA had
accepted a total of $45 billion in Troubled Asset Relief Program (TARP) funds from the US
Government, though the bank had recently committed to pay back the funds in their entirety.2
Nonetheless, Lewis had his defenders. First, they argued, the BofA-Merrill Lynch deal made
business sense. While BofA was a strong commercial and retail bank with stable deposits, the
purchase of Merrill Lynch would add the investment expertise that it had long sought to
develop.3 Second, by preventing Merrill Lynch from becoming the next domino to fall after
the bankruptcy of Lehman Brothers, BofA had helped to avert a major financial panic; it had
done so at the behest of the US Government, which had pushed to close the deal within 48
hours. In this view, BofA was performing a vital public service in the worst economic crisis
since the Great Depression in 1929. 4 Finally, unlike many of its counterparts on Wall Street,
BofA had been relatively cautious regarding the real estate boom, safeguarding its financial
health, and Lewis had put it in a position to enter the global banking elite with the Merrill
Lynch acquisition.5
Background
The seeds of the 2008 financial crisis had been sown during the three preceding decades.
First, beginning in the Carter administration and accelerating during Reagan’s presidency
(1981-89), the banking industry was progressively deregulated: not only were leveraging
requirements continually lowered, but watchdog organisations, such as the Securities and
Exchange Commission (SEC), were weakened by changes in the law as well as by the
appointment of free-market advocates who often seemed not to believe in the mission of their
agencies. Second, in an effort to extend home ownership to lower-income consumers,
mortgage standards were slackened under pressure from the US Government. Third, interest
rates fell to historic lows, creating a speculative bubble in the housing and other markets.
Fourth, Wall Street leaders created a series of compensation incentives that rewarded short-
term risk taking, particularly with the invention of a number of questionable financial
instruments, such as credit default swaps. Hence, once real estate prices stopped rising in
1 Stephen Bernard and Ieva M. Augstums, Associated Press, February. 5, 2010.

2 Louise Story and Eric Dash, The New York Times, 2 October 2009.
3 Andrew Ross Sorkin, Too Big to Fail, Viking, 2009, p. 334.
4 Story and Dash, loc. cit.
5 Sam Mamudi, “Lehman folds with record $613 billion debt”, MarketWatch, 15 September 2008.
Copyright © 2012 INSEAD 1 04/2013-5824

2007, it was probably too late to avoid a major financial correction, which then became the
most threatening economic crisis in 80 years.6
Diminished Regulatory Control
From 1980, successive US presidents increasingly scrapped or de-legitimized the regulations

that governed the financial sector, particularly regarding the real estate market. First, the
fragmented regulatory apparatus offered bankers ample opportunities to play the system. US
regulatory institutions included the Office of Comptroller of the Currency, the Federal
Housing Finance Board, the Federal Trade Commission, the Office of Thrift Supervision, and
the Federal Deposit Insurance Corporation (FDIC). Depending on their location and
personnel, the stringency of their supervision of the market varied significantly. There was
also a proliferation of legislation, such as the Community Reinvestment Act, Gramm-Leach-
Bliley Act, and the Bank Holding Company Act. Not only did these confuse financial actors
seeking the appropriate standards to apply, but they offered them the opportunity to “shop”
for the level of enforcement they desired. 7 For example, though non-bank mortgage lenders
were subject to Home Ownership and Equity Protection Act (HOEPA) rules, federal
authorities had no power to enforce policies designed to outlaw predatory lending because
these lenders and brokers were primarily regulated in their respective home states.8
Second, the legal barriers that limited certain types of trading were lifted. In particular, at the
behest of Citigroup, the Glass-Steagall Act was thrown out in 1999; it had barred commercial
banks from trading in stocks and bonds, which economists had believed was a significant
contributing factor to the Great Depression.9 Moreover, with free market advocates in charge
of regulatory agencies, many existing laws were ignored or rarely enforced. Cuts in career
positions also made it more difficult for them to do their jobs. For example, observers had
repeatedly warned the SEC about irregularities they suspected in Bernard Madoff’s
investment firm, which was later revealed to be a multi-billion dollar Ponzi scheme; in spite
of warnings from several whistle-blowers, no serious investigation was undertaken until after
its spectacular collapse. Third, because of the evolution of certain practices, even the US
Federal Reserve (the “Fed”) was losing its ability to influence home construction and
mortgage rates.10 (See Exhibit 2, Correlation between Federal Funds Rate and Mortgage
Rates.)
Debt, Home Ownership and Easy Credit
It was under President Reagan that household consumer debt initially grew explosively; it
rose from 60% of income in 1981 to 119% by 2007. Meanwhile, the savings rate – at 10% of
income in the 1970s – dropped to near-zero. In particular, Reagan-era legislative changes
eliminated restrictions on mortgage lending that dated from the Great Depression. 11 Then, in
1992, the US Congress began to push the government-sponsored mortgage lenders Fannie
Mae and Freddie Mack to increase the availability of mortgages to low- and moderate-income
6 Sorkin, op. cit., p. 534.

7 Alex Nowrasteh, “Incomprehensible Regulatory Regime Covers Subprime Loans”, Financial Times, 18
December 2007.
8 Jeremy Grant and Eoin Callan, “Paulson Attacks ‘Shameful’ Lenders”, Financial Times, 17 October 2007.
9 Louis Uchitelle, “Elders of Wall Street Favor More Regulation”, The New York Times, February 17, 2010.
10 Ben S. Bernanke, Jackson Hole Speech, Financial Times, 31 August 2007
11 Paul Krugman, “Reagan Did It”, The New York Times, June 1, 2009.

borrowers. With explicit mortgage financing targets for borrowers with incomes below the
median in their area, Fannie and Freddie began to provide subprime and adjustable-rate
mortgages (ARMs), often requiring less than a 10% down-payment.12
To implement the Community Reinvestment Act (CRA), the number of bank loans extended
to low- and moderate-income families increased by 80%, while injections of liquidity further
stimulated the demand for relatively low-priced property. As such, there was a huge increase
in subprime mortgages, i.e. loans to high-risk borrowers with low or uncertain incomes, high
debt-to-income ratios, and poor credit histories. Typically, these subprime mortgages included
very low initial “teaser” rates, a floating-rate arrangement that later could rise to a much
higher repayment burden. On the other end, the Taxpayer Relief Act of 1997, by making
capital-gains exclusions more available, fuelled the demand for higher valued property.13
Historically Low Interest Rates
For a number of reasons, interest rates in the US fell in the early 2000s to persistently low
levels. Having accumulated huge cash reserves from decades of export surpluses, China and
others were lending and investing these funds back into the US. As of the end of February
2009, China held 23.81% of the total of $3.126 trillion in US Treasury bonds; Japan, the
United Kingdom, and the oil exporting nations held between 20% and 35% more. This
“savings glut” significantly lowered US interest rates. (See Exhibit 1, Foreign Holders of US
Debt.) In addition, following the collapse of the dot.com bubble in 1999 and the recession
sparked by the terrorist attacks of September 11, 2001, the US Federal Reserve Bank cut
interest rates rapidly and significantly in the hope of stimulating growth. Fed Chairman Alan
Greenspan lowered the Fed’s lending rate to 1% until 2004, after which it rose in increments
of 0.25% for some time thereafter. This environment of cheap credit further encouraged
investors and financial institutions to speculate in the real estate market, bidding up property
values, while enticing household consumers to take on additional debt.14
The Controversial Incentive System
Wall Street firms were renowned for compensating their employees handsomely. Beyond
their six-figure salaries, these rewards came in the form of bonuses at the end of the fiscal
business year, with top performers paid in the hundreds of millions of US dollars. The
purpose of bonuses, it was argued, was the recruitment and retention of the best employees.
However, critics warned that this incentive system encouraged short-term risk-taking for high
returns, while accepting virtually no responsibility for the longer-term consequences of their
actions. Because the bonuses of their supervisors, including risk management teams, were tied
to these same results, they tended to turn a blind eye to these practices. Critics feared that such
practices undermined the assumption of rationality so popular with economists and free
market enthusiasts – the system, in their view, was not “self-regulating”.15
12 Russell Roberts, “How Government Stoked the Mania”, Wall Street Journal, 3 October 2008
13 Ibid.
14 Ashok D. Bardhan & Dwight M. Jaffee , “Global Capital Flows, Foreign Financing and US Interest Rates”,
Research Institute for Housing America and the Mortgage Bankers Association 10 August 2007.
15 Nassim Nicolas Taleb, “How Bank Bonuses Let Us All Down”, Financial Times, 25 February 2009.

New Instruments and Practices
In this atmosphere of deregulation, perverse incentives, and the push to increase home
ownership, actors in the real estate market changed their behaviour, sometimes radically. The
new instruments affecting the real estate market included mortgage-backed securitization and
credit default swaps. While beneficial in certain respects (e.g., securitization brought greater
liquidity to the market), not only did they enable financial actors to conceal the risks they
were facing, but the spread of their use vastly increased the inter-connections between all
firms involved in this market. Meanwhile, as home ownership rates rose along with real estate
prices, speculation and profitable “paper” transactions grew accordingly.
The Instruments
From the early 1980s, the US real estate market had entered a period of sustained growth,
though there were periods of slower growth, such as the recessions of the early 1990s and in
the aftermath of the dot.com crash. After the 2001 slowdown, the real estate boom seemed to
accelerate to the point that many feared it had become a speculative bubble. To service this
market – ostensively adding liquidity and spreading risk – certain actors on Wall Street
created or adopted a number of financial instruments. They included:
• Collateralized debt obligations (CDO). These instruments repackaged a pool of bonds,

derivatives, and other instruments, such as corporate bonds. The CDO derived its value
from converting illiquid assets, such as buildings, into liquid financial instruments. A
mortgage CDO bundled thousands of individual mortgages into a single bond which was
supposed to diversify default risk.16
• Mortgage-backed securities, a subset of CDO. These were bundles of mortgages that were
sold to Fannie Mae, which repackaged them to sell as stocks to individual investors. This
process enabled banks to take mortgages off their balance sheets.17
• Credit default swaps (CDS). These were insurance policies against the risk of default –
investors, who bought them like bonds, were paid a premium to underwrite the risk of the
various instruments above. Barring a series of defaults on the scale of the Great
Depression, CDS served as an extremely lucrative way for insurance companies to grease
the trading system: they lowered the cost of taking risks as well as created confidence in
investors.18
From 2000 to 2006, the asset-backed securitization market experienced a six-fold growth to
$3 trillion, of which about 77% originated from the US. The attractive profit margin from
securitization encouraged investment banks to rely increasingly on this riskier business to
generate profits.19
Beyond the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, there
were private mortgage insurers and private mortgage pools which handled mortgages that the
GSEs did not, including some that did not meet the GSE eligibility criteria. As of the 1990s,
16 “Wall Street Wizardry Amplified Credit Crises”, Wall Street Journal, 27th December 2007
17 http://useconomy.about.com/
18 Sorkin, op. cit., p. 157.
19 “Banks Profit from Asset-Backed Securities”, Paul J. Davies, Financial Times, 3 June 2007

the increased reliance on securitization led to a greater separation between mortgage lending
and mortgage investing, even as the mortgage and capital markets became more integrated.
As of 2007, these private pools made up nearly $2 trillion of US residential mortgage debt,
while GSE mortgage-backed securities exceeded $4 trillion. 20 As banks simultaneously
played the roles of mortgage lender, mortgage-backed-securities issuer, and product sales
advisor, the risks of conflicts of interest multiplied.21
The Weakening of Lenders’ Standards
Mortgage brokers were gradually replacing more stringently regulated banks as the primary
mortgage originators and intermediaries of the banks. By 2007, approximately 70% of US
mortgages originated through such non-bank mortgage lenders.22 Disregarding clear warnings
from economists and market watchers since 2005, the Fed under Alan Greenspan refused to
regulate them, arguing that they were beyond the jurisdiction (i.e. commercial banks) of the
Fed.23 Because these non-bank mortgage lenders were not subject to any mortgage default
penalties, they had little motivation to ensure the viability of the mortgages they originated.
On the contrary, given the demand for mortgage-backed securities from Wall Street, they had
an incentive to churn out mortgages as quickly as possible, reducing lenders’ standards and
ignoring standard business practices.24 Fannie Mae was responsible for over 70% of mortgage
originations in the US. Its involvement in CDS trading and guarantee of the value of
mortgage-backed securities (undertaken during favourable economic times) played a crucial
role in the encouragement of investor confidence in mortgage-related financial products.25
There were plenty of warnings about the deterioration of lending standards. A Financial
Services Authority (FSA) review in November 2007 raised concerns about lax assessments of
borrowers’ ability to afford their mortgages, highlighting the flawed collection of customer
information which enhanced the risk of default and fraud. Some brokers, it was observed,
offered mortgages they knew would become unaffordable; they also accepted self-
certification from borrowers without investigating their plausibility.26
To attract prospective home buyers, a number of questionable techniques entered the practice
of mortgage lenders. First, there was the 80/20 loan, whereby lenders assumed that, as house
prices would continue to appreciate, 20% of the value of a house could be “financed with
safety”. As such, a credit rating that would have been inadequate under more stringent lending
regimes would no longer prevent the borrower from getting a mortgage.27 Second, adjustable-
rate mortgages (ARMs) were offered to borrowers unable to meet earlier levels of the initial
20 Bernanke, loc. cit.

21 Peter Thal Larsen, “FSA Advises City Banks on Dealing with Potential Conflicts of Interest”, Financial
Times, 17 November 2005.
22 Jeremy Grant and Eoin Callan, “Paulson Attacks ‘Shameful’ Lenders”, Financial Times, 17 October 2007.
23 Edward Luce, “Few Escape Blame over Subprime Explosion”, Financial Times, 6 May 2009.
24 Martin Feldstein, “Housing, Housing Finance, and Monetary Policy”, Financial Times, 13 September 2007.
See also Saskia Scholtes, “FDIC Braced for Surge in Mortgage Fraud”, Financial Times, 4 March 2009.
25 Clive Crook, “Guarantees for America’s Guarantors”, Financial Times, 14 July 2008.
26 Jennifer Hughes, “FSA Hits at Mortgage Brokers”, Financial Times, 26 November 2007. See also Elaine
Moore, “FSA Criticizes Brokers for Bad Practice”, Financial Times, 30 November 2007.
27 “The Outlook for Mortgages”, Financial Times, 28 September 2007. Interviewed experts are Ray Boulger,
vice-chairman of the Association of Mortgage Intermediaries (AMI), and Harry Dinham, past president of
National Association of Mortgage Brokers(NAMB)

capital outlay requirement, which in theory would be recouped later, under higher premiums.
In a worst-case scenario, as home prices fell, many home buyers who had originally bet on
rising home appreciation would be forced into foreclosures, triggering a free-fall in the value
of mortgage-related CDOs and consequent balance sheet write-downs by financial institutions
and investors.28 (See Exhibit 3, Early Payment Defaults on Subprime Loans.)
AIG
Among AIG’s principal clients were Wall Street firms that used CDS to hedge their holdings
of complex subprime mortgage-backed securities and European banks in “regulatory capital
forbearance” trades. The purchase of CDS allowed these banks to eliminate the need to hold
large amounts of capital against their long-term holdings of securities, further increasing their
leverage. In the event of a decline in value or default rate of the underwritten securities, the
reasoning went, collateral guarantee requirements would rise. At the same time, CDS were
sold under the guarantee of AIG’s own credit rating – should it be downgraded, AIG’s cost of
capital for its operating expenses would rise. Conversely, in a bear market, falling security
values would simultaneously increase both the risk of a CDS default and a downgrading of
AIG’s credit rating. In this case, the insurer would face a potentially catastrophic liquidity
crisis as CDS claims and collateral calls mounted. 29 Furthermore, given AIG’s business
relationships with virtually every player in the financial sector, a liquidity crisis at the insurer
threatened to spread in an uncontainable domino effect.30 This high level of inter-connection
of the CDO market meant that the entire financial system might implode.31
Questionable Investor Due Diligence
According to FT journalist Martin Wolf, securitization enabled banks that originated and
traded in the mortgage market to pass the risks on to investors who wanted longer-term,
higher-yielding assets. By the same token, new lines of credit became available to riskier
borrowers. 32 A number of factors contributed to this, including:
• Reduced balance sheet accountability. To minimize their financial and reputational risks,
lending originators removed accounts receivable from their financial accounts.33
• Repeat layering of tranches of securities. CDOs were segregated into senior and junior
“tranches” based on their purported risk. The riskier junior tranches of CDOs (e.g. pooled
junk bonds and subprime mortgages) offered the highest returns to investors. However,
28 John F.Wasik, “U.S. Mortgage Time Bomb Needs Defusing Yesterday”, Bloomberg, 2 February 2009.
29 Satyajit Das, “Credit Default Swaps and Amplified Losses”, Financial Times, 4 March 2009.
30 Jake Cohen, Anatomy of A Crisis, INSEAD Knowledge 11/2008.
31 S&P/Case-Shiller U.S. Home Price Index Composite-20 SPCS20R which uses the Karl Case and Robert
Shiller method of a house price index using a modified version of the weighted-repeat sales methodology to
adjust for the quality of the homes sold. See also Sorkin, Too Big To Fail, pp. 529-535.
32 Martin Wolf, “Life Could Yet Follow Death for the Idea of Securitization”, Financial Times, 3 October
2007.
33 Full Text of Jackson Hole Speech, remarks by Chairman Ben S. Bernanke at the Federal Reserve Bank of
Kansas City’s Economic Symposium, Jackson Hole, Wyoming, Financial Times, 31 August 2007

the opaqueness of the system led to systematic risk under-estimation, as mortgages were
indiscriminately bundled into large CDOs.34
• Unreliable credit ratings. Critics charged that the rating agencies – Standard & Poor’s,
Moody’s, and Fitch – were issuing systematically inflated ratings in order to facilitate the
boom of structured securities. Whether due to outdated methodologies or the corruption of
their professional standards due to a conflict of interest (they were paid by those they
rated), this contributed to the potential volatility of the market.35
Bank of America
After having maintained interest rates at historically low levels, the Federal Reserve began to
raise them incrementally in the second half of 2004. By mid-2006, the subprime mortgage
market began to appear vulnerable: holders of ARMs saw their rates rise, requiring higher
monthly payments than many could meet. The entire mortgage finance system, based on the
assumption of ever-rising property values, began to shift into reverse. Many rushed to sell
their homes, creating further downward pressure on housing prices. This threatened to turn
into a cascade of financial failures as CDOs dropped in value and banks lost their capital in
defaults and withdrawals.36
A Perfect Storm
The initial defaults frightened neither the investment bankers, who were handling mortgage
securitization, nor investors. In the first half of 2006, investors bought $1 trillion of
mortgaged-backed securities, up 5% from the previous year. In a sign of confidence that the
worst was over, Wall Street banks acquired a number of major mortgage lenders.37 However,
by June 2007, two hedge funds managed by Bear Stearns had suffered substantial losses and
required huge capital injections from the bank. Both funds had heavily invested in high risk
mortgage-backed securities and had used those securities as collateral to borrow more capital
for investment purposes. Bear Stearns’ troubles, many feared, would trigger a loss of
confidence in the wider market for other complexly structured financial securities.38
To avoid a freeze-up of the credit markets, the Federal Reserve, the European Central Bank,
the Bank of England and other central banks immediately injected billions of US dollars into
the financial system in the hope of reviving confidence in it. Unfortunately, their efforts failed
to address the underlying issues: a declining housing market and its impact on subprime
security holdings. As a result, banks could not off-load significant quantities of securities
34 “The Outlook for Mortgages”, Financial Times, 28 September 2007. Interviewed experts are Ray Boulger,
vice-chairman of the Association of Mortgage Intermediaries (AMI), and Harry Dinham, past president of
National Association of Mortgage Brokers(NAMB).
35 Sam Jones, “How Moody’s Faltered”, Financial Times, 17 October 2008. See also Joanna Chung, “SEC
Crackdown on Credit Rating Agencies”, Financial Times, 3 December 2008.
36 Brian Louis, “Rising Subprime Mortgage Default Adds to Unsold Homes Inventory”, Bloomberg, 9 March
2007. Brian Louis, “Rising Subprime Mortgage Default Add to Unsold Homes Inventory”, Bloomberg, 9
March 2007.
37 “Mortgages Grow Riskier, and Investors Are Attracted”, Vikas Bajaj, New York Times, 6 September 2006
38 “Bear Stearns Hedge Fund on Brink of Failure After Bad Subprime Bets”, Ben White and Saskia Scholtes,
Financial Times, 20 June 2007

from their accounting books – investors feared their prices would fall and hence stopped
purchasing them. To protect themselves, the banks adopted a conservative approach towards
their cash to ensure liquidity and balance sheet capacity, thereby depriving the market of
credit access. Without credit, economic activity began to seize up. The global economy was
suddenly facing the prospect of a meltdown on the scale of the Great Depression.39
Countrywide Financial
As America’s largest mortgage lender, Countrywide Financial was coming under mounting
pressure. At its peak, with a stock price of $45.26, the company was a $500 billion home
lender with 900 offices and $200 billion in assets. However, given its exposure on the
subprime market, Countrywide was suddenly forced to draw down its entire $11.5 billion
credit line. With regulators blaming Countrywide for helping to fuel the housing bubble by
offering loans to high-risk borrowers, the company had little prospect of a public rescue.40
To Bank of America CEO Ken Lewis, the crisis appeared as a great opportunity to enhance
the bank’s role in mortgage banking. Though also exposed in the mortgage crisis, Bank of
America had exited the subprime market in 2001, having judged it to be overly risky. As a
result, BofA was far better positioned financially than most of its competitors.41 As
Countrywide’s stock collapsed, in August 2007 BofA took a 16% stake in the company with a
$2 billion investment in preferred stock. This preferred stock paid 7.25% interest and was
convertible to common stock at $18 each. Though some hoped the investment would instil
confidence in the market, Countrywide’s stock price continued to fall. 42 By January 2008, it
had dropped by an additional 60%. Bank of America agreed to buy the remainder of the
company for $4.1 billion. The acquisition was controversial: some argued that Countrywide
had already proven to be a bad investment and that buying it was even more risky. Supporters
countered that Lewis had a history of highly successful acquisitions.43
Lehman Brothers
Major banks and financial institutions across the world reported heavy losses in 2007
resulting from their investments in mortgage-backed securities. These securities, well
subscribed by large institutions and hedge funds in previous years, became unmovable and
illiquid investments in the markets. Amid huge write-downs, the banks’ equity value eroded
rapidly, raising concerns about their ability to meet the regulatory capital requirement (often
defined as shareholders equity to risk-weighted assets). This shook public confidence in the
banks’ ability to weather the storm.44
39 Vikas Bajaj and Floyd Norris, “Central Bankers to Lend Billions in Credit Crisis”, The New York Times,
13 December 2007.
40 See Graham Bowley and Gretchen Morgenson, “Bank Agrees to Buy Troubled Loan Giant for $4 Billion,
The New York Times, 11 January 2008, and “Lehman, Merrill Latest Dominoes In Financial Crisis”,
NPR.com, http://www.npr.org/templates/story/story.php?storyId=94632004, September 15, 2008.
41 Bank of America, 2001 Annual Report, p. 3.
42 Charles Duhigg, “Bank of America’s Chief Makes Big Bet”, The New York Times, 12 January 2008.
http://www.nytimes.com/2008/01/12/business/12bank.html?scp=3&sq=duhigg&st=nyt
43 Ibid.
44 Nathaniel C. Nash, “Agreement On Banks’ Capital Set”, The New York Times, 12 July 2008.

With its insolvent hedge funds, Bear Stearns was the first major bank to fall. It was late
winter, 2008. Short of sufficient cash to meet investors’ demands and operational business
needs, and unable to raise additional capital, Bear Stearns sold itself to JP Morgan, with the
Federal Reserve brokering the deal and guaranteeing funds for Bear’s assets. After a brief
period of volatility, the market seemed to stabilize. Many hoped that the Federal Reserve
would prevent further deterioration of the banking system by creating new forms of stimuli,
such as expanding its lending window from commercial banks to investment banks, or
perhaps widening the types of assets acceptable as collateral.45
However, by the summer of 2008, the US Department of Treasury was forced to nationalize
both Fannie Mae and Freddie Mac and replace top management. 46 Rather than re-instil
confidence in the market, short-sellers began to speculate about the next likely institution to
fail. Many pointed to Lehman Brothers, whose mortgage business exposure resembled that of
Bear Stearns. To save Lehman Brothers, the Federal Reserve Bank of New York gathered
executives of the major Wall Street banks and brokerages together for a series of informal
meetings. In mid-September, the government-led talks broke down and, in spite of several
serious prospective buyers, in the end no one appeared willing to purchase Lehman Brothers,
even when offered a deal structured in a manner similar to the one that Federal Reserve had
provided for JP Morgan’s purchase of Bear Stearns. The Federal Government would not,
Treasury Secretary Hank Paulson announced, bail Lehman Brothers out. Soon it would be
forced to file for bankruptcy protection. It would be the biggest bankruptcy in US history, at
$639 billion.
Rumours began to circulate that the second largest investment bank in the US, Merrill Lynch,
would be the next to fall. In an effort to save Merrill, Paulson and Timothy F. Geithner,
President of the New York Fed, initiated a new series of meetings with the heads of the top
US banks and brokerage firms.47
Merrill Lynch
From 2002, when he was appointed CEO of Merrill Lynch, Stan O’Neal announced that he
was determined to end the company’s image as the steady, stodgy “Mother Merrill”. To
generate higher returns, he said, the firm would take more risks. O’Neal began by expanding
Merrill’s trading base as well making investments in leveraged buyouts, most notably a $4.2
billion investment in Scottish & Newcastle’s pub estate and $2.9 billion in the retail chain
Debenhams. He then moved aggressively into the mortgage industry, with the repackaging
and sale of home loans on the debt markets. 48 In order to speed up the process, Merrill
acquired mortgage origination companies so that collateral for the CDOs was readily and
quickly available.49
45 Andrew Ross Sorkin, “JP Morgan Pays $2 a Share for Bear Stearns”, The New York Times, 17 March
2008.
46 Stephen Labaton and Edmund L. Andrews, “In Rescue to Stabilize Lending, U.S. Takes Over Mortgages
Finance Titans”, The New York Times, 7 September 2008.
47 Jonathan D. Glater and Gretchen Morgenson, “A Fight For a Piece of What’s Left”, The New York Times,
15 September 2008.
48 Andrew Clark, “Merrill Lynch, the firm lost $8bn and the chief executive had to go - with $159m”, The
Guardian 30 October 2007.
49 Jill Drew, “Frenzy”, Washington Post, 16 December 2008.

With AIG as its partner, Merrill became the largest issuer of CDOs, underwriting 136 CDO
deals with a value of $136 billion by the end of 2008. 50 For every CDO, banks earned
between 0.4% and 2.5 % of the total amount in underwriting fees, which created an “opium-
like addiction” among both the banks and insurers. However, in 2005, sceptical of Merrill’s
extremely aggressive policies, AIG stopped insuring even its highest-rated CDOs. Undaunted,
Merrill continued as before. By the first quarter of 2007, it had achieved higher profit growth
than its three biggest rivals, Lehman Brothers, Bear Stearns and Goldman Sachs.51 Indeed, at
the height of the CDO frenzy (2006-2007), Merrill made $800 million, more than any other
firm.52
When the subprime mortgage markets began to slow, the entire CDO market abruptly
unravelled (subprime mortgages accounted for $100 billion of the $375 billion CDO market).
To many observers this indicated that financial markets and credit rating agencies had failed
to anticipate the possibility of a large-scale collapse in the housing market.53 Even so, Merrill
refused to write down its positions to reflect market value until October 2007, when it was
forced to admit to liabilities of $7.9 billion and wrote off $9 billion in holdings. O’Neal was
forced to resign, though he retained $30 million in retirement benefits and $129 million in
stocks and options.54
The new CEO, John Thain, also failed to acknowledge the extent and depth of Merrill’s
financial condition. Nonetheless, by the summer of 2008, with an additional $10 billion in
CDO losses, it became clear that the bank was in serious trouble. Under the auspices of the
New York Federal Reserve Bank, Thain turned to BofA CEO Ken Lewis to purchase Merrill,
though he had turned down an offer from Lewis only a few weeks earlier. After minimal
negotiation over 48 hours, Thain sold Merrill for $50 billion, at $29 per share.55
The entire transaction had been carried out in an atmosphere of near-panic at the impending
bankruptcy of Lehman Brothers. Both Treasury Secretary Hank Paulson and NY Fed
President Timothy F. Geithner had pressured BofA to purchase Merrill – not only did they
argue that saving it would reassure the markets, but it was almost a patriotic duty. The deal,
announced on 15 September, 2008, came soon after Lehman Brothers had filed for
bankruptcy. The idea, insiders said, was to demonstrate to the market that even though
Lehman had failed, the big banks on Wall Street were cooperating to keep the system afloat.
In any event, because the government authorities had no established system for liquidating
investment banks, the only option was to encourage the banks to merge, a strategy dubbed
“policy by deal”.56
50 “What Went Wrong Ethically in the Economic Collapse?” Alexander F. Brigham and Stefan Linssen,
Ethisphere Magazine 31 December 2008; “Why Merrill Lynch Got Burned” Matthew Goldstein,
BusinessWeek, 25 October 2007.
51 Gretchen Morgenson, “The Reckoning: How the Thundering Herd Faltered and Fell”, The New York
Times, 8 November, 2008.
52 “Why Merrill Lynch Got Burned” Matthew Goldstein, BusinessWeek, 25 October 2007.
53 Richard Tomlinson and David Evans, “The Ratings Charade”, Bloomberg Markets, July 2007.
54 “Herd’s Head Trampled”, The Economist, 30 October 2007.
55 Andrew Ross Sorkin, “Lehman Files for Bankruptcy; Merrill Sold”, The New York Times, 15 September
2008.
56 See Sorkin, Too Big to Fail, pp. 352-371.

Aftermath
As the deal headed for a stockholder approval vote at the beginning of December, 2008,
BofA’s proposed acquisition became the subject of intense debate. Criticism focused
primarily on the price to be paid and the potential risks, both of which were judged too high.
Some argued that, regardless of the pressure from the US Government, BofA should have
waited for the markets to adjust (i.e. contract or implode) following the news of Lehman’s
bankruptcy. Others feared that BofA had so rushed the deal that it was impossible to conduct
proper due diligence for a firm of Merrill’s size. After all, the banks had already failed to
accurately assess their own financial situations.57
On the positive side, supporters of the deal argued, BofA was the best candidate for the
merger. The bank had a relatively strong financial position and was considered one of the best
survivors of the crisis. Moreover, with BofA’s long history of failed attempts to build a
respectable investment banking business, the merger might be a once-in-a-lifetime
opportunity – the acquisition of Merrill Lynch could put Bank of America at the top in just
one deal. In early December 2008, the combined banks were valued at $176 billion. The
crown jewel of the acquisition, it was reported, were the 16,000 investment advisors at
Merrill, who many believed were among the best in the industry. Ken Lewis argued that BofA
got a good price at the time of the deal and that the future had appeared too uncertain to
second guess it at the moment.58
As the merger vote approached, Merrill’s operating losses – $21 billion in the fourth quarter,
the worst in the company’s history – were devastating. Lewis had to make a decision: he
could renegotiate the deal, walk away, or proceed as planned. Lewis pondered these options,
later claiming that he was persuaded not to alter the deal by regulators, who believed that any
change could reignite financial panic. Indeed, he did not inform BofA shareholders of this
information prior to the vote. “I do think we were doing the right thing for the country,” he
said.59 He was also aware of the outrage that the company would face regarding the $3.6
billion in bonuses that BofA had approved for Merrill’s executives. Though Thain had
lobbied for as much as $40 million for himself, he eventually agreed to take no bonus.60
On December 5, BofA shareholders voted to approve the merger. Almost immediately, a

number of disturbing revelations surfaced. On December 11, in light of disappointing fourth
quarter results, BofA announced that it planned to lay off 35,000 employees over the next
three years. News of Merrill’s fourth quarter losses also became public, causing a drop in
BofA’s shares from $14 to $10. Lastly, the confidential side-amendment awarding bonuses
was reported. By February 2009, the combined entity was valued at approximately $39
57 Mark Williams, “A Breach of Fiduciary Duty at Bank of America?” Forbes.com 26 February 2009.
http://www.forbes.com/2009/02/26/bank-america-fiduciary-opinions_merrill_lynch.html.
58 Louise Story, “For Bank of America, the Pressure Mounts Over Merrill Deal”, The New York Times, 17
January 2009.
59 Ibid.
60 Greg Farrell and Henny Sender, “The Shaming of John Thain”, Financial Times, 13 March 2009.

billion.61 Like other US banks, BofA would require funds from TARP, which eventually rose
to $45 billion.62
In the meantime, believing that he should be viewed as Lewis’ co-equal, Thain had negotiated
a new title for himself: President of Global Banking, Securities, and Wealth Management.
Though one of his key selling points was that this would be good for Merrill employees, his
leadership was blamed for an exodus of top talent from Merrill, which further undermined the
rationale for the acquisition. It was at this point that Andrew Cuomo, Attorney General of the
State of New York, launched an investigation into BofA regarding its bonus payments.63
On 22 January 2009, Lewis flew to New York to fire Thain, who became the scapegoat for all
that went wrong with the deal. While in the corporate jet, details of Lewis’ trip leaked to the
press, which was already abuzz with revelations that Thain had spent $1.2 million on re-
decorating his office. Thain had been a BofA employee for only a few weeks.64
By August 2009, the investigation into bonus payments led to a preliminary settlement,
according to which BofA would pay $33 million without acknowledging any guilt. However,
in the fall of 2009, a federal judge threw out this settlement as having provided insufficient
information regarding the behaviour of the BofA leaders prior to the merger vote. Under
pressure from stockholders and board members, Lewis announced that he was taking early
retirement.65 At the beginning of 2010, the Securities and Exchange Commission (SEC)
decided to expand the case against BofA to include the non-disclosure of Merrill’s losses in
October and November of 2008.66
61 “For Bank of America and Merrill, Love Was Blind”, Louise Story and Julie Creswell, New York Times, 8
February 2009.
62 Greg Farrell and Henny Sender, loc. cit.
63 Ibid.
64 Ibid.
65 Louise Story and Eric Dash, The New York Times, 2 October 2009
66 Greg Farrell, “Door Open for New SEC Suit Against BofA”, Financial Times, 12 January, 2010.

Exhibit 1
Major Foreign Holdings of U.S. Rising Public Debt
Exhibit 2
Correlation between Federal Funds Rate and Mortgage Rates
Note: The Federal Fund Rate is the primary monetary tool used by the Federal Reserve to influence interest rates
and the economy. It dictates the prime rate used to determine the interest rate payable by borrowers, including
mortgage borrowers. Through buying and selling of government securities or other financial instruments, thereby
controlling its national money supply, the target Federal Fund Rate is achieved.

Exhibit 3
Early Payment Defaults on Subprime Loans
Percentage Default
Months since Origination
Source: Calculations from First American LoanPerformance data.

Note: Figure 2 shows the percentage of borrowers with subprime mortgages in the 2004, 2005, 2006, and 2007
vintages whose mortgage balances in a given number of months were in default. Sample restricted to thirty-year,
first-lien mortgages originated on one- to four-family properties in the contiguous United States. Adjustments
have been made for calendar effects.


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Bank of America Acquires

Copyright © 2012 INSEAD

1 Stephen Bernard and Ieva M. Augstums, Associated Press, February. 5, 2010.

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Diminished Regulatory Control

From 1980, successive US presidents increasingly scrapped or de-legitimized the regulations

Debt, Home Ownership and Easy Credit

6 Sorkin, op. cit., p. 534.

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Historically Low Interest Rates

The Controversial Incentive System

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• Collateralized debt obligations (CDO). These instruments repackaged a pool of bonds,

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The Weakening of Lenders’ Standards

20 Bernanke, loc. cit.

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Questionable Investor Due Diligence

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On December 5, BofA shareholders voted to approve the merger. Almost immediately, a

Copyright © 2012 INSEAD 11 04/2013-5824

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Months since Origination

Source: Calculations from First American LoanPerformance data.

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