Has the Dying Bank of America Managed to Ensure Its Next Taxpayer Bailout?
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That scenario, the one B of A presents, is not credible. It is far more likely that B of A’s senior management made it clear to the head of the due diligence review that the deal was going to be done and that his or her report should support that conclusion. This alternative explanation fits well with B of A’s actual decision-making. Countrywide’s (and B of A’s) reported financial condition fell sharply after the deal was signed. Lewis certainly knew that B of A’s actual financial condition was much worse than its reported financial condition and had every reason to believe that this difference would be even worse at Countrywide given its reputation for making fraudulent loans. B of A could have exercised its option to withdraw from the deal and saved vast amounts of money. Lewis, however, refused to do so. CEOs do not care only about money. Ego is a powerful driver of conduct, and CEOs can be obsessed with status, hierarchy, and power. Of course, Lewis knew he could walk away wealthy after becoming a engine of mass destruction of B of A shareholder value, so he could indulge his ego in a manner common to adolescent males.
Acquiring Merrill Lynch: the Lure of Liar’s Loans
Merrill Lynch is the quintessential example of why it was common for the investment banks to hold in portfolio large amounts of collateralized debt obligations (CDOs). Some observers have jumped to the naïve assumption that this indicates that the senior managers thought the CDOs were safe investments. The “recipe” for an investor maximizing reported income differs only slightly from the recipe for lenders.
- Grow rapidly by
- Holding poor quality assets that provide a premium nominal yield while
- Employing extreme leverage, and
- Providing only grossly inadequate allowances for future losses on the poor quality assets
Investment banks that followed this recipe (and most large U.S. investment banks did), were guaranteed to report record (albeit fictional) short-term income. That income was certain to produce extreme compensation for the controlling officers. The strategy was also certain to produce extensive losses in the longer term – unless the investment bank could sell its losing position to another entity that would then bear the loss.
The optimal means of committing this form of accounting control fraud was with the AAA-rated top tranche of CDOs. Investment banks frequently purport to base compensation on risk-adjusted return. If they really did so investment bankers would receive far less compensation. The art, of course, is to vastly understate the risk one is taking and attribute short-term reported gains to the officer’s brilliance in achieving supra-normal returns that are not attributable to increased risk (“alpha”). Some of the authors of Guaranteed to Fail call this process manufacturing “fake alpha.”
The authors are largely correct about “fake alpha.” The phrase and phenomenon are correct, but the mechanism they hypothesize for manufacturing fake alpha has no basis in reality. They posit honest gambles on “extreme tail” events likely to occur only in rare circumstances. They provide no real world examples. If risk that the top tranche of a CDO would suffer a material loss of market values was, in reality, extremely rare then it would be impossible to achieve a substantial premium yield. The strategy would diminish alpha rather than maximizing false alpha. The risk that the top tranche of a CDO would suffer a material loss in market value was highly probable. It was not a tail event, much less an “extreme tail” event. CDOs were commonly backed by liar’s loans and the incidence of fraud in liar’s loans was in the 90% range. The top tranches of CDOs were virtually certain to suffer severe losses as soon as the bubble stalled and refinancing was no longer readily available to delay the wave of defaults. Because liar’s loans were primarily made to borrowers who were not creditworthy and financially unsophisticated, the lenders had the negotiating leverage to charge premium yields. The officers controlling the rating agencies and the investment banks were complicit in creating a corrupt system for rating CDOs that maximized their financial interests by routinely providing AAA ratings to the top tranche of CDOs “backed” largely by fraudulent loans. The combination of the fake AAA rating and premium yield on the top tranche of fraudulently constructed (and sold) CDOs maximized “fake alpha” and made it the “sure thing” that is one of the characteristics of accounting control fraud (see Akerlof & Romer 1993; Black 2005). This is why many of the investment banks (and, eventually, Fannie and Freddie) held substantial amounts of the top tranches of CDOs. (A similar dynamic existed for lower tranches, but investment banks also found it much more difficult to sell the lowest tranches.)