LEADERSHIP AND ETHICAL DECISIONS PERFORMED BY KENNETH LEWIS AND THE FED DURRING THE FINANCIAL CRISIS OF 2007-2008

November 29, 2010

Introduction

The robust leadership decisions of both the Fed and Kenneth Lewis, CEO of Bank of America (B of A), were not only ethical and accurate, but could have simply saved our financial system as we know it. During the weekend of September 13-14, 2008 Kenneth Lewis met with CEO of Merrill Lynch (Merrill), John Thain, in order to try and rescue Merrill from a hasty bankruptcy that lurked around the corner. Lewis was thinking that it was the perfect opportunity to add the only thing that B of A lacked after recent acquisitions, a “Wall Street investment bank that underwrote and sold securities” (Pozen and Beresford, 2010). On December 5, 2008 B of A’s shareholders voted to approve the merger between the two (Pozen and Beresford, 2010). It wasn’t until days later that Lewis became progressively more concerned about the growing fourth quarter losses on Merrill’s books, from $5.38 billion on November 12 to $12 billion on December 14, one month later. By mid December Lewis began looking for a way out of the deal before the scheduled closing date in late January. Both the Fed and the U.S. Treasury Secretary, resisting that Lewis walk away, threatened to fire Lewis and replace the board at B of A if the merger didn’t take place. Lewis, afraid of legalities from not disclosing the losses to their shareholders before the vote, and the drop in B of A’s share price due to Merrill’s losses found himself in the biggest ethical dilemma of his life. Should he maximize shareholders’ profit and walk away from the deal? Should he continue on with the merger as the Fed states, there are larger issues at stake? What about his job and the jobs of all the board members?

Background – Kenneth Lewis

Kenneth Lewis was born in 1947 and earned a bachelor’s degree in finance from Georgia State University. Lewis is the two-time winner of American Banker newspaper’s “Banker of the Year” award (2002, 2008). In 2007 he was named as one of the 100 most influential people in the world by Time magazine. Lewis joined North Carolina National Bank (NCNB) as a credit analyst (Kenneth Lewis – Biography, 2010). NCNB expanded and adopted the name NationsBank in 1991 and then Bank of America in 1998 (Pozen and Beresford, 2010). Lewis became NationsBank president in 1993 until 1998 and then President for Consumer and Commercial Banking from 1998 to 1999. In 1999 he became COO of B of A and then in April of 2001 was named chairman and CEO of B of A.

Throughout Lewis’s time as CEO, and chairman of the board of B of A, he aquired many companies. He acquired FleetBoston Financial in 2003, credit card issuer MBNA in 2006, LaSalle Bank Corporation in 2007, U.S. Trust also in 2007, and finally Countrywide Financial in 2008 (Pozen and Beresford, 2010).

By 2008 Lewis had expanded B of A from the east coast to the west coast. B of A now dominating all retail banking franchises just lacked one thing, an investment bank.

Background – The Federal Reserve (Fed)

On December 23, 1913 Congress founded the Federal Reserve. It was enacted by Congress to serve as the nation’s central bank (The structure of the Federal Reserve System, 2010). The Fed is mandated, by law as of November 16, 1977, to “maintain long-run growth of the monetary and credit aggregates commensurate with the ‘economy’s long run potential to increase production,’ so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” (The Federal Reserve Act, 2008).

Ben Bernanke was elected as the chairman of the Fed on February 1, 2006. Mr. Bernanke is arguably one of the most powerful people in the world, if not the most. This also makes Mr. Bernanke one of the most effective and influential leaders within the world. As stated in our week three lecture, “Above all else, people want leaders who are credible. We want to believe in our leaders. We want to have faith and confidence in them as people. We want to believe that their word can be trusted, that they have the knowledge and the skill to lead, and they are personally excited and enthusiastic about the direction in which we are headed. Credibility is the foundation of leadership” (Yuki, 1989). Mr. Bernanke is not only knowledgeable, influential, and credible, but also is held responsible for our financial system and economy.

The Financial Crisis of 2007-2008

It is essential that you must understand the financial crisis of 2007-2008 in order to get the correct framework for the decisions that must come to be made by both the Fed and Lewis.

Fannie Mae and Freddie Mac were created by the government, in which they buy mortgages from banks, so that banks may turn around and lend more money to homebuyers. The government originally created this program to make more money available to people wanting to own their own homes. The problem that occurred is that banks lending the money no longer have due diligence to ensure that the money gets paid back as they are going to just sell the mortgages to either Fannie Mae or Freddie Mac (Leavitt, 2010).

In May of 2000, the fed funds rate was at 6.5%, following the September 11, 2001 attacks the rate had been cut to 1.75%, and finally in June 2003 it was cut to 1%. This dropped the average 30-year mortgage to 5.23%, the lowest on record. Now with more money than ever to lend and the lowest interest rates on record, everyone was looking into buying homes (Dunbar, 2010).

Mortgage-backed securities, created in the 1980s, works when a lender sells the mortgage to an investment bank (Merrill, Bear Sterns, Lehman Brothers, Fannie Mae, Freddie Mac…) and then they combine it with many other mortgages into a fund. The fund is then sliced into pieces and sold to investors as “mortgage-backed securities.” The interest that is paid on the mortgage goes to the owner of these securities rather than the originating lender. However, some investors nervous that some of the mortgages might not be paid, and their investment would be worthless, wanted insurance. “Credit-default swaps” are when an investor can buy a swap from a company, such as AIG, to protect their investment against losses. These swaps did nothing more then fuel the demand for mortgage-backed securities, which made investors line up to buy the “seemingly safe securities” (Dunbar, 2010).

As the demand increased for mortgage-backed securities, the demand also increased for larger mortgages. This fueled the fire for subprime loans. According to John Dunbar (2010), “the Federal Reserve reported subprime loans accounted for about 19 percent of all home loan originations in 2004…” Lenders, again, were unconcerned about the creditworthiness of the borrowers as they planned on selling the loans to investment banks. Dunbar (2010) goes on to state, “Lender profits increasingly became dependant on quantity, not quality. Pretty soon, those in the business were joking about ‘NINJA’ loans – as in loans made to borrowers with ‘no income, no job, and no assets.’”

In 2004, as political pressure pushed for more affordable housing goals, Fannie Mae and Freddie Mac started buying billions of dollars worth of mortgage-backed securities from investment banks in order to free up more money to lend. With interest rates down and what seemed like an unlimited amount of money to be lent, home prices shot through the roof. The Fed, afraid of rising inflation, began raising the fed funds rate where it topped out at 5.25% in the summer of 2006. This cooled the housing market, and property values began to drop. Borrowers in subprime mortgages that where relying on selling their homes for a profit, or refinancing them before their rates changed, found themselves in trouble (Dunbar, 2010). Mr. Dunbar states, “Between 2000 and 2007, underwriters of mortgaged-back securities poured more than $2.1 trillion into underwriting subprime mortgage backed securities, according to Inside Mortgage Finance, and the loans had spread far and wide – to bank portfolios, hedge funds, pension plans, and more.”

It is important to realize that banks with excess reserves lend their money to other banks in order to earn interest on their money. Therefore, as mortgage defaults began raining in, losses began piling up on investment banks, to include Freddie Mac and Fannie Mae. Bear Stearns was the first U.S. bank to fail in March 2008. This in turn, began the domino effect of great financial losses to banks throughout the world. As Ben Bernanke stated, “the financial shocks that hit the global economy… were the worst since the 1930s, and they helped push the global economy into the deepest recession since World War II” (Rhee, 2010).

Lehman Brothers’ Failure and the Fed’s Response

In 2003 and 2004 Lehman Brothers acquired five mortgage lenders that specialized in Alt-A loans, another word for “NINJA” loans. From 2005 to 2007 Lehman reported record profits every year. Lehman invested its surplus assets among in two Bear Sterns hedge funds, among many other things. During 2007 Lehman underwrote $85 billion in mortgage-backed securities, more than any other investment bank. In August of 2007 with the failure of its two Bear Sterns hedge funds, Lehman’s stock declined dramatically. On March 17, 2008 Bear Sterns barely missing bankruptcy, thanks to JP Morgan and the Fed coming to their rescue, made investors confidence drop dramatically; as Bear Sterns was the second largest underwriter to mortgage-backed securities, falling short to Lehman Brothers. This caused Lehman’s shares to fall a stunning 48%. Throughout the summer of 2008 Lehman sought out to merge with another company. Many attempts from big-name banks looked into acquiring Lehman, but none ever did. After the last attempt by South Korean bank, Lehman’s stock took another hit of 45%, and a 66% increase in credit-default swaps (most from AIG). On Monday September 15, 2008 Lehman declared bankruptcy, which made their stock decline 93% from its previous close. Many banks and investment banks had bonds or other securities with Lehman Brothers to include Merrill Lynch. As soon as Lehman reported bankruptcy all of these assets were wiped out! Leaving hundreds of banks and investors in the red (Case study: The collapse of Lehman Brothers, 2010). “Lehman’s collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008…” (Case study: The collapse of Lehman Brothers, 2010).

Knowing that the U.S. financial system couldn’t take another blow of this magnitude the Fed finally stepped in. On the next day, September 16, 2008 the “Federal Reserve Board authorized the Federal Reserve Bank of New York to lend up to $85 billion to insurer AIG…” (Pozen and Beresford, 2010). The Fed, now rapidly trying to stop the domino effect from destroying the U.S. financial system, allowed investment banks Goldman Sachs and Morgan Stanley to become bank holding companies, making them eligible for bailout money.
The Merger Between Bank of America and Merrill Lynch

On September 13, 2008 John Thain, CEO of Merrill Lynch, called Ken Lewis. Thain asked Lewis if he would meet so that they could talk. Later that same day the two met and reportedly felt that both of them thought that the two companies would make a good match. “After less than 48 hours of due diligence the two firms agreed that B of A would acquire 100% of Merrill in an all-stock transaction…” (Pozen and Beresford, 2010). Soon after things settled down, B of A was highly scrutinized for their lack of due diligence in this merger, and later settled with the Securities and Exchange Commission (SEC) for $150 million of dollars (Story, 2010). It was reported that both firms believed that the merger between the companies was logical (Pozen and Beresford, 2010). However, investors must not have had the same opinion, as B of A’s shares fell 21% the next trading day. According to Pozen and Beresford (2010), “B of A shareholders were unaware of the true extent to which losses at Merrill had multiplied following the September merger agreement.” “On November 12, Merrill’s fourth quarter losses were estimated at $5.38 billion…” “By the end of November, Merrill’s estimated fourth quarter losses were close to $7 billion.” Later it would be realized that Merrill’s actual fourth quarter losses would be $15.3 billion dollars! (Pozen and Beresford, 2010)

Due to the staggering losses that Merrill was apparently having Ken Lewis began looking into a way out of the deal. Lewis and other B of A executives began looking into invoking the merger’s material adverse change (MAC) clause – “a legal provision that gave the buyer the right to terminate an agreement prior to closing” (Pozen and Beresford, 2010). On December 17, 2008 Lewis called U.S. Treasury Secretary Paulson telling him that he was thinking of invoking the MAC clause. Paulson urged Lewis to meet with him; later that same day Lewis met with Paulson, Bernanke, and other Fed members (Pozen and Beresford, 2010). The meeting ended with “Paulson and Bernanke telling Lewis to ‘stand down’ so they could discuss the matter” (Pozen and Beresford, 2010). Again, on December 25, 2008 Lewis contacted Paulson to further discuss the possibility of invoking the MAC clause. In this instance Paulson was very clear with Lewis stating, “the government… does not feel it’s in your best interest for you to call a MAC,” and remarked that if B of A called it or intended to call it, “[the Treasury and the Fed] would remove the board and management” (Pozen and Beresford, 2010). Despite an enormous amount of controversy with the government stepping in and pressuring Lewis, and the losses piling up on B of A’s shareholders, Lewis decided to complete the merger with Merrill.

The Fed’s Point-of-View

Ben Bernanke and the Fed were rapidly trying to stop the domino effect of the U.S. financial system during this time. It was noted months later, by Lewis, that “[The Fed] had been so strong about the fact that they strongly advised us not to do [the MAC] that it would cause harm to the bank and the system, and the system wouldn’t be good for us either – that it would damage the system” (Pozen and Beresford, 2010). I think it is obvious that the Fed thought that the financial system couldn’t survive another investment bank failure. Therefore, as the Fed’s mandate to maintain and protect the U.S. economy they saw it necessary to do whatever need be to ensure this deal went through. From the Fed’s perspective they were pressuring Lewis in order to help the economy and try and level off the continuing drop in the markets.

Kenneth Lewis’s Point-of-View

Lewis, worried about the compounding losses that Merrill began taking on, wanted out of the merger. As CEO and chairman of the board of B of A, Lewis’s responsibility is to maximize the profits of his shareholders and ensure the success of the company. One can only wonder what Lewis was actually thinking, but the facts are pretty clear. Losses were mounting as Merrill began to drastically deteriorate, within days millions piled up. Lewis contacted the Treasury Secretary to give him a heads up that B of A was now looking for a way out. Paulson and Bernanke told Lewis to sit tight and go ahead with the merger. They “promised” Lewis more capital from the TARP fund if he goes through with the merger in order to offset the losses that Merrill had incurred (Pozen and Beresford, 2010). I assume Lewis knowing that he could get more capital thought it would ease the pressures building around him. In order to cover himself from a legal perspective, Lewis tried to get these promises in writing. “Lewis feared ‘lawsuits from the shareholders for NOT invoking the MAC, given the deterioration at ML’” (Pozen and Beresford, 2010). When Bernanke sent in a request to give Lewis a letter, advising him that it would be in his best interest, Scott Alvarez, General Counsel on the Federal Reserve Board (Alvarez, 2008), responded to Mr.

Bernanke via email stating:

“I don’t think it necessary or appropriate for us to give Lewis a letter along the lines he asked. First, we didn’t order him to go forward – we simply explained our views on what the market reaction would be and left the decision to him. Second, making hard decisions is what he gets paid for and only he has the full information needed to make the decision – so we shouldn’t take him off the hook by appearing to take the decision out of his hands.”

Lewis now had to make a decision based on the fact that if he goes ahead with the merger he could face a lawsuit, his shareholders would lose large amounts of their investments, his reputation would be damaged, and if the Fed doesn’t follow through with their promise it could force B of A into bankruptcy as well. However, if Lewis backed out of the deal he would get fired, all the members of the board would get replaced, it could potentially be detrimental to the U.S. financial system, although the shareholders may be better off, and B of A could continue being a profitable business. The decision was ultimately left up to Lewis to decide. Lewis later stated, in a testimony in front of Congress, he chose to go through with the merger because he thought it best for everyone involved. He believed the Fed, that the U.S. financial system depended on it and without the deal it could cause a financial collapse. He stated that if it did cause a financial collapse, it would just hurt B of A’s shareholders any which way you look at it. Finally, he stated that even though they are incurring losses right now, the acquisition would make B of A a better company and more profitable in the future.
Ethics, Corporate Social Responsibility, and Leadership

It is my personal opinion that yes, maybe the financial crisis of 2007-2008 could have been prevented, but once set in place the Fed was left with dealing with a “wicked problem.” You can never finish or solve the domino effect that had inspired upon financial institutions during this crisis, but only rather slow it down and let itself work its way out. There are no “true or false” solutions to this problem, as there is no immediate or ultimate test for a solution to this problem. As the Fed steps in and implements different policies and bailouts it is going to be a “one-shot operation” and even though they may learn from their actions they won’t be able to do them again (at least in this situation). This problem with financial institutions is not only unique but is a symptom of bad decisions that have plagued both political parties and financial institutions. Finally, there is no right or wrong but rather a common focus to improve the current situation in the U.S. financial system. This wicked problem is due to the fact that businesses are human-centric systems and is indirectly related to certain previous policies. It is my belief that both the Fed and Kenneth Lewis dealt with this problem in a responsible and ethical manner. Furthermore, I believe we will come to see that both of their leadership actions have not only helped our economic state, but also ensured a more responsive recovery.

The Federal Reserve

The Fed (as well as the U.S. Treasury Secretary) used its power and influence to ensure that no more panic came to the market and helped stabilize U.S. financial institutions. The Fed displayed all five sources of its influence: reward, coercive, legitimate, expert, and referent power. It displayed its “reward power” by rewarding (although it may not be looked at as a reward) B of A extra funds to complete the merger with Merrill Lynch. As Lewis began to lack a commitment to fulfill the merger, the Fed stepped in, displaying their “coercive power,” and threatened the jobs of both Lewis and the board members, whether or not it is the reason they went on to merge we will never know. Without a doubt the Fed had both “legitimate” and “expert power;” the government appoints them and all of them are experts within the finance field. Finally, it is my belief that the Fed was able to use “referent power” by getting Lewis to comply with their wants by making him truly believe that the U.S. financial system depended upon that merger. Most, if not all, of this power held by the Fed would be worthless if people (in this case Lewis) did not believe that the Fed was trustworthy.

As research has depicted time and time again, collaboration with people you trust leads to a more energized team and increases productivity. Because Ben Bernanke has stood by his “word” and has been consistent with his intentions, Lewis believed him when he said that he would get more funds to B of A if they went ahead with the merger. Even though there was clear evidence that Lewis failed to spend enough due diligence in analyzing Merrill Lynch before jumping into an agreement, Bernanke never blames him or his team, but rather simply looks for a solution to the problem. Bernanke demonstrated his leadership and trustworthiness by maintaining integrity and telling the truth.

Kenneth Lewis

Throughout the decisions that Kenneth Lewis makes in this case he uses an integrated approach combining moral, economic, and legal points-of-view. Before making his decision to complete the merger, Lewis was thinking of all aspects of the decision. Lewis considered the benefit to the economy, as well as the harm it would ultimately cost the shareholders of B of A. He respected his peers on the board as he continually kept them informed and he also respected the Fed and the U.S. Treasury Secretary by keeping them in the loop and not making snap judgment decisions, even though he was not obligated to do so. Furthermore, as best as one can judge, Lewis treated everyone he dealt with in this event with fairness and equality. Finally, Lewis showed an obvious concern for the board members when their job was on the line, as well as for the entire U.S. economy. I believe that Lewis proves that acting morally will ultimately provide greater long-term benefits to not only his business, but also our economy.

It is my belief that this case highlights the problems with the “classic view” of corporate social responsibility. First, had Lewis strictly stuck with the idea that the only thing important in his decision was the profits of Bank of America, or to minimize their losses, he would not have gone through with the merger. I believe that Lewis went above and beyond the “moral minimum of the market,” in which he tried to prevent specific harms from occurring to our economy. Secondly, Lewis uses the power of his corporation in a manner, in which I believe society will come to appreciate in the coming years. Finally, even though the economy is, and should be, controlled or regulated by the Fed, Treasurer, S.E.C., and the government, Lewis does, what he feels is his part to provide a helping hand, being in the situation that he was in. All of this firmly supports Milton Friedman’s argument that the job of society should be to establish a framework of law, such that corporations as B of A should serve society by not only seeking profit, but also within the “rules of the game.” These “rules of the game” should very well include promoting a healthy U.S. economy.

Conclusion

Lewis obviously used an integrated approach when making his final decision to complete the merger with Merrill Lynch. If Lewis did follow the “invisible hand” argument, where the assumption is that a system of exchange based on self-interest will promote public welfare, then he would have chosen not to go ahead with the merger. In return, this could have caused the economy, as we know it, to have collapsed. Instead it is my belief that Lewis and the Fed both followed ethical and responsible leadership tactics that enabled them to work as a team in order to accomplish what was needed to sustain our economy and help us move out of this prolonged recession.

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