Behind Ken Lewis' Panic

Gerald Herbert / AP Photo In an exclusive excerpt of The Sellout, Charlie Gasparino reveals the inside story of how Paulson and Bernanke forced BofA to buy Merrill Lynch and prevented another meltdown.

With so much to worry about after Lehman Brothers' bankruptcy and the panic selling it touched off, including the continued saga of Citigroup, officials in the Federal Reserve and the Treasury Department could take some comfort that at the very least Merrill Lynch had been saved. The systemic risk of Merrill's folding like Lehman had was far too devastating for either Ben Bernanke or Hank Paulson to imagine. It had a balance sheet twice as large as Lehman's—close to $1 trillion—which meant twice as many trades to unwind and losses to account for. More than that, Merrill was, for all intents and purposes, a big bank, and with that it carried another set of concerns for regulators. Citigroup had close to $1 trillion in customer deposits in checking and savings accounts, but Merrill managed more than $2 trillion for small investors through its vast network of retail brokers scattered throughout the country, in small towns and big cities alike.

Lewis was desperate. “I need help,” he pleaded to Bernanke. He relayed how surprised he had been—“stunned” was the word he used—to learn that Merrill Lynch’s balance sheet problems were not over.

So Bernanke and Paulson thought, "Thank God Ken Lewis and Bank of America had the cash and the vision to buy Merrill before the week-from-hell began" as they moved on to other crises, including the final nail in the coffin for Wall Street, when the Fed announced that both Goldman Sachs and Morgan Stanley would become commercial banks with full access to all the ways banks can borrow from the Fed's discount window. After the announcement, neither Goldman nor Morgan promised to open branch offices or hand out toasters and debit cards to their customers. But the designation signaled a new era of deep and possibly painful regulation for the independent investment banks. After all, they had spent the past two decades borrowing to finance their increasingly risky trades under the purview of what was known as "self regulation," the concept that Wall Street could police itself through its membership in organizations like the New York Stock Exchange, the National Association of Securities Dealers, and the SEC.

The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System. By Charles Gasparino. 576 pages. HarperBusiness. $27.99. The problem was that the self-regulators did very little regulating and the SEC missed too many crises, including the Great Financial Crisis of 2007 and 2008. Now the investment banks would be treated like the commercial banks, regulated by the Federal Reserve (Fed officials have offices in each bank), a regulator with a record of achievement just good enough (the Fed hadn't missed the Madoff scandal) to give investors some hope that at the very least the lunatics weren't in charge of the asylum.

So as officials from the Fed and the Treasury left for the holidays, a seeming break from the madness once again set in both on Wall Street and in Washington. The "crisis" seemed to be over. Depositors stopping yanking money out of Citigroup; confidence returned to the money-market-fund business after the government announced a voluntary program to insure money-market funds. Perhaps it would be a quiet Christmas after all.

All that, however, changed with one telephone call.

“Maybe he's looking for a little candy," Ben Bernanke told Kevin Warsh, a key Federal Reserve governor who had played a major role in the agency's response to the financial crisis, about the desperate call that Bank of America CEO Ken Lewis had just made to the Fed boss. It was December 15, and Lewis was desperate. "I need help," he pleaded to Bernanke. He relayed how surprised he had been—"stunned" was the word he used—to learn that Merrill Lynch's balance-sheet problems were not over. Merrill was still losing money, lots of it. The way Lewis described it to officials, after shareholders had voted to approve the merger in early December, he had been informed by his finance people that the sludge on Merrill's books, seemingly undetected by his due diligence team, had eroded in value to such an extent that he could not go through with the merger on his own.

It wasn't necessarily subprime debt that had been hit, though there was still some of that on the firm's books. It was exposure to monolines, bonds that had been covered by the bond insurers Ambac and MBIA, which had lost their triple-A ratings during the crisis, plus other debt, which combined to produce a toxic brew of losses that would eventually total $15 billion ($21.3 billion on a pretax basis).

Lewis was now threatening to walk away from the deal (or at the very least to renegotiate the terms in a major way) unless he could get federal assistance to make the numbers work. It could still be done, of course.