Tuesday, January 12, 2010

Bank of America's Shareholders (and All Wall Street Shareholders) Should Reject Bonus Plans

By Janet Tavakoli

In July 2009, New York Attorney General Andrew Cuomo's report found that, among other things, the compensation structures at most banks were "a major impetus for the subprime fiasco."1

Shareholders fed up with the fact that key contributors to the global credit crisis plan to pay billions of dollars worth of cash and stock in bonuses to employees might consider following Goldman's suit. Goldman Sachs's shareholders brought separate actions against the Board of Directors for alleged breach of fiduciary duties in approving billions of dollars in bonuses.

Bank of America and its acquisitions, Countrywide and Merrill Lynch, were neck-deep in the subprime crisis. In July 2008, Bank of America acquired Countrywide, which made $97 billion in subprime or high interest loans during the peak years of 2005 through 2007.2 On October 6, 2008 (three days after TARP was approved), Bank of America agreed to settle a multi-state predatory lending lawsuit against Countrywide for $8.7 billion. Bank of America received its first $25 billion TARP injection around three weeks later.

Bank of America proposes to pay billions of dollars worth of cash and stock bonuses to its Merrill Lynch employees. Merrill Lynch claims that the fact that it lost tens of billions of dollars on so-called super senior 'investments" during the crisis is proof it innocently sold risky investments to others. Don't believe it. Here's what happened. Merrill was involved with a lot of subprime lending and packaging and knew or should have known exactly what it was doing. What is more, Merrill had other pockets of risk unrelated to subprime.

For example, in December 2006, Ownit, a California-based mortgage lender partly owned by Merrill, declared bankruptcy. Its CEO, William Dallas, stated he was paid more to originate no-income-verification loans than for loans with full documentation. Michael Blum, Merrill Lynch's head of global asset-backed finance, sat on Ownit's board. When Ownit declared bankruptcy—instead of demanding a fraud audit—Blum faxed in his resignation.

After the bankruptcy, Merrill continued packaging Ownit's loans. Following a multi-year pattern, Merrill disguised the risk. Merrill packaged Ownit's risky loans in 2007, and failed to disclose that it was Ownit's largest creditor. Within a year, the so-called "AAA" rated tranche was downgraded to a junk rating of B, meaning you are likely to lose your shirt. (A mutual fund was stuck with it.) This meant that "investment grade" tranches below the "AAA" were worthless or nearly worthless, because those investors agreed to take losses before the "AAA" investors.

Losses were not simply due to fickle market prices. There was permanent value destruction.

Merrill Lynch further disguised risk by repackaging phony "investment grade" tranches into new investments called CDOs and CDO-squared. Credit derivatives amplified the problem, because one could sell value-destroying investments more than once. This was only obvious to professionals, because some mortgages took a couple of years for payments to reset. By 2007, things were so bad that many loans were total shams and began defaulting almost immediately. This is the classic end of a Ponzi scheme.

Read the rest here.

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based consulting firm to financial institutions and institutional investors. She is the author of a book on the cause global financial meltdown: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009), Structured Finance & Collateralized Debt Obligations (Wiley 2003, 2008), and Credit Derivatives & Synthetic Structures (Wiley 1999 and 2001).

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