How Ken Lewis Has Failed the Test of Good Leadership

FT had a remarkable article Saturday explaining what is behind the write-downs in December for Merrill Lynch. Briefly, the article says that Ken Lewis sent his chief financial officer Neil Cotty to review the Merrill finances in the fourth quarter of 2008 and it is Mr. Cotty who decided on the write-downs to be taken. Here is a reasonable explanation of these events.

The logical thing to do when you are buying a company is to write-off all the bad news before you buy so that it does not affect your own bottom line. It is logical that Ken Lewis sent Neil Cotty, his chief accounting officer, to clean things up before finalizing the purchase in December. This is a normal process. It seems that Neil Cotty essentially decided on what write-down should be made. This is also normal. Thus we come to the first major variance with a lot of B of A (BAC) public announcements. Contrary to public announcements, B of A probably decided on the reserves to be taken in the fourth quarter in Merrill Lynch. That is to say, B of A actions decided what would be the bad public news about Merrill’s losses. But in the real world, this is normal.

But it now seems Cotty, and therefore Ken Lewis, found a lot more bad news than Lewis had expected. This fact, much more loss than expected, is the real problem. The losses were so great that the deal did not make sense economically. Ken Lewis had committed to buy a company which, with the real numbers in hand, did not make sense to buy. How did Ken Lewis get in this position? The answer is that B of A did not do adequate due diligence before agreeing to buy Merrill. Let’s look at what this tells us about Ken Lewis.

I believe a good CEO has three qualities: 1) a winning global vision for the business, 2) good operating skills to implement that vision, and 3) personal leadership skills that motivate employees and executives to support and implement that vision. Let’s look how Ken Lewis measures up against these three qualities.

1. A winning global vision for the business. Ken Lewis’s view for B of A seems to be a copy the Citibank (C) plan of making a financial supermarket. The two key elements for Mr. Lewis to implement his financial supermarket were the purchase of Country Wide and Merrill. However, by the time Mr. Lewis was implementing his plan, Citibank had virtually already died of this same strategy. History shows that conglomerates of any kind and particularly financial conglomerates work in growing business environments where you make money by buying more businesses. However, they do not work in fundamentally declining business environments which require outstanding operating management that really knows the business as opposed to looking at financial numbers. It seems reasonable to assume Mr. Lewis’s flawed view of business strategy blindsided him to the practical problems he would find in trying to implement his strategy.
2. Good operating skills to implement that vision. Everyone knew that Merrill had all sorts of problems. How could Ken Lewis not have done a very thorough due diligence prior to making that decision? He has tried to explain that good people might jump ship and the business franchise would be worthless, but if he had done his due diligence, it would have become clear that both of these problems were going to happen anyway. Since due diligence is rule number one for an acquisition, particularly of $50 billion, his disregard for this can only be explained by his flawed global view of the business.
3. Personal leadership skills that motivate employees and executives to support and implement that vision. Leadership is sometimes confused with the power to fire a person or the ability to give a lot of money in compensation to a person. Both of these techniques fail horribly to provide good management and in part are the cause the current financial debacle. Leadership means that your people believe in your vision and have faith in your ability to successfully implement it and they believe that you will treat them personally in a fair way. Employees, who go home at night thinking they may be fired the next day, are not employees focusing on the business. Senior and middle level executives tell us that Ken Lewis fails in all these areas. In percentage terms, B of A probably has more executives looking for a new job than any other major institution. Morale is destroyed in B of A. Hope is destroyed. Merrill Lynch traders use nicknames for Ken Lewis which associate him to North Korea’s dictator.

I believe that Ken Lewis fails the test of what good leadership should be. A man who has a flawed global plan for his institution, who does not seem to have the operating skills to make his plan happen (and then blames his subordinates when something goes wrong with his plan), and finally has destroyed the morale of his people, probably cannot take the bank safely forward to success. However, I am not an insider and this issue must be resolved by the shareholders and directors who may have better information than I.

There is also a larger issue here. The Obama government is throwing trillions of dollars at the problems trying to get a financial solution to the problems of America. In my mind, this is wrong. The problem is that we have too much money and too much bad credit. Throwing trillions more will cause much bigger losses and runs the risk of hyperinflation. At both public and private levels, we need to focus on getting senior executives of our major businesses to have really viable plans to take their firms through the current problems successfully. While money will play a role, creative and effective workout plans for our private sector (both large and small enterprises) will beat a lot of money in terms of providing solutions to the current problems and will take much less money. Money without a good plan is wasted money. We need our senior business executives focusing on market place solutions for their business, not how to try to game the system to get bailout money from the government. Ken Lewis is an example of an important minority of our business leaders who are pursuing the wrong objectives for their institution, and thereby have an important deleterious effect on the general population.

Disclosure: none

Comments

[ebschor:]

BAC was forced to acquire ML for the greater good of this country (and the world). In the long run the acquisition will pay off as it will help offset profit squeezing of BAC's lending business when interest rates start to rise.

BAC tried to renegotiate the deal or back out of it completely due to MAC (material adverse changes) but were told it would be "in their and the country's best interest" if the deal went through. Basically "strong-arming" from the US gov't.

This fact makes your entire article baseless.

Mar 22 11:27 AM

[einstein p ...:]

Was Ken Lewis also forced to buy Countrywide or did he think it was a good acquisition at the time? Seems to me, he made the same mistake twice. If, on the other hand, the US government is now running the show and Lewis is merely a patriotic puppet of the new world order, at least we will be able to mail a letter and make a deposit at the same place.

Mar 22 12:29 PM

[waf76:]

I do believe pressure was exerted on Ken Lewis by the Government as well but this was after he found out Merrill was worse than expected. Regardless, the shareholders got hosed. Last week's uptick was just some short covering. Nothing material has changed in the financials. The market went up as a result that these CEOs who drove their companies into the ground decided to declare they made an operating profit the first 2 months of 09. This qualifies as some type of success these days. This is unaudited of course and doesnt change the fact they still have tons of toxic assets on the balance sheet which are probably overstated even with FASB 157.

Mar 22 02:09 PM

[PaperGains:]

The man is a serial acquirer of companies. Bigger isn't always better. The universal bank model is a dangerous model, as it increases too much systemic risk and is too difficult to manage. Lewis purchased too many risky firms in a short time, MBNA, Countrywide, and Merrill. He risked everything, as these companies weren't fully digested before buying the next.

Think about the amount of risk Lewis took and think about how important BAC was to the entire system. Small companies take that kind of risk, not large multinationals. Large companies never risk everything on a deal or series of deals. They protect shareholder's interests firs, thus the reason I don't believe that he was forced to buy Merrill.

Poor leader.

papergains

Mar 22 02:21 PM

[James Wood:]

The three people commenting on this article refer to the issue if the government forced B of A to buy Merrill "for the good of the country". Once Mr. Lewis discovered what he had got his bank into, he wanted out and at that time the government did pressure him to go through with the deal. However, the initial decision to buy both Country Wide and Merrill were decisions taken by Mr. Lewis without any pressure from the government. The enormous loss suffered by the shareholders of B of A would have been much less if neither of these voluntary decisions were taken by Mr. Lewis.

Mar 22 02:26 PM

[einstein p ...:]

The latest installment of the government attempt to bail out the financial system is PIC. (We do love our acronyms) which is going to be unveiled tonight on 60 Minutes. (They were going to unveil the program on Leno, but they wanted someone to actually take them seriously). Supposedly, under the new acronym, the US government will buy up and guarantee all toxic assets, which effectively will bankrupt the country but put the banks on solid footing.


On Mar 22 02:09 PM waf76 wrote:

This is unaudited of course and doesnt change the fact they still have tons of toxic assets on the balance sheet which are probably overstated even with FASB 157.

Mar 22 02:53 PM

[ebschor:]

The enormous loss by the shareholders? BAC shareholders have been making money hand-over-fist the last few weeks. If you're referring to people that held from $50 to $2.50, we'll that's for another article.

As for Countrywide and ML, I'll be willing to bet that both of those acquisitions play out for the best. And I'm not talking long-term. I bet we'll see the value in these acquisitions as soon as Q1, 2009.

When inflation hits, banks with no exogenous businesses to lending will provide the next round of bank closures. B of A, GE and Wells will do just fine. Citi is a totally different animal and I leave them out on purpose. You have no idea how painful the removal of liquidity from the economy will be when it's time to pull the plug on Helicopter Bernanke's monitary policies. Skyrocketing interest rates. You'll think Carter is President again.

Mar 22 05:49 PM

[Jim Bob Jones:]

While it seems logical that any business should take it's lumps for bad leadership it also seems logical that with a failure of the economy of this magnitude that some one such as Lewis would have to step up to prevent further erosion of jobs and business. We tend to forget that BAC is gobal and with that in mind has responsibilities not just to the US but others as well. We must also remember that a business does not stay at a certain level,it either grows or shrinks. No business I know of hires people to shrink the business. All CEO's are gamblers as there is a certain amount of risk in growing a company just as there is risk sitting on a bench waiting for the bus. How his leadership will be judged has yet to come. It's easy to quarter back after the game.

Mar 22 07:34 PM

[Big Jack58:]

Countrywide and Merrill will be big earners for BAC. Everyone makes these acquisitions out to be disasters because they've lost some money lately. Hmmm, maybe BAC knew that ahead of the mergers and therefore paid a reduced price for these firms. Countrywide refused a $26B buyout from BAC 12 months prior to selling for $4B. If Countrywide was not expecting to have future write-offs, they wouldn't have sold for so cheap. Merrill was in the same boat. That company wouldn't sell for $100B 12 months prior to being bought for less than $29B (it wasn't $50B as stated in this article because BAC's stock price declined). So when the good times roll, you're going to have an all-star bank and people that wrote these article will quickly forget how they were nothing more than bandwagon chicken littles. "Ken Lewis is a terrible leader". "Ken Lewis ruined BAC". "BAC is insolvent". Blah, blah, blah. BAC still has over $90B in capital reserve and is looking at huge revenue in 2009 (don't forget there's a very favorable yield curve for large banks right now), so they can absorb several quarters of write-downs before feeling the big pinch. We'll talk in 12 months when BAC is the dominators of their industry.

Mar 23 05:56 AM

[hwood007:]

I have doubts that anyone would have had the skills to value the paper losses that were on Merrill books at the time the offer to buy was made. I have found that you can not judge the depth of the swamp from firm ground.


On Mar 22 02:26 PM James Wood wrote:

> The three people commenting on this article refer to the issue if
> the government forced B of A to buy Merrill "for the good of the
> country". Once Mr. Lewis discovered what he had got his bank into,
> he wanted out and at that time the government did pressure him to
> go through with the deal. However, the initial decision to buy both
> Country Wide and Merrill were decisions taken by Mr. Lewis without
> any pressure from the government. The enormous loss suffered by the
> shareholders of B of A would have been much less if neither of these
> voluntary decisions were taken by Mr. Lewis.

Mar 23 11:14 AM

[HBWOW:]

Lewis and the other bank "leaders" are probably more capable of handling the monkey job for an organ grinder. HE IS THE ONE at the helm when a lot of the bad derivatives (not just the mortgage packages but all derivatives on and off the books) were being acquired. His fiduciary responsibilities, I think, would preclude B of A's acquisition of ANY of these types of highly questionable value, creditability, and collectablity. Also if the Merrill deal was discovered to be other than the value when acquisition was contracted, B of A had every right to back out, but didn't. Mr. Lewis suggests he did not know of bonuses until after the checks written, WOW, how thorough did B of A do their expected and required homework before closing the deal? I don't care if these were "contractual" deals as the contracts can and should be challenged as not in the best interests of the stockholders nor B of A as the acquirer. I always felt that bonuses can only be considered if the company is successful BEYOND EXPECTATIONS and individual merit and contribution in achieving such superb profits. The insiders of many of the large corporations seem to consider only their greed not to be confused nor warped by performance or profitability with taking their huge salaries, perks, options, and retirement packages all with total disregard for the stockholders and the companies lending institutions (we can always borrow more).

Mar 23 03:51 PM

[TopGoalScorer:]

It's not my article, however, the fact is - you're speculating on what was or was not said between BoA & the Fed.

What we do know, is that Ken proceeded anyway, AND he was under no material obligation to keep the deal running.

The reality is (and I speak from personal experience) the beast appears to be too big to manage, and the management team are broadly inexperienced due to a vast amount of time many of them have spent working for the same organisation.

On Mar 22 11:27 AM ebschor wrote:

> BAC was forced to acquire ML for the greater good of this country
> (and the world). In the long run the acquisition will pay off as
> it will help offset profit squeezing of BAC's lending business when
> interest rates start to rise.
>
> BAC tried to renegotiate the deal or back out of it completely due
> to MAC (material adverse changes) but were told it would be "in their
> and the country's best interest" if the deal went through. Basically
> "strong-arming" from the US gov't.
>
> This fact makes your entire article baseless.

Mar 24 01:07 PM

[wcinvest:]

The Countrywide acquisition was ok. It would have been much better if BAC could have wiped out all legal liability from Countrywide and bought them in bankruptcy even if that meant paying a few billion more. And BAC should have raised 25-40 billion of capital before the Countrywide acquisition and lowered the dividend by 50% after that acquisition.

BAC did its extended due deligence on that deal and realized the losses would be at the high end of their estimates but that the deal still made sense because BAC has a cost of capital advantage over Countrywide. Traditionally, mortgage originations is usually a stable business that is fairly easy to manage. It is a business BAC was already in. Strategically and operationally, the deal made tons of sense but I only give it an ok since BAC could have probably gotten Countrywide while taking on less risk.

Merrill was a boneheaded move since the deal was rushed but in the end that acquisition should pay dividends... But the market killed BAC for the Merrill deal since BAC agreed to a conversion rate valuing MER at $50 a share when in fact Merrill may have been forced to sell for $10-15 a share in a matter of a few days or a week. Lewis deserves to lose his chairman of the board position and half the board should go because of this decision unless their are mitigating circumstances that haven't come to light.

Folks talk about BAC failing from its size and compare it to Citigroup. The companies are really quite different because of BAC's dominance in the US and their deposit base.

JPM Chase is probably closer to BAC and I don't their their size will hurt them. Unlike Citi, operationally BAC is very well managed. Lewis won't do another acquisition anytime soon so I am not concerned about that.

Apr 05 10:48 PM

[ebschor:]

Hey TopGoalScorer,
Based on Ken Lewis testimony today it looks like we now DO know I was right about BAC being strong-armed by the gov't. Sometimes it's not good to be right...

Apr 23 01:33 PM