Government Stimulus and Artificial Value, Part 1

Good morning, dear readers.  This is a piece I wrote about two months ago in response to claims that economic stimulus initiatives were working as intended.  Though Christina Romer, the chair of President Obama's Council of Economic Advisors, has claimed recently that stimulus has done the bulk of its work, there are rumblings in the halls of Congress that yet more stimulus money may be in order.  Those who know me best will tell you I have been against every stimulus attempt the government has made from the beginning, for the very simple reason that it counteracts all logical understanding of how economic forces work.  Economic advancement is propelled by the exact same forces from the individual citizen to the government, and those forces rely at all times on perceptions of value.  It is my belief that stimulus skews those perceptions, and so counteracts itself.  As an illustration, I have used the example with which I am most familiar: the acquisition of Merrill Lynch by Bank of America.  Please enjoy.




August 23, 2009

             Few subjects on the public stage have been as politically polarizing as government involvement in the economy.  Through monetary policy and fiscal policy citizens trust Washington DC to have the economic savvy to do what’s best to foster growth within America, and to the politicians’ credit action is certainly being taken with prosperity in mind.  The question is, will the $3 trillion dollars already spent and the $13 trillion allocated to the current stimulus programs perform as intended?  The trap into which we are in danger of falling is one in which stimulus money targets take the place of true demand.  Consequently (should this occur), any GDP growth we see in the short term will be unsustainable as it is not coming about from true consumer confidence and demand.

            The whole idea behind a capitalist system is that firms must remain commercially viable in order to exist.  If they cannot remain so, there is an understanding that it is for one of two reasons:

1.      
       1.    The product or service the firm offers is no longer wanted by its consumer base, and all producers of that same product or service are similarly affected.

2.     
              2.   The product or service the firm offers is no longer offered in a way that consumers prefer, and other producers within that industry offer either superior products or services or they offer them in a way consumers like more.

There is a further understanding that if a firm fails and is unable to reorganize effectively through bankruptcy, the ensuing unemployment of the firm’s workers and the unsatisfied demands of the firm’s former customers is TEMPORARY.  Both logic and history bear out that competitors quickly absorb the demand of the defunct company.

If bankruptcy goes to the point that in order to satisfy creditors revenue-generating assets are sold, the buyer is almost certainly going to be a competitor, someone who will continue to use those assets, be they factories, assembly lines, or even (ideally) whole business units in their original capacity.  There will be changes, of course.  If those assets had been functioning as part of an effective overall business strategy that strategy would not have failed and led to the purchase in the first place.  Whatever happens to those assets, however, they will used to service both the customer of the purchaser and the customer of the seller, as there is no reasonable expectation that they will no longer need the product or service the seller used to provide.  The final firm that emerges is one that will be able to service more customers more efficiently and with a more varied and/ or more commercially viable product mix than either the purchaser or seller could have prior to the transaction. 

             A case-in-point is the sale of Merrill Lynch to Bank of America earlier this year.  In order to avoid a fate similar to what Lehman Brothers met, John Thain (CEO of Merrill Lynch), Ken Lewis (CEO of Bank of America), and a team of Merrill Lynch and Bank of America employees worked with Federal Reserve officials through a solid weekend to prepare an agreement that would merge the two companies, exchanging each share of Merrill Lynch stock for .8595 shares of Bank of America stock.  Though they had different competitive advantages, the two companies offered similar services.  Both had deposits, both had investment services, and both had credit departments. 

When Bank of America finalized the deal, it became clear that the ultimate entity that was left was a hybrid of the two firms, taking the strengths of each and folding the weaker functions into the other.  Global Wealth Management (investments and financial advising), for example, was left for Merrill Lynch to run under its own name, one which it had been determined was known among consumers mainly for its investment services.  Financial advisors under Bank of America now worked under the Merrill Lynch colors.  Also worth noting is that Global Wealth Management was a division of Merrill Lynch that actually made a profit in fiscal 2008, in stark contrast with their Global Markets and Investment Banking division, which took a pre-tax loss of $6 billion in the third quarter alone.  Conversely, Merrill Lynch’s credit card programs, deposits, and consumer bank accounts were folded into Bank of America’s preexisting programs.  Due to their scope, and market share which gave them half the deposit accounts in the country, Bank of America had the advantage of economies of scale, making them far more competitive than Merrill Lynch had ever been for that side of the business.

The benefits as reported to the public and to the employees of both banks were that they now had an inside track to the others’ clients.  Through clients of Merrill Lynch who had portfolios and deposits with the bank could access both quite easily, they often banked elsewhere (whatever client benefits Merrill Lynch brought to the table, low fees weren’t one of them).  In the same way, Bank of America financial advisors, by the admission of one director of that firm, had always been something of an afterthought.  Now clients of the newly merged firm would have access to the competitive fees of Bank of America AND the expertise of Merrill Lynch advisors.  Thus, we see that the clients of both firms are, far from being left out in the cold, have the best of both worlds.

This is the extent to which the ML-BofA transaction, in its objective, typifies the ideal free-market model as it applies to uncompetitive firms.  A firm failed, another was there to pick up the pieces, and the end result was a stronger firm than the previous two had ever been individually. 

There is a second part of the story, though, and it resembles far less a basic capitalist system and far more a culture of government economic intervention.   It was never a secret that the Fed and Secretary Paulson wanted to avoid a similar aftermath to the one associated with the fall of Bear Stearns early in 2008, and so worked very closely with Ken Lewis and John Thain to get a deal done quickly.  In an internal address to Merrill Lynch employees John Thain described the meeting he had attended along with executives from Lehman Brothers at the Federal Reserve Bank in New York.  At that meeting it was made clear to all parties present that both banks were in immediate danger of failure, and that, absent some form of deus ex machina bankruptcy proceedings would have to begin soon for both.  The only possibility of some semblance of survival was a sale to a more solid bank.  Bank of America was one of the players big enough and stable enough to absorb one of the banks, and Merrill Lynch was determined to be the lesser of the two evils.  That two banks of that size could come to any sort of merger agreement within a 48-hour period is a testament to the urgency Ben Bernanke and other federal officers felt to avoid the imminent adverse effects the failure of Merrill Lynch would have had on the financial markets.

The urgency was so acute, in fact, that an industry that constantly stresses due diligence to its insiders at the lowest levels neglected it at the highest.  The months following September 18 were devoted to looking into all the details of the two firms, and it was then that the true sordid story of Merrill Lynch came out.  Unacceptable levels of exposure to overly risky assets and loss projections that were higher than had first been reported during the 48-hour whirlwind romance, and Ken Lewis quickly became afflicted with buyer’s remorse.  It soon became clear, however, just how closely linked Bernanke and other officials considered the stability of a major firm like Merrill Lynch and the overall economy.  In an article Fox News published on June 11, 2009 was the following: 


“In testimony before the committee, Lewis said publicly for the first time that his job was threatened after he expressed second thoughts about the merger. Lewis said then-Treasury Secretary Hank Paulson and federal regulators made clear that if the bank reneged on its promise they would force his ouster and that of board members at the bank.

‘What gave me concern is that they gave that threat to a bank in good standing," Lewis told the House Oversight and Government Reform Committee. "So it showed the seriousness with which they thought that we should not’ back out.”

            In fairness to former Secretary Paulson, the article went on the explain that these conditions were brought to the fore because $20 billion of the $45 billion Bank of America ultimately received through TARP funding were directly contingent on the successful acquisition of Merrill Lynch.  This begs the question, however, of who is truly the best judge of value in a situation like this.  To the government officials involved, the value in the transaction was solely in maintaining the stability of the markets.  To Ken Lewis and the Board of Directors at Bank of America, the value lay less in “taking one for the team” and more in maintaining commercial viability.  They are in business, after all.

            In both cases value was misplaced.  Lewis’ misgivings were vindicated regularly between September and January when shareholders approved the deal as Merrill Lynch announced increasingly abysmal financial performance, but both his and the board’s hands were tied.  The “stability” of the markets depended on the successful merger.  Unfortunately for Henry Paulson and Ben Bernanke’s rationalization of governmental arm-twisting, the DJIA (presumably despite the successful merger) fell from nearly 11,000 on September 18, 2008 to just above 6,500 on March 9, 2009.  By no reasonable standard can this be called a stable market, and it is for this reason, that the successful execution of the deal contributed little if anything to the stability of the markets, that that pressure to put it through was a result of an erroneous value judgment.

Thank you all for reading.  Please join us again on Friday for the exciting conclusion.