Yesterday, the House Oversight and Government Reform Committee subpoenaed Federal Reserve internal documents, notes, and emails in advance of the testimony by Bank of America’s Ken Lewis on Thursday.  The hearing is on the alleged pressure applied by Secretary Paulson and Chairman Bernanke to go through with BofA’s acquisition of Merrill Lynch.  Accounts of this pressure first surfaced in a letter to Congress and testimony released by New York State attorney general Andrew Cuomo.  This subpoena may not seem like a big deal, especially since the Fed has indicated that it would supply the requested information, but it is for many reasons.  But first, what is at issue?

Briefly, we can glean much from Attorney General Cuomo’s letter to the Congress, the SEC, and Congressional Oversight Panel.  This much seems reasonably clear:

1. A few days after the BofA shareholder vote on Dec. 5, 2008, approving the acquisition of Merrill Lynch, the latter’s projected losses for the 4th quarter jumped by $3 billion and ultimately proved to be $6 billion.
2. The declining financial condition of Merrill was such that Mr. Lewis had essentially all but concluded that BofA should exercise what is called a “material adverse change” (MAC) clause in the merger agreement, allowing BofA to either abandon or possibly renegotiate the terms of the deal.
3. Mr. Lewis informed Secretary Paulson of his concerns, and between Dec. 17 and Dec. 22 a series of discussions took place between Mr. Lewis, Mr. Paulson, Chairman Bernanke, and other regulators.  Policy makers made it clear that they were concerned about the systemic risk to the financial system and to BofA if the merger not go through, and apparently they strongly pressured Mr. Lewis not to invoke the MAC clause.
4. On Dec. 21 Secretary Paulson reportedly threatened that if BofA abandon the merger then its management and board might or could be replaced.  According to the Cuomo letter, Mr. Paulson indicated that this communication was at the request of Chairman Bernanke.
5. On Dec. 22, at the bank’s board meeting, the views of the regulators were presented concerning systemic risk, the existence of the threat, and the willingness of the government to provide financial assistance to ensure that the transaction was completed.  It was also indicated that the financial assistance could not be confirmed in writing.  Other testimony indicated that if the commitment was put in writing, then the Treasury would have to disclose it, which the regulators did not want.  In that meeting, the board also included a statement in its minutes that the existence of the threat did not influence its desire to proceed with the acquisition. (It is not unreasonable to think that this statement was a way for the board to provide itself some cover from liability).
6. On Dec. 30, at another BofA board meeting, further discussions with regulators about the commitment of financial support were considered, and Mr. Lewis made clear his view that were it not for the systemic risk issues, the MAC clause should be invoked.  However, the commitment of government support to make BofA whole seemed, by inference from the board minutes, to be sufficient to put that problem aside.

This brief summary doesn’t do justice to the nature of the discussions already in the public domain among the regulators, the bank’s management, and its board.  But it does suggest several issues that should be explored in the hearings in the interest of transparency, since taxpayer money was being used to encourage a merger that management was otherwise reluctant to pursue.

First, it is clear that policy makers’ actions and concerns meant that they were functioning as a de facto systemic-risk regulator, even though there was no explicit authority to do so.  Second, in that capacity they knowingly committed taxpayer funds to make sure the merger went through, while not wishing to make that commitment known to either the general public or to BofA’s shareholders.  That is, as the de facto systemic-risk regulator they were exercising regulatory discretion to downgrade the interests of BofA’s shareholders in favor of what they perceived to be the undefined, but potentially negative, consequences of “systemic risk.”   In the process, the agency in charge of protecting shareholder interests – the SEC – was apparently not involved or informed in any way.  Third, while both Secretary Paulson and Chairman Bernanke have steadfastly asserted that they did not specifically advise Mr. Lewis on what his responsibilities were regarding disclosures to shareholders, this seems based on the available information to be a distinction without a difference.  It may be relevant from a legal perspective but not substantive as far as what was intended.  The testimony by Mr. Lewis suggests there was a threat, a commitment of funds to ensure that the transaction took place, an expression of concern about public disclosure, and the granting of regulatory forbearance, which together raise significant questions about intent. 

All of these issues will be explored tomorrow in greater depth, we hope.  More important, however, is the lessons that will be drawn by Congress at it considers regulatory and agency reform and what powers and authorities to grant to the responsible agencies in a financial crisis.  This case makes it clear that a crisis – and even non-crisis situation – can sometimes create conflicts among the interests of various affected parties or stakeholders, in this case the interests of the taxpayer, the financial system and real economy, and shareholders.  In a paper with a former colleague at the Atlanta Fed, Larry Wall, we pointed out that when a regulatory agency is charged with multiple regulatory goals (such as monetary policy, banking supervision, and consumer protection) any conflicts that arise will be resolved internally to the agency, with the most weight given to the objective which it deems most important.1  This means that agencies with overlapping regulatory responsibilities – as in the case of banking regulation and supervision – will oftentimes resolve those goal conflicts differently.  Hence, careful consideration should be given to deciding when the public interest is best served by having those conflicts externalized and when they can be resolved internally. 

That is what is at root in the current discussion about the Merrill Lynch acquisition.  Mr. Lewis and the BofA board were caught in the middle of a problem for which they potentially faced legal liabilities to shareholders for their actions and at the same time they must deal with the Fed and Treasury, who had other concerns.

Now, about the subpoena and the issues it raises.  First, it says something about both the continuing Congressional complaints of lack of transparency on the part of the Fed when it comes to the recent responses it has taken to the financial crisis, and the erosion of the Fed’s reputation and credibility with Congress.  That it should be forced, rather than acting voluntarily, to release information requested by Congress when there are less than compelling reasons for not releasing that information, sure looks like a power play between the Fed and Congress. 

Second, such subpoenas are extremely rare, indeed.  The last Congressional subpoena of the Fed was in 1990 when Congress subpoenaed the Fed to release examination reports on a foreign bank operating in the US, accused of channeling funds to Saddam Hussein.  In that case, the documents in question were actually the property of several state bank regulators and not the Federal Reserve.  The Fed was willing to release the documents, but state authorities used the courts to fight Congress’ right to obtain the documents from a secondary source.  The subpoena did not involve a substantive issue concerning the Fed itself.

Third, in this case, most of the documents requested relate to communications between the Fed, Mr. Lewis, and the Treasury, pertaining to the Merrill acquisition and not examination reports.  The Fed initially let the committee staff review the requested information on the Fed’s premises for several days.  The reason for this restriction on distribution of the documents was that the documents supposedly included information that had been collected under conditions of confidentiality.  Now, the committee has determined that it wants its members to have access to the documents.  What substance is in those documents that require direct inspection by each Congressman and that could not be conveyed by their staff remains a mystery.  It will hopefully be revealed tomorrow.  Also unclear at this time is whether the treatment of such documents would or would not be subject to the same confidentiality agreements negotiated between Chairman Greenspan and Congressman Gonzalez in 1991, pursuant to its request of the Saddam Hussein financial records.  Again, this looks like a power play between the Congress and the Fed rather than a substantive issue concerning regulatory reform, as discussed earlier.  As such it is simply another indication of the willingness of Congress to press the Federal Reserve on its independence – issues that arise because of the Fed’s multiple regulatory roles.

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