What a week we just had on Wall Street.  I believe I speak for a lot of people when I say, in my lifetime, I never thought I would see some of the chaos that ensued last week on Wall Street.  One event that brought a lot of attention to itself; the hastily assembled deal by Bank of America to buy Merrill Lynch for $50 billion in stock.

Over the weekend of September 12th through the 14th, several Wall Street executives met in New York to come up with a plan to bail out Lehman Brothers. Those talks quickly broke down when many different firms could not come to terms with Lehman.  One of those firms was Bank of America.

So, when that deal collapsed, the attention then turned to another storied Wall Street Investment Bank, Merrill Lynch.  John Thain, the chairman and CEO or Merrill feared his firm was next; that there would be a potential run on Merrill and the firm would face a liquidity crisis.  Some question John Thain’s rush to consummate this transaction, but it is clear he did not want his firm to face the same fate that Lehman did the following Monday, September 15th; bankruptcy and liquidation in US Bankruptcy court.

So how could this happen?  It is somewhat complex and beyond the scope of this little blog article, but I will do my best.  There are two major financial institutions that you have been hearing a lot about in the news; Money Center Banks and Investment Banks.  They may sound the same, but they really are structured, and regulated, much differently.

The term money center bank refers to the traditional brick and mortar bank branch you are familiar with; Bank of America, Wachovia, SunTrust, etc.  These are large bank holding companies that have many different separate entities under them such as retail banks, brokerage services, and in some cases, investment banking operations.  Now for the big difference, the money center banks have a large deposit base from their customers; in the case of Wachovia, about $400 billion in deposits.  These deposits are used to facilitate liquidity and the orderly operation of the entire firm, retail bank, investment bank, brokerage, etc.  The bank makes money off of the deposits it holds, and uses that money to fund ongoing operations.

Investment banks do not have this large deposit base; they make their money by consummating corporate investment banking deals, underwriting the initial public offering of a firm, etc.  There are typically large fees that are charged for these services.  Well, it comes as no surprise that the volume of those transactions has greatly diminished over the last 12 months.

So, when an investment bank needs additional capital, it has to go to the world wide capital markets and secure additional capital.  Well, that has been a little difficult as of late, especially as the credit quality of many of these investment banks has been deteriorating over the last several months.  Credit quality is like a credit score that is issued to large institutions, such as banks, giving an overall grade of the banks ability to meet its debt obligations.  The lower that score goes, the more it costs the bank to “borrow” funds to maintain liquidity and fund day to day operations.  Much like you and me; our score goes down and the cost for our credit increases.

In the case of Merrill, this is exactly what was happening.  Their cost of credit was increasing; they were facing a small liquidity issue on the Friday before all of this transpired; Lehman was on the brink of Collapse, so John Thain made a decision to protect the firm and his shareholders.  After all, that is what the CEO is supposed to do.

Only time will tell if this was a smart move on Bank of America’s part.  BofA is still digesting the purchase of Countrywide with all of the deteriorating assets that were on their books.  In fact, on October 20 the investing public will get to see what impact Countrywide is having on BofA’s balance sheet.  If the risks taken by BofA CEO Ken Lewis pan out, it is certainly going to make Bank of America a financial services giant, but it is going to take years to integrate all of these companies and begin realizing benefits of the combined company.