Yesterday, former U.S. Treasury Secretary Henry Paulson testified before the House Committee on Oversight and Government Reform regarding the acquisition of Merrill Lynch (ML) by Bank of America (BAC) in a hearing entitled “Bank of America and Merrill Lynch: How Did a Private Deal Turn Into a Federal Bailout? Part III”.

Chairman Edolphus Towns (D-NY) set the tone for the hearing in a strongly-worded opening statement in which he called the BAC-ML merger “a marriage of convenience,” and stated that the merger occurred “against a backdrop of unchecked government power, with no transparency or accountability.” He raised a number of questions that the Committee would address, most notably whether government officials pressured BAC to complete the merger and to refrain from public disclosure of escalating ML losses in exchange for the U.S. government’s commitment to provide billions in federal funding.

Under questioning from Chairman Towns regarding the events prior to the closing of the BAC-ML transaction, Secretary Paulson noted that while the Treasury was supportive of BAC, he indicated to BAC Chief Executive Officer Kenneth D. Lewis, who had testified at an earlier hearing before the Committee, that invoking the merger agreement’s material adverse change (MAC) clause would indicate a “colossal lack of judgment” and would jeopardize not just BAC and ML but also the financial system, since “the interests of the nation and Bank of America were aligned with respect to the closing of the Merrill Lynch transaction.” Allowing the merger to fail, he continued, could have caused “significant disruption to the interbank and credit markets which would have rippled out to financial institutions broadly.” Under questioning from Ranking Member Darrell Issa (R-CA) regarding a letter dated April 23, 2009, from New York State Attorney General Andrew Cuomo, in which the Attorney General stated that Mr. Lewis had indicated to him that if BAC invoked the MAC clause, its management and board would be replaced by the Federal Reserve, Secretary Paulson denied making any explicit threat but stated that he did explain to Mr. Lewis the Federal Reserve’s statutory authority to remove BAC management and its board of directors should it lose confidence in their competence. Later, Mr. Paulson characterized the conversation as one in which he reaffirmed the support of the government for BAC, but that he did not think MAC clause invocation was not a legally valid option for BAC. In testimony before the Committee on June 26, Federal Reserve Chairman Ben Bernanke also denied that he had threatened to oust BAC’s management.

Committee member Jim Jordan (R-OH) expressed his concern that, in meetings with representatives of financial institutions in late 2008 regarding TARP, Secretary Paulson pressured those financial institutions to take TARP funds regardless of whether those institutions needed those TARP funds. Mr. Paulson denied applying any pressure.

Mr. Paulson came under severe criticism from Congressman Stephen F. Lynch (D-MA) and Michael Turner (R-OH) who expressed the view that Mr. Paulson had misled Congress regarding the purpose of TARP. Mr. Paulson denied any intention to mislead Congress, noting that Treasury decided to shift the focus of TARP funding from asset purchases to direct equity investments in financial institutions during the ten-day period after TARP approval, when, he said, the “the situation changed dramatically,” triggering a shift in Mr. Paulson’s and Mr. Bernanke’s view of the most effective use of TARP funds.

Committee member Mike Quigley (D-IL) contrasted Treasury’s and the Federal Reserve’s response to BAC and ML with that of the bankruptcy of Lehman Brothers and discussed the concept of “moral hazard.” Quigley asked why the Treasury Department and the Federal Reserve considered a government bailout of Lehman a moral hazard and not Bear Stearns, AIG, and Fannie Mae and Freddie Mac. Paulson noted that Lehman had both a liquidity and capital problem and there were no buyers either on an assisted or unassisted basis, and a Federal Reserve loan would not have saved Lehman. By contrast, Bear Stearns had a willing buyer, J.P. Morgan, even though Bear Stearns also had a liquidity and capital problem. AIG was perceived as a liquidity, not a capital, problem. Therefore, according to Mr. Paulson, there were no Treasury or Federal Reserve powers (at that time) for direct equity investments in Lehman nor was there a buyer (as there was with Bear Stearns), even though Barclays later acquired some of Lehman’s operations. Mr. Quigley asked whether BAC had indicated an interest in buying Lehman but was ultimately dissuaded from doing so by the Treasury Department, and Mr. Paulson stated that, in his view, BAC was never serious about a Lehman transaction. Paulson denied any understanding between Mr. Lewis and himself, and that Paulson said that he viewed Mr. Lewis was fully capable of managing BAC.

In response to questioning from Committee members Jackie Speier (D-CA) and Paul E. Kanjorski (D-PA), Mr. Paulson stated that the completion of the BAC-ML merger meant that taxpayers had averted economic calamity and that the consequences of not completing it would have led to “chaos or people even questioning the basic system.”

Chairman Towns concluded the hearing by announcing that he intended to schedule a hearing after the August recess to include testimony from former SEC Chairman Christopher and current FDIC Chairman Sheila C. Bair regarding their roles in the events surrounding the BAC-ML transaction.