WASHINGTON — Any doubt that the government did not strong-arm Bank of America Corp. into a merger with the troubled Merrill Lynch evaporated Thursday when former Treasury Secretary Henry Paulson unapologetically copped to the charge.
"I was attempting to send a very strong message to Ken Lewis in terms of how strongly the Fed and Treasury viewed this matter," Paulson told a House panel, referring to B of A's chief executive.
Paulson's message to Lewis: finish the Merrill transaction or lose your job.
Paulson told the House Oversight and Government Reform Committee that he and Federal Reserve Board Chairman Ben Bernanke were trying to protect the economy from a collapse of the financial system, which they feared might occur if B of A backed out of the Merrill deal.
But their aggressive action has spurred a debate over whether regulators should use a bank chief executive's job as leverage to accomplish a policy goal.
"It's not a good idea," said Chris Low, the chief economist at First Horizon National Corp.'s FTN Financial. "If it were, it would be better outlined in the regulators' responsibilities. Threats and extortion are not part of their powers."
Others argue that Paulson and Bernanke were right to get tough with B of A, since the Charlotte company was getting billions in government assistance.
"When they are coming to the government for support, then it's absolutely the obligation, I would say of the Fed and Treasury to say, 'You know, it's a quid pro quo. We are not just handing you money because we like you guys,' " said Dean Baker, the co-director of the Center for Economic and Policy Research.
Regulators have long had influence over the CEO suites at financial institutions.
The Federal Deposit Insurance Corp. Improvement Act of 1991 gave regulators the power to threaten removal of management if a bank is classified as substantially undercapitalized.
During the financial crisis, the government has canned the chief executives of Fannie Mae, Freddie Mac and American International Group. The FDIC is said to be pressing for a management change at Citigroup Inc.
But some observers view Paulson's pressure of Lewis in a different light.
For one, Lewis's job was threatened, not over B of A's performance, but because of the impact abandoning the Merrill deal might have on the broader economy.
"We're talking about using that very formal step in context, not just of the financial institution itself, but in terms of the bigger picture of the financial crisis," said Kevin Jacques, the chairman of the finance department at Baldwin-Wallace College. "This is a response to macro issues and it almost strikes me like we're taking bank regulation and making it another tool of economic stabilization, and that's trouble.
"Do you really want to use bank regulation as a discretionary tool for economic stabilization?"
There is also widespread suspicion of the justification that Bernanke and Paulson have offered for their interactions with Lewis: the already strained economy would falter if the transaction did not proceed.
A new e-mail that surfaced during Thursday's hearing indicated that even some Fed insiders found that argument "a little over the top."
It is "equally possible that the market looks at Merrill's 2008 [fourth-quarter losses] and sees [Bank of America] making a smart move by walking away from a Black Hole into which large amounts of time, effort and money would have been going," Adam Ashcraft, a staff member at the Federal Reserve Bank of New York, wrote in a Dec. 21 e-mail. "In other words, it is not clear that the market reaction to [Bank of America] is so clearly negative. It might be, but a little more balance here might be worthwhile."
Still, Cornelius Hurley, a former Fed lawyer who is now the director of the Morin Center for Banking and Financial Law at the Boston University School of Law, said Paulson's actions should be considered against the backdrop of their timing. Fannie, Freddie and Lehman Brothers had already collapsed and the market could ill-afford another catastrophe.
"It's a little like Bush and his reaction to 9/11," he said. "He did some wild and crazy things that a lot of people feel he should never have done, but what were his alternatives?"
But others point to options short of explicitly putting Lewis' job on the line. For one, Low said the regulators should have been better prepared for a possible Merrill collapse.
"They knew on the day that Bear Stearns failed that Lehman and Merrill were in trouble," he said. "They had a long time — months — to take steps so that they could put Merrill into receivership if necessary and they didn't do it. The reason Paulson felt compelled to force B of A to pick up Merrill was because there was no other process to do it and that's his fault."
James Barth, a senior fellow at the Milken Institute, said regulators could have employed public enforcement actions.
"You can have cease-and-desist orders," he said. "You can tell individuals they have so many days in which to engage in appropriate behavior."
At a minimum, said Robert Gnaizda, of counsel for the Black Economic Council, the Treasury and the Fed could have thrown their weight around more effectively. "Rather than threaten them with the loss of the jobs, create the incentives so they want to do a better job," he said.
As more about the Merrill transaction comes to light, some are suggesting the government could have simply nationalized B of A — at least temporarily.
"If this is what the government wants to do for the sake of the financial system, there's an easier way to do that and that's to nationalize the banks," Jacques said.
Baker, of the Center of Economic and Policy Research, agrees that nationalization may have been a more effective route.
"I'm sort of inclined to think in the case of B of A they should have" been nationalized, he said. "Why is it still a private company? Why do we still have the same management there? That's hard for me to see."
But Low views that option as even more disruptive than the saga over Lewis' job, which did not become public until months later.
"A big part of it is there was huge public opposition to any more government involvement," he said. "If we nationalized any of the banks at that point, there would have been a huge public outcry."
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Corrected July 17, 2009 at 7:53PM: An earlier version of this story misnamed the House panel before which former Treasury Secretary Henry Paulson testified on Thursday. He testified before the House Oversight and Government Reform Committee. An editing error was to blame.