Paulson Ordered the Code Red

Ken Lewis proved he was the best man to lead Bank of America ( BAC) after acquiescing to regulators' pressure to go forward with the Merrill Lynch deal, Former Treasury Secretary Henry Paulson told lawmakers on Thursday.

Paulson faced harsh questioning from members of the House Committee on Oversight and Government Reform, who said he acted inappropriately by bullying the CEO into the deal. Paulson says he did threaten to remove management if it walked away from the deal, confirming what Lewis and Federal Reserve Chairman Ben Bernanke had earlier said.

"I was attempting to send a very strong message to Ken Lewis in terms of how strongly the Treasury and the Fed felt about these matters," Paulson said in response to a question about regulators' heavy-handed tactics.

Paulson and Bernanke have defended their moves by saying the deal was necessary not only for the health of the incredibly fragile financial market last winter, but for BofA and Merrill as well. They also said that a legal analysis by government experts found that it would not have been legally defensible for Lewis to invoke a material adverse change, or MAC, clause to abandon the acquisition.

Paulson Parries Politicians

" Exercise of the MAC clause was not a legally reasonable option and, accordingly, that the merger contract was binding," Paulson said in a prepared statement. "Moreover, all public officials involved, including Mr. Bernanke and me, believed that the failure to consummate the merger would likely create immediate financial market instability, would threaten the viability of both firms, and would call into serious question the judgment of Bank of America's leadership."

He also said that the interests of BofA and the broader financial system "were aligned" in the deal, and that "there was not sufficient TARP capacity" to handle the "chaos" that would have ensued if BofA walked away from the deal.

But some members of the committee questioned why, if the leadership showed questionable judgment, Paulson and Bernanke hadn't ousted Lewis as CEO.

Their questioning comes at a vulnerable time for Lewis, after shareholders stripped the CEO of his chairman title and the board has faced a massive restructuring at the behest of regulators. The Wall Street Journal reported on Thursday morning what was widely suspected: That regulators were steering the ship of the leadership shuffle, under a secret memorandum of understanding.

Despite an apparent lack of support from shareholders, regulators and lawmakers who don't trust Lewis' judgment, Paulson insisted that he was still the best man to lead BofA.

"You have to ask yourself, is this management capable of running the firm, and is there someone else there or someone else you know of that can do a better job?...These large, complex institutions are not easy to run, and it's not easy to find people to run them during the time of a financial crisis," Paulson said, after noting that he had worked to find replacements for the top jobs at Fannie Mae ( FNM), Freddie Mac ( FRE) and American International Group ( AIG).

Detractors have assailed regulators, and particularly Paulson, as bullies who forced BofA into a bad deal, laden with toxic assets and additional bailout funds it would not have otherwise had to receive. Some shareholders and observers have been critical of BofA neither disclosing Merrill's escalating losses as soon as they became evident, nor the back-door discussions with regulators.

Both Paulson and Bernanke assert that they never pressured BofA to keep mum about anything it was legally required to disclose.

Paulson is the last of the trifecta of decision-makers to publicly disclose details about how the Merrill deal went down. Lewis first disclosed the discussions in sealed testimony to New York Attorney General Andrew Cuomo, which were eventually made public. Bernanke testified last month.

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