BofA-Merrill tale: Paulson's turn

WASHINGTON (CNNMoney.com) -- Did government officials overstep their authority and force Bank of America to take over troubled Merrill Lynch at great taxpayer expense?

That's what lawmakers plan to ask former Treasury Secretary Henry Paulson, who returns to Capitol Hill on Thursday to testify about the controversial deal struck during the height of the banking panic last fall.

Members of the House Committee on Oversight and Government Reform will do the questioning. The panel has already grilled the chiefs of Bank of America (BAC, Fortune 500) and the Federal Reserve.

Last September, Bank of America's purchase of Merrill Lynch was trumpeted as good news -- an example of the financial sector saving its own -- especially when compared to the near-simultaneous bankruptcy of Lehman Brothers.

Yet, the BofA-Merrill deal later nearly collapsed and was rescued by billions of taxpayer dollars and government intervention, the full extent of which had not fully surfaced until officials started investigating earlier this year. The House Oversight hearings aim to get to the bottom of the government's role in salvaging the deal.

Paulson is expected to defend his role in helping save the merger after it started to come undone.

The merger's failure "would have threatened the stability of our entire financial system and the viability of both Bank of America and Merrill Lynch," Paulson said in prepared remarks obtained by CNNMoney.com.

For Paulson, the hearing will mark his first appearance before Congress since he left office in January. The former Treasury chief has been working as a visiting scholar at Johns Hopkins University's Paul H. Nitze School of Advanced International Studies. He is also working on a book about the financial crisis, according to former employees he has interviewed.

The panel's chairman, Rep. Edolphus Towns, D-N.Y., has said he is most interested in uncovering what turned Bank of America's acquisition of Merrill Lynch from a "private business deal" into one that hinged on another $20 billion bailout.

He says the decisions and negotiations that eventually led to a bailout in January have been "shrouded in secrecy."

The committee hopes Paulson can answer a series of questions. Among them: How did the government learn about Merrill Lynch's deteriorating financial condition? When and how did the government commit to providing more taxpayer dollars to Bank of America?

The lingering questions are particularly important, because they could prove impediments to lawmakers' willingness to endow regulatory agencies, including the Treasury Department and the Federal Reserve, with more tools to crack down on Wall Street.

"Before Congress acts on the president's financial services reform proposal, we need to have a thorough understanding of what caused the current financial crisis and how the federal government responded," Towns said last month.

But House Republicans, who lack much power due to Democrats' commanding majority, have used the BofA-Merrill deal to champion populist furor about the use of taxpayer dollars to bail out banks.

For example, the panel's ranking member, Rep. Darrell Issa, R-Calif., released letters he had sent to Treasury Secretary Tim Geithner and New York Attorney General Andrew Cuomo asking for more records about the acquisition.

"What exactly are they afraid we'll find?" his spokesman said.

Julian Zelizer, a Princeton University professor and expert in the history of Washington policy and politics, said the hearing gives Republicans an opportunity to raise questions about government intervention.

"Any kind of investigation into corruption of power, even if there's no validity to the attacks, is a way to raise questions about the broader Democratic agenda," Zelizer said.

The House panel's questions about the BofA-Merrill deal stem from separate probes by the New York Attorney General's Office and the Special Inspector General for the Troubled Asset Relief Program, the $700 billion bailout program enacted last October.

In December, Bank of America CEO Kenneth Lewis approached regulators, including Paulson and Fed Chairman Ben Bernanke, and threatened to scuttle the acquisition after discovering the scope of Merrill's losses, according to records released by Cuomo.

In his prepared testimony, Paulson said he believed that the economy, the financial markets and firms were "fragile" at that point. He was worried that there wasn't enough money in the federal bailout program to "respond to the financial chaos" to result from the collapse of the BofA-Merrill deal.

He also will talk about how he and other regulators believed that if the deal failed, the markets would question the health of BofA, putting the bank's shareholders and the nation's financial system at risk.

After behind-the-scenes wrangling, BofA received $20 billion in aid in January on top of $25 billion it received last fall as part of TARP.

The bank also got loss guarantees on $118 billion in assets to help the company absorb its purchase.

Paulson defended the extra bailout funding, saying he had made it clear since October that the government would act to prevent failure of systemically important firms.

"It was clear that if the merger proceeded, and the combined Bank of America-Merrill Lynch entity needed financial support, the government would work to provide such appropriate and necessary support," Paulson said in his prepared remarks.

Last month, when testifying before the House panel, Bernanke denied accusations that he threatened to replace Bank of America managers if they didn't go through with the purchase of Merrill.

Lewis told lawmakers that he felt pressure to go through with the acquisition.

E-mails among Fed officials that came to light last month suggested that Lewis may have used the threat of scuttling the Merrill deal as a so-called bargaining chip for more government assistance.

But Paulson is expected to explain that threats of replacing management weren't merely intended to push the company into going through with the deal. He stressed that BofA's withdrawal would show a "colossal lack of judgment" and jeopardize the companies and the financial system, giving the Fed the right to use its power to replace management.

"I intended to deliver a strong message reinforcing the view that had been consistently expressed by the Federal Reserve ... and shared by the Treasury, that it would be unthinkable for Bank of America to take this destructive action," he said.