July 16 (Bloomberg) -- Former U.S. Treasury Secretary Henry Paulson defended his role in pressuring Bank of America Corp. to complete its takeover of Merrill Lynch & Co. against lawmakers’ accusations that investors and the public were improperly kept in the dark.

The takeover happened “against a backdrop of unchecked government power,” Edolphus Towns, a New York Democrat and chairman of the House Oversight and Government Reform Committee, told Paulson at a hearing of the panel today. “This is unacceptable and must be prevented from happening again,” Towns said.

The committee is trying to determine whether government regulators put undue pressure last year on Bank of America, the biggest U.S. bank by assets, to complete the takeover during the height of the financial crisis. Chief Executive Officer Kenneth Lewis told Congress last month the bank considered abandoning the deal in December as Merrill’s losses spiraled toward more than $15 billion.

Paulson defended his role, saying that letting Bank of America abandon the takeover was “unthinkable” and that his statement that the Fed might remove management was “appropriate.” Allowing Bank of America to break its contract to buy Merrill would have been “very risky” and shown a “colossal lack of judgment,” Paulson said.

Extent of Problems

Paulson confirmed that he told Lewis the Fed might remove management and the board of the Charlotte, North Carolina-based bank if they didn’t complete the takeover of New York-based Merrill. Shareholders of both companies approved the purchase Dec. 5, before the bank said it realized the full extent of Merrill’s problems.

Paulson said he never discouraged Lewis from making required disclosures about Merrill’s losses.

“I never, ever suggested to him that he delay any disclosure,” Paulson said. He said he declined Lewis’s request that Treasury provide a letter confirming U.S. support because no program had been developed.

Lawmakers repeatedly expressed their skepticism.

“There are those of us that don’t agree with your analysis,” said Representative Dan Burton, an Indiana Republican. “I don’t think anyone is buying what you are saying.”

“You guys intimidated Mr. Lewis,” said Representative Jim Jordan, an Ohio Republican. There was “a pattern of deception,” he said.

$20 Billion Rescue

Bank of America in January sold $20 billion in preferred shares to the Treasury and agreed to a $118 billion loss-sharing agreement that was never implemented. Lawmakers pressed Paulson on why Lewis wasn’t fired as part of the rescue agreement.

Bailing out Bank of America without removing its top management “sent a signal to the management of all systemically significant banks that their mistakes and misdeeds will be treated differently and more gently by regulators,” said Representative Dennis Kucinich, an Ohio Democrat.

Paulson said, “These large, complex financial institutions are not easy to run and it’s not easy to find strong people to run them during a financial crisis.”

Regulators in January downgraded their overall rating of Bank of America to “fair” from “satisfactory” and are requiring the lender to overhaul its board and address risk and liquidity management issues, the Wall Street Journal reported today, citing people familiar with the situation. The board added four new members in June, while six directors have resigned since May.

‘Shake the Market’

The rescue funds were approved because officials believed the announcement of billions of dollars in Merrill losses would “truly shake the market,” Paulson said.

Paulson also said the Treasury Department repeatedly asked Bank of America to acquire Lehman Brothers Holdings Inc. in the days before the September collapse of the New York-based investment bank. Bank of America was “never seriously interested” because it wanted to buy Merrill, he said.

Lehman was forced into bankruptcy on Sept. 15 after a weekend of negotiations at the Federal Reserve Bank of New York failed to produce a buyer and Fed and Treasury officials decided not to provide a loan. Lehman’s failure caused the financial crisis to take “a quantum leap up in terms of seriousness,” Janet Yellen, president of the Federal Reserve Bank of San Francisco, said in an April speech.

Representative Stephen Lynch, a Massachusetts Democrat, and other lawmakers accused Paulson of misleading lawmakers over the bank rescue plan known as the Troubled Asset Relief Program, approved by Congress last year.

Changed Focus of TARP

Lynch said Paulson “in a matter of days” changed the focus from buying up toxic assets to bailing out banks.

“If you had come up here with Mr. Bernanke and said, ‘I have got a plan, I want to take $800 billion in taxpayer money and I want to give it to my pals in the nine biggest banks of America,’ how many votes do you think you would have got?” Lynch said, referring to Federal Reserve Chairman Ben S. Bernanke.

Responding to that criticism, Paulson said he and “many others” initially “underestimated” the extent of the financial crisis. The government needed to change gears on the TARP program as the “situation began to crumble around the world,” he said, adding that Congress allowed for such flexibility and taxpayers will get the bank-rescue money back with profit.

Goldman Sachs Profits

Representative Elijah Cummings, a Maryland Democrat, questioned how Paulson’s former employer, Goldman Sachs Group Inc., could report a record $3.4 billion second-quarter profit yesterday as U.S. home foreclosures hit record levels. “The people that are paying the price had nothing to do with the problem,” Paulson said. “It is a terrible thing.”

Bailing out financial firms has saved jobs and averted foreclosures, said Paulson, who was Goldman’s chairman from 1999 through 2006, when President George W. Bush tapped him to become Treasury secretary.

Bank of America completed the acquisition of Merrill Lynch on Jan. 1. Paulson said completion of the takeover and the rescue plan “not only protected our country’s financial system, but also was in the best interest of the shareholders, customers, employees and creditors of Bank of America and Merrill Lynch.”

The panel has already heard from Lewis, who declined to characterize the U.S. actions as a threat, and from Bernanke, who testified that Lewis had the final say on the Merrill takeover.

After the hearing, Towns told Bloomberg Television he wasn’t entirely satisfied with Paulson’s testimony. “We had some winners and some losers” during the financial crisis, Towns said. “How did we arrive at who was going to be a loser? We didn’t get that today.”

To contact the reporters on this story: Catherine Dodge in Washington at Cdodge1@bloomberg.net; David Mildenberg in Charlotte at dmildenberg@bloomberg.net

Last Updated: July 16, 2009 16:17 EDT