The Final Days of Merrill Lynch

It’s been almost a year since Bank of America agreed to buy Merrill Lynch, on September 15, for $50 billion in stock, in what now looks like one of the most fraught deals in the history of American business. The deal was announced on the same day that Lehman Brothers filed for bankruptcy protection and the day before Treasury and the Federal Reserve decided to throw an $85 billion lifeline to AIG, the global insurer that had foolishly underwritten the risks of the financial system. Although the end of Wall Street was imminent, Bank of America’s offer valued Merrill Lynch at $29 per share—a 70 percent premium over the stock’s closing price on the previous Friday, and nearly twice its book value.

Bank of America’s generosity allowed Merrill to dodge a bullet, as it was just days away from following Lehman into bankruptcy court. Merrill’s CEO, John Thain, had spent much of the previous weekend at the New York Federal Reserve Bank’s Italianate palazzo in downtown Manhattan, in strained discussions about the financial industry’s mounting distress, and he knew his firm’s future was imperiled. Like Lehman and Bear Stearns, which had failed six months earlier, Merrill had a balance sheet chock-full of problem assets that it had been using as collateral in the overnight-financing markets.

Thain knew the willingness of short-term lenders to keep funding Merrill would disappear rapidly if his firm lost the market’s confidence, as both Lehman and Bear Stearns had. Without short-term financing, Merrill would not be able to meet its obligations as they became due and the firm would fail. “I anticipated that the failure of Lehman would have caused very severe problems for Merrill Lynch,” Thain said afterward, “and the potential withdrawal of cash” would cause a severe liquidity crunch for the firm, with no easy solution.

By Sunday night of that infamous September weekend, Thain and Ken Lewis, the CEO of Bank of America, had cut their deal. “Acquiring one of the premier wealth-management, capital-markets, and advisory companies is a great opportunity for our shareholders,” Lewis said the next morning. “Together, our companies are more valuable because of the synergies in our businesses ... I look forward to a great partnership with Merrill Lynch.” Added Thain: “Merrill Lynch is a great global franchise, and I look forward to working with Ken Lewis and our senior management teams to create what will be the leading financial institution in the world, with the combination of these two firms.”

Even at the time, it looked to many like an odd union—a formerly high-flying Wall Street firm, founded in 1914, scooped up by the Wal-Mart of the banking industry, a Charlotte-based bank known for its brawn in commercial banking. Nonetheless, champagne toasts and all the usual corporate euphoria accompanied the announcement of the deal. For Bank of America, it was a move into the fast lane of high finance, and a validation of sorts: on October 19, a triumphant Lewis appeared on 60 Minutes, and to the question of whether he had conquered Wall Street, he responded, “We have, yes, we have won in that sense.” For Merrill, it was—if nothing else—a second lease on life.

Three months later—even before the deal closed—the engagement was on the rocks, the mood soured by staggering losses at Merrill, and Bank of America’s executives were looking for a way to break it off. What followed was an unprecedented series of steps, taken in December by Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson, to keep the two companies together.

Many of the most stunning details of the hidden negotiations between Paulson, Bernanke, and Lewis would have remained secret if not for the singular persistence of Andrew Cuomo, the New York attorney general, who in February took the depositions of both Lewis and Thain as part of his investigation into why Merrill, though reeling financially, had paid some $3.6 billion in bonuses to its employees before the deal closed. Cuomo has since released large portions of the depositions. The following account of the events that transpired during the waning days of the Bush administration comes from those transcripts, from the subsequent testimony of Lewis and Bernanke before Congress in June, and from interviews with insiders and knowledgeable observers. (Paulson, Bernanke, and Lewis all declined to be interviewed.) The narrative that emerges is troubling. It raises serious questions about the sanctity of legal contracts in post-crash America, and about the fast-evolving relationship between American government and industry.

At the time Lewis struck the deal with Thain, in September, he was plenty sanguine about Merrill’s financial prospects—and boasted about them publicly. In a February 2009 interview with Maria Bartiromo, on CNBC, Lewis said he and his team had seen “everything we needed to see” about Merrill. He pointed out that he had the benefit of the “very, very extensive” analysis done by Bank of America’s financial adviser, J. Christopher Flowers—the billionaire private-equity investor and former Goldman Sachs banker—who had first studied Merrill’s books in December 2007, when he was considering making an investment in the firm, and then again over the weekend the deal was struck. In a press conference on the morning of September 15, Lewis said that Flowers had told him Merrill’s balance sheet was becoming much more stable. “He was very complimentary of what [Thain] and his team had done,” Lewis said, “in many cases not only reducing the marks”—the value placed by Merrill on the securities on its balance sheet—“but getting rid of the assets, which is the best thing to do. So [Merrill had] a much lower risk profile than he’d seen earlier on.”

But in fact the firm’s finances were rapidly deteriorating. Lewis and his executive team began receiving weekly reports about Merrill’s condition immediately after he inked the deal in September. By the end of November, Merrill’s losses had ballooned to $9 billion, and some Bank of America officials had begun to doubt seriously the wisdom of the deal. Most of the losses were coming from wrong-way bets in the firm’s sales-and-trading department and from the continued write-down of squirrelly securities. But even Merrill’s crown jewel—its global network of stockbrokers—had suffered a severe decline in monthly revenue, from more than $1 billion in October to $797 million in December. Apparently, these losses were well beyond what Lewis or Flowers had thought possible.

With losses mounting, Lewis began to speak with his top managers and lawyers about the possibility of invoking the merger agreement’s material adverse-change clause—or MAC, as it is known on Wall Street—if Merrill’s condition continued to worsen. This legal escape hatch, built in one form or another into nearly every merger agreement, theoretically could have let Bank of America walk away at any point before the deal officially closed, on January 1, 2009. The MAC clause was nothing to trifle with; a slew of lawsuits by Merrill Lynch and its shareholders would almost certainly follow, and prevailing in court after invoking a MAC clause is exceedingly difficult. Still, if it came down to it, battling a lawsuit would be better than trying to inhabit a house aflame.

Another out was available, but it was only days from disappearing. On December 5, Bank of America’s shareholders would formally vote on the deal. If they voted no, the merger would be dissolved, with no legal obligations on either side.

The termination of the merger agreement with Bank of America would likely have meant the end of Merrill, since the firm was unlikely to be able to meet its debts as they became due. And presumably the termination would have been an embarrassment for Lewis, who had long coveted Merrill, and had championed the deal. With the shareholder vote nearing, and despite Merrill’s deteriorating finances, Bank of America’s executives and lawyers decided to move forward, with considerable “mixed emotions,” according to one of them, as reported in The Wall Street Journal in February: “Everyone wanted to see the deal go through.”

On December 5, the shareholders of Bank of America approved the deal, as did the shareholders of Merrill Lynch. No information about Merrill’s growing losses was provided to Bank of America’s shareholders before the vote, as several members of Congress noted at a June hearing to investigate the merger.

Lewis “had an easy out before the shareholder vote,” a senior Wall Street mergers-and-acquisitions banker, who was also trained as a Wall Street lawyer, told me. “He could easily have disclosed to his shareholders that ‘We have done two months of due diligence now, and look at the 600 things we’ve found.’ I’ve always wondered how could it be that they did not disclose to the world what they knew before December 5.”

Some observers say Lewis’s failure to disclose to his shareholders the extent of the problems at Merrill before the shareholder vote may have constituted securities fraud: a violation of the Securities and Exchange Commission’s rule 10b-5, which prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. “He committed classic securities fraud,” the senior Wall Street mergers banker says flatly. “He had a material knowledge of a material event in the middle of a shareholder vote.” A Bank of America spokesperson, in an e-mail response to my questions about the company’s disclosures, simply said, “We believe we made the required disclosures before the December 5 shareholders meeting.” At least eight shareholder lawsuits have been filed against Lewis, Bank of America, and Thain. CalPERS and CalSTRS, two California pension funds that together own 38.5 million Bank of America shares, are seeking to lead a consolidated class-action lawsuit against the bank for failing to disclose the facts about Merrill before the December 5 vote.

After the vote, Lewis was nearly euphoric. “It puts us in a completely different league,” he said. Meanwhile, Bank of America’s internal lawyers and its external counsel at Wachtell, Lipton, Rosen, & Katz continued to debate whether the Merrill losses would constitute a MAC or were, as some believed, comparable to what other Wall Street firms were experiencing. It was not an easy call, given the high stakes and the plenty ambiguous wording of the clause, which expressly excluded, as reasons to void the contract, changes in “general business, economic or market conditions.”

Based on recent case law, most litigators had concluded that nothing short of a metaphorical nuclear war would allow the MAC’s successful invocation. “In my mind, there were several minuses,” Lewis said in his February deposition, recapturing his earlier thinking as the days passed and the news of Merrill’s losses grew worse still. “We could have done the MAC and then have [Merrill] go bankrupt. Then you would lose your case, and you have a company that’s damaged pretty badly and you have to take it anyway.”

On December 9, Joe Price, Bank of America’s CFO, reported Merrill’s still-increasing losses to the bank’s board of directors. On December 14, Price called Lewis and told him that Merrill’s losses were now $12 billion. (By the end of December, they reached $15.3 billion.) Lewis later said that what he mainly remembered from the conversation with Price was just the “staggering amount of deterioration” in Merrill’s financial performance.

Shortly after the December 14 call from Price, Lewis began to worry that Merrill’s losses had simply become too great to bear. He consulted with counsel and again considered how he might abandon the deal. Ed Herlihy, the partner at Wachtell Lipton who had helped initiate the Merrill deal, and who had long acted as an adviser to Lewis, called Ken Wilson, a just-retired Goldman vice chairman and a friend and confidant of Hank Paulson, the Treasury secretary and former Goldman CEO. Wilson had joined the Treasury Department a few months earlier as an adviser to Paulson, and he listened in awe as Herlihy told him the magnitude of Merrill’s losses, and with dread as Herlihy told him that Bank of America was thinking about walking away from the deal. “The amount of devastation to the financial system if Merrill blew up would have been unfathomable,” Wilson told me in May. “It would have been Lehman squared. Just horrific.” He told Herlihy that Lewis should call Paulson directly.

On the morning of December 17, Lewis called the Treasury secretary from his office in Charlotte. “I told him that we were strongly considering the MAC and thought we actually had one,” Lewis recalled in his deposition.

“We probably should talk,” Paulson replied. “Could you be here by six o’clock?”

Lewis showed up at the Federal Reserve in Washington at the appointed hour, along with Joe Price and Brian Moynihan, Bank of America’s newly named general counsel (Moynihan would later succeed Thain atop the newly acquired Merrill Lynch). By then, Paulson had arranged for Bernanke to be there, too.

Lewis kicked off the discussion by talking about how Bank of America, in the fourth quarter of 2008, would likely suffer its first quarterly loss in 17 years—a loss entirely independent of the Merrill deal—and then Price walked Paulson, Bernanke, and their aides through the magnitude of the losses that Merrill had taken. “The main thing we were concerned about was the very large hole that would have been created” in Bank of America by Merrill’s losses, Lewis said in his deposition. The Bank of America executives then broached the idea of invoking the merger agreement’s MAC clause. But Paulson and Bernanke were unreceptive. They warned Lewis and Price against taking that step, and they urged caution. Lewis was told to “stand down” for the moment, he recalls, until Paulson and Bernanke had a chance to put their heads together. “And so we left,” Lewis said.

By December 20, Bernanke had come to the view that “the MAC threat is irrelevant because it is not credible,” according to an e-mail written that day by Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond, who had just spoken to Bernanke. “Also,” he wrote, Bernanke “intends to make it even more clear that if they play that card and then need assistance, management is gone.”

On Sunday, December 21, Lewis tracked down Paulson to talk more about the possibility of invoking the MAC clause. Just that morning, at 8:17, Mac Alfriend, a senior official at the Richmond Fed, had sent an e-mail to his colleagues: “Merrill is really scary and ugly.” About two hours later, Bernanke had written to his Fed colleagues, saying he thought Lewis’s “threat to use the MAC is a bargaining chip, and we do not see it as a very likely scenario at all.” He urged them to come up with “some analysis” to convince Lewis why calling the MAC “would be a foolish move and why the regulators will not condone it.”

Lewis first tried to call Paulson at Treasury, and was given his cell-phone number. He eventually reached the Treasury secretary at a ski cabin in Colorado. Paulson—known as “The Hammer” since his days on the offensive line at Dartmouth—did not mince words with Lewis. “I’m going to be very blunt,” he said, according to Lewis’s deposition. “We’re very supportive of Bank of America and we want to be of help, but the government does not feel it’s in your best interest for you to call a MAC.” According to Lewis, Paulson told him the government felt “so strongly” about this that he said, “We would remove the board and management” if Lewis tried to invoke it. At that, a shaken Lewis stood down again. He later said he knew that Paulson wasn’t joking around, and “that he wouldn’t say something that strong if he didn’t feel like it was a systemic risk as well.”

“Hank, let’s de-escalate this for a while,” he told Paulson. “Let me talk to our board.” Paulson seemed happy with Lewis’s suggestion to ratchet things back. “Good,” he said. “I’ll call Ben and tell him that.”

The next day at 4 p.m., Lewis convened a special board meeting via conference call, to convey management’s recommendation that the merger with Merrill Lynch be completed on its original terms. He reiterated Paulson’s view that a failure to complete the merger would result in a “systemic risk” to the U.S. economy—and that invoking the MAC clause would cause the Fed and Treasury to remove Bank of America’s management and its board of directors.

Although the government’s threat was unprecedented—and would have been almost inconceivable before the collapse of Bear Stearns in March 2008—Lewis argued against challenging Paulson and Bernanke. He also chose not to inform his shareholders or the public about his conversations with Paulson and Bernanke. “We bank 99 percent of the Fortune 1,000, … a third of all commercial companies, [and] every other American,” he said in his deposition. “If it’s bad for America, then it’s bad for us.” In his interview with Maria Bartiromo in February, Lewis elaborated. The decision, he said, came down to “enlightened self-interest. Because we’re so inextricably tied in with the U.S. economy and have such large market shares, what’s good for America is good for Bank of America.”

Enlightened or not, Bank of America’s self-interest would only later be fully disclosed: in return for swallowing Merrill despite its worsening troubles, Paulson and Bernanke had verbally promised Lewis more money from the TARP—the $700 billion Troubled Asset Relief Program, which had become law in October 2008—to bolster the capital of the combined firm. In addition, they promised to take billions of dollars of toxic assets off the company’s balance sheet.

Although this new deal with Treasury and the Fed could not be completed by the time the merger was to close on January 1, Lewis told his board he had received an oral commitment that the capital infusion and toxic-waste removal would be in place by January 20, the day Bank of America was to release its 2008 earnings report. Lewis said Bernanke told him, “We view you as strong and having acted appropriately in difficult circumstances … We’ll make sure you continue that way … We want to do something that when the public hears about it [the new government financing], your stock goes up.” That must have sounded welcome to Lewis. Around the time of the conversation, Bank of America’s stock had fallen, from almost $34 a share before Lewis had decided to buy Merrill to about $13.50 a share.

The board urged Lewis to try to get Paulson and Bernanke to put the government’s offer of more capital into writing, and he dutifully picked up the phone and called Bernanke to ask. “Let me think about it,” Bernanke told him. In the end, Bernanke didn’t speak to Lewis about the promised new financing; Paulson did. He told Lewis he didn’t want to put anything on paper. “First, it would be so watered down,” Lewis remembered Paulson telling him, “it wouldn’t be as strong as what we were going to say to you verbally. And secondly, this would be a disclosable event, and we do not want a disclosable event.” (Some legal authorities, of course, believe the discussions and correspondence to that point should have been disclosed to shareholders, since they were material and might reasonably have been expected to affect the trading of the securities of the two firms.)

Just before 5 p.m. on December 22, Lewis sent his board an e-mail. “I just talked with Hank Paulson,” Lewis wrote. “He said that there was no way the Federal Reserve and the Treasury would send us a letter of any substance without public disclosure which, of course, we do not want.” “Thought so,” board member Thomas Ryan, the CEO of CVS Corporation, wrote back five hours later.

Still, no board revolt came to pass. The minutes of the board meeting that day reveal a splendid piece of legal ass-covering: the board states for the record that it “was not persuaded or influenced” by the government’s threats to remove it and the management, and that it would reach the decision that was in the “best interest of the Corporation and its shareholders” without regard to the “representation”—threat—by Paulson and Bernanke. That noted, and snarky e-mail aside, the directors seemed content to follow Lewis’s lead.

Lewis, of course, had a problem on his hands. Because he could not get the government’s offer in writing, by going through with the deal he would be putting his company and his shareholders at a huge financial risk if Paulson and Bernanke changed their minds. Still he went forward, with no disclosures to his shareholders. “I had verbal commitments from Ben Bernanke and Hank Paulson that they were going to see this through, to fill that hole, and have the market perceive this as a good deal,” Lewis said in his deposition in February. “I was going on the word of two very respected individuals high up in the American government.”

When asked about whether he would have disclosed the risk to which he was exposing his shareholders if it had been up to him, Lewis replied, “It wasn’t up to me.” The particulars of the deal, he noted, were not up for debate either: “It was said that, ‘We want this deal done on time and on these terms.’ There wasn’t an ability to renegotiate.” But every deal can be renegotiated, right? “Not when you’re told that you can’t,” Lewis said. Asked whether he was angry that he didn’t feel he had a choice in the matter, Lewis replied, “I think I was a little shocked. Everything got back to the fact that I was shocked at how strongly they felt about the consequences… I think they were doing it in good faith. They thought everything they said—about the danger that Merrill’s failure would pose to the financial system—“was true.” Lewis conceded he could have said no and resigned, but he never considered doing that.

But there is no question that Lewis was growing increasingly worried about potential shareholder litigation. On December 22, Bernanke confided in an e-mail to his Fed colleagues that Lewis “now fears lawsuits from shareholders for NOT invoking the MAC, given the deterioration at ML.” Bernanke said he told Lewis that he didn’t “think that’s very likely,” but Lewis “asked whether he could use as a defense that the gov[ernment] ordered him to proceed for systemic reasons. I said no.”

Lewis nonetheless wanted a letter from Bernanke that could be used in Bank of America’s defense. Bernanke asked Scott Alvarez, the Fed’s general counsel, if they could give Lewis a letter saying that he had been formally advised that “a MAC is not in the best interest of his company.” On December 23, Alvarez wrote back: “I don’t think it’s necessary or appropriate First, we didn’t order him to go forward—we simply explained our views on what the market reaction would be and left the decision to him. Second, making hard decisions is what he gets paid for and only he has the full information to make the decision—so we shouldn’t take him off the hook by appearing to take the decision out of his hands.” Bernanke still wondered, “What would be wrong with a letter, not in advance of litigation but if requested by the defense in litigation, to the effect that our analysis supported the safety and soundness case for proceeding with the merger and that we communicated that to Lewis?” In response, Alvarez advised Bernanke to “hold fast” on any such letter. “I want to avoid the Fed being the centerpiece of the litigation,” he wrote.

On December 30, at another Bank of America board meeting, convened two days before the Merrill deal was to close, Lewis reported that since the December 22 board meeting, he had told “federal regulators—primarily Kevin Warsh, a Federal Reserve Board member—that “were it not for the serious concerns regarding the status of the United States financial-services system” and the consequences that would have befallen the financial system as “articulated by the federal regulators,” Bank of America would have invoked the MAC clause and sought to renegotiate the terms of the deal. He explained to his board that he had also told regulators that it was “appropriate” for the federal government to make Bank of America “whole for the deterioration in Merrill Lynch’s operating results and financial condition.” In his conversations with Warsh, Lewis explained Bank of America’s “needs and expectations” regarding the financing that Paulson and Bernanke had informally promised.

Lewis also reminded his board that Treasury and the Fed would not put its commitment to him and Bank of America in writing, because such “assurances” would require the “formal action” of the Fed and Treasury, and thus “require public disclosure,” which might have caused another crisis. Still, Lewis told the board, management had documented the commitment as best it could through “e-mails and detailed notes” of the conversations with Warsh and others. Lewis and Price shared with the board the various ideas they had discussed with Warsh, Bernanke, and Paulson about how the government’s new capital injection might work, and concluded by saying they would “continue to work” with federal regulators to make it all happen by January 20. “Robust discussion ensued,” the meeting minutes deadpanned, “including the Corporation’s recourse should the federal regulators fail to comply with their assurances on which the Board and management have relied.”

On January 1, Bank of America closed its deal with Merrill Lynch, as had been agreed in September. No aspect of the original terms was renegotiated. “We created this new organization because we believe that wealth management and corporate and investment banking represent significant growth opportunities, especially when combined with our leading capabilities in consumer and commercial banking,” Lewis said, mouthing the pabulum that typically attends corporate-merger announcements. He didn’t mention any of the profound events of the previous weeks. “We are now uniquely positioned to win market share and expand our leadership position in markets around the world.”

Bank of America ended up releasing its 2008 financial results 15 days later. Tucked into the press release was the news that Merrill Lynch had lost a staggering $15.3 billion in the fourth quarter. In the same press release was the first public announcement of Bank of America’s secret deal with Paulson and Bernanke. The government would invest another $20 billion into Bank of America—bringing the total TARP funds at the bank to $45 billion—and would also “provide protection against further losses” on $118 billion in toxic assets, primarily taken from the Merrill Lynch balance sheet.

In a narrow sense, Lewis’s gamble had paid off. But the merger—even with the government’s largesse accounted for—has proved so far to be a lousy deal for Bank of America and its shareholders. On January16, the bank’s stock closed around $7 per share, as investors worried about both the size of the losses and the need for another government bailout. It reached its nadir of $3.14 per share six weeks later, a collapse of 90 percent since before Lewis decided to do the Merrill deal. (In June, after the bank raised $38 billion, $4.1 billion more than the $33.9 billion of new capital mandated by Treasury’s “stress tests,” the stock was trading at around $12 a share.) The backroom dealing and arm-twisting that kept the deal moving may have succeeded in saving Merrill from immediate collapse, but only at the expense of the health and stability of the nation’s largest bank—an institution far more important, systemically, than Merrill, and one that must now be propped up, indefinitely, no matter the cost.

On one level, the merger between Bank of America and Merrill Lynch is a simple story of executive hubris and cowardice. Leaving aside the question of whether Lewis’s failure to publicly disclose new information—about Merrill’s losses, about his deal with Paulson and Bernanke—was legal, his passivity throughout the process was, in the eyes of some financial-industry insiders, contemptible. One senior Wall Street executive, upon learning of Lewis’s actions, was incredulous. “There is no question what I would have done if I were in his shoes,” he told me. “I would have told [Bernanke and Paulson] I was calling the MAC, was releasing the decision publicly, and dared them to fire me and the board—and that never would have happened, trust me.” Even a former Merrill Lynch executive, who was involved in the sale of the company to Bank of America and was familiar with the MAC language in the contract, said Lewis should have used Merrill’s fourth-quarter losses and the threat of calling a MAC as leverage to renegotiate downward the absurd price of the Merrill deal. “He could have used the MAC clause as a pretext to renegotiate the deal,” he said. “That would have been a prudent thing to do.”

Mark Sunshine, the president of First Capital, an international commercial lender, is somewhat more charitable. He worries that Ken Lewis’s decisions have exposed Lewis to civil liability, and “could have criminal implications.” But he also told me he knows how difficult it would have been for Lewis to ignore the requests of the Treasury secretary and Federal Reserve chairman in a time of financial crisis. And he said he is not sure, under the circumstances, whether he would have acted all that differently. “In those circumstances, most people would do what they were asked to do,” he said.

A moment later, after some reflection, he added, “But it also sounds an awful lot like what happens in a banana republic or in Putin’s Russia, when the captains of industry did favors for the government in exchange for economic subsidies. How do you stop from going down the slippery slope and becoming like Putin’s Russia?”

The most important questions arising from the Bank of America–Merrill Lynch merger do not involve Ken Lewis. They involve Hank Paulson, Ben Bernanke, and the U.S. government.

In an interview with Andrew Cuomo, Paulson “largely corroborated” Lewis’s rendition of the events of December 2008, Cuomo wrote in an April 23 letter to federal officials. “Secretary Paulson indicated that he told Lewis that if Bank of America were to back out of the Merrill Lynch deal, the government either could or would remove the Board and management.” Paulson told Cuomo he “made the threat [to Lewis] at the request of Chairman Bernanke”; but Bernanke would not discuss the matter with Cuomo, invoking the Federal Reserve’s little-known “bank-examination privilege,” which was designed to preserve candor in communications between bankers and examiners. Bernanke did testify before Congress on June 25: “I did not tell Bank of America’s management that the Federal Reserve would take action against the board or management,” he said. A spokesman for Paulson later said Paulson’s admonitions to Lewis were “his own” and not made at the behest of Bernanke. Regardless, the pressure that both Bernanke and Paulson put on Lewis was extraordinary—and questions about the legality and propriety of these actions are serious enough to have spurred a congressional investigation, still ongoing at the time of this writing.

Some observers are convinced that government officials crossed a line—“There’s no question there was coercion and bribery here,” argues Sunshine. But based on available evidence, none of the legal experts with whom I spoke believed that the government clearly broke any laws. H. Rodgin Cohen— the senior partner at the law firm Sullivan & Cromwell and an ultimate Wall Street insider—does not fault public officials for doing what they believed at the time to be in the best interests of the financial system. “There are differences between persuading and helping people understand where their best interests lie, and actually abrogating a contract,” he told me. “People want a proactive administration, but there is a difference between being proactive and violating the Constitution. You can adhere to the rule of law and have a clear sense that the rule of law can be used proactively to accomplish what you are trying to accomplish.”

In any case, and for better or worse, the federal government has reached deep into the financial-services industry in its response to the crisis. Through the extension of TARP funds and other mechanisms, it has gained heavy leverage, and is likely to retain that leverage for at least the next several years. And as the long aftermath of 9/11 has shown us, novel exertions of federal power and the suppression of private rights, undertaken in moments of crisis and confusion, can become cancerous precedents.

The question many Wall Street executives are asking themselves—and the single most important question to come out of the whole affair—is whether last December’s undisclosed pas de deux between Lewis, on the one hand, and Paulson and Bernanke, on the other, represents a onetime event or whether, in the post-TARP world, both Wall Street and Main Street should expect to see the long arm of the government interfering with business deals and private contracts on a more regular basis.

“As a legal matter, the sanctity of contracts is fundamental,” said Cohen, who has been a legal adviser to many of the banks that faced recent crises. “And I don’t know how you go much beyond that, because once you destroy that foundation, then it starts to affect the underpinning of all business relationships—which assume that contracts are enforceable.”

As the crisis has receded this year, the government has remained aggressive, seeking business outcomes it finds desirable with some apparent indifference to contractual rights. In Chrysler’s bankruptcy negotiations in April, for example, Treasury’s plan offered the automaker’s senior-debt holders 29 cents on the dollar. Some debt holders, including the hedge fund Xerion Capital Partners, believed they were contractually entitled to a much better deal as senior creditors holding secured debt. But four TARP banks—JPMorgan Chase, Citigroup, Morgan Stanley, and Goldman Sachs—which owned about 70 percent of the Chrysler senior debt at par (100 cents on the dollar), had agreed to the 29-cent deal. By getting these banks and the other senior-debt holders to accept the 29-cent deal and give up their rights to push for the higher potential payout they were entitled to, the government could give Chrysler’s workers, whose contracts were general unsecured claims—and therefore junior to the banks’—a payout far more generous than would otherwise have been possible or likely. Essentially, the government was engineering a transfer of wealth from TARP bank shareholders to auto workers, and pressuring other creditors to go along.

On April 30, when President Obama announced the bankruptcy, he forcefully stated the White House position: “While many stakeholders made sacrifices and worked constructively,” he said, “I have to tell you, some did not. In particular, a group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout. They were hoping that everybody else would make sacrifices, and they would have to make none. Some demanded twice the return that other lenders were getting. I don’t stand with them. I stand with Chrysler’s employees and their families and communities.”

In the face of this kind of political pressure, Perella Weinberg, the owner of Xerion, backed down. “In considering the President’s words and exercising our best investment judgment,” the firm said in a statement, “we concluded that the risks of potentially severe capital loss that could arise from fighting this in bankruptcy court far outweighed any realistic potential upside.” Tom Lauria, an attorney who was representing the firm during the negotiations, said in a May 1 radio interview that his client had been told by the administration that the White House press corps would destroy Perella Weinberg’s reputation if it continued to fight the deal. He later told ABC News that Treasury adviser Steven Rattner had made the threat. (The White House denied making any threats, and Perella Weinberg denied Lauria’s account of events, without elaboration.) Lauria said, in his radio interview, “I think everybody in the country should be concerned about the fact that the president of the United States, the executive office, is using its power to try to abrogate that contractual right.”

A somewhat similar story played out during GM’s bankruptcy—the government again put together a deal that looked to many like a gift to the United Auto Workers at the expense of bondholders, who were pressed hard to quickly take a deal that would leave them with 10 percent of the equity of the reorganized company (plus some out-of-the-money warrants) when they likely would have been able to negotiate for more in a less well-orchestrated bankruptcy proceeding. The Obama administration also famously browbeat AIG employees, who had a contractual right to some $165 million in bonuses, to void that right. (In the face of the government’s pressure and the public outcry, some 15 of the top 20 recipients of the retention bonuses agreed to give back a total of more than $30 million in payments.) Curiously, the government has put no pressure on Merrill executives to return their $3.6 billion in bonuses that were paid out in December 2008, even though the company had suffered those huge losses.

“The rules as to how the government will act are not what we learned,” explained Gary Parr, the deputy chairman of Lazard and one of the leading mergers-and-acquisitions advisers to financial institutions. “In the last 12 months, new precedents have been set weekly. The old rules often don’t apply as much anymore.” He said the recent examples of the government’s aggression are “a really big deal,” but adds, “I am not sure it is going to last a long time. I sure hope not. I can’t imagine the markets will function properly if you are always wondering if the government is going to step in and change the game.” One former Treasury official in the Bush administration told me he believes that the Obama administration has been disturbingly heavy-handed with the automobile companies and those who have lent to them. “It’s very easy, when you’re holding all the cards, to impose your will,” he said. “And when you are the only source of financing, forget it.”

It can be hard to find sympathy for some of the people now decrying the government’s actions. And surely, the fat cats who always seem to find a way of bending the system to their advantage should be expected to make concessions as we seek to right the economy—especially where bankruptcy and taxpayer bailouts are concerned. Many observers have argued that if anything, the government has not been aggressive enough in reforming the financial system. But there’s a difference between reform—the development and application of new, clear standards for the system as a whole—and ad hoc interference.

The pattern of government intervention in the past year is at times bewildering. Why did Paulson and Bernanke decide to save AIG and Merrill, but not Lehman? Why did they let Merrill pay $3.6 billion in bonuses but make a federal case out of the $165 million paid out to AIG’s professionals? How should businesses and investors think about bond purchases, mergers, compensation, and a range of other activities that are essential to a smoothly functioning economy, but now carry the uncertainty of potential government intervention? Creeping uncertainty of this sort would inevitably slow and distort the economy. It would also lead to charges of crony capitalism and favoritism—indeed, it already has.

The legacy of the crash and our response to it has yet to be fully written. And we will never—can never—know if the actions taken by Bernanke and Paulson in December prevented a meltdown many times worse than the one we experienced last fall. Given the gravity and the time pressure of the situation, it is perhaps best to give them the benefit of the doubt.

Yet the very success that Bernanke and Paulson (and later, the Obama administration) seem to have had in ameliorating the crisis may, over time, carry unintended consequences. Pressure for aggressive reform of the financial system appears to have waned in recent months. Meanwhile, the pressure applied on Bank of America and other private institutions, as it has come to light, has for the most part been met with a collective shrug (although some members of Congress, particularly Democrats Dennis Kucinich and Elijah Cummings, seem determined to get to the bottom of who did what to whom and why). This raises the possibility that Treasury and the Fed will continue to simply manage the financial industry informally for some years to come, confident in their ability to pull the right levers and twist arms when necessary behind the scenes. That’s a scenario that seldom ends well; we should hope it doesn’t come to pass.

Last September, as Wall Street turned to rubble and panic threatened to come unleashed, Ken Lewis, the CEO of Bank of America, agreed to swallow Merrill Lynch, one of the country’s most toxic investment houses. The deal was not altogether voluntary; as details have slowly emerged, the coercive role of the Fed and Treasury has loomed larger. What exactly happened in the weeks leading up to the merger? Did the deal save us all from economic apocalypse? And what does the government’s unprecedented role in it portend for the future of our economy?