POWER PLAY

It was Dick Grasso's moment, the culmination of frantic, round-the-clock work by the New York Stock Exchange chairman to reopen markets after the attacks of 9/11. Six days later Grasso would show the world that the exchange's ability to lift itself off the mat was proof of the country's resilience. He had his lines ready: "Today, America goes back to business," he would soon declare to the waiting traders. But who would be joining him on the podium for the much-anticipated ringing of the opening bell? Certainly the titans of Wall Street thought they should share the spotlight.

Among them: Hank Paulson, chairman of the blue-chip investment bank Goldman Sachs and an NYSE director. But Grasso wanted only police, firemen and officials like Mayor Rudy Giuliani. Paulson would have to watch from the floor. After Grasso's ruling, he left to work on a client matter.

That incident was, in many ways, a prelude to the battle now consuming Wall Street over Grasso and the $139.5 million pay package that got him fired last fall. L'affaire Grasso, as many on Wall Street call it, is now widely viewed as a showdown between Grasso and Eliot Spitzer, the New York state attorney general who last week sued Grasso, charging that he misled the board about his contract. But the controversy is in fact the fallout of a much longer power struggle between Paulson and Grasso over who rules the Street. For now, it appears the Harvard M.B.A. man, Paulson, has bested Grasso, who was raised in working-class Queens, and didn't graduate from college. It was Paulson, after all, who worked behind the scenes to have Grasso fired. This battle has just started, and Grasso is digging in for a long fight, threatening to drag a parade of Wall Street executives into court as part of a countersuit he's said he will file shortly. Grasso says his reputation has been damaged, and he appears intent on doing the same to former colleagues on the NYSE board. Many on the Street say the PR fallout, which may worsen yet, resulted from miscalculations by Paulson that may cost him dearly in support from his peers and within his firm.

Paulson is trying to shore up his position. Lately he's been speaking frequently to officials at other firms--an unusual move for him, since he rarely socializes with rivals. "Tell me why Hank Paulson wants to talk to me?" asks one executive. (Paulson, through a spokesman, says he's simply trying to "limit the damage to the U.S. financial markets, not to cover his own backside.") Paulson is also trying to downplay his rivalry with Grasso, telling acquaintances that he in fact was "the best friend that Grasso never realized he had" because he told Grasso that it would be suicidal to take his $139.5 million payday in one lump sum. Paulson, in his only public comments about Grasso since the controversy erupted, told NEWSWEEK that he thinks the whole episode has been "a real tragedy." He acknowledges he led the ditch-Grasso effort, but says he had no other choice. "The only thing I thought about was protecting the institution and the credibility of the institution." He adds that a plaque at the exchange that lauds Grasso's 9/11 efforts should remain up, even though some Grasso opponents have fought to remove it. "I don't feel any animosity toward Dick," Paulson says.

But animosity is all that Grasso feels toward Paulson, and he routinely refers to Paulson as a "snake." NEWSWEEK has learned that Grasso will name Paulson in a countersuit. He will claim that Paulson never objected to the size of his pay when he was on the comp committee. Grasso also says Paulson helped him handle the controversy, suggesting he release details of his pay package close to Labor Day because "the press won't be around." Paulson doesn't dispute his account. After Labor Day, when Grasso was fighting for his job, he decided to give up a $48 million payment he was owed. Grasso says that during a conference call with the NYSE board, Paulson applauded the decision. "Dick, this is tremendous," Paulson said, according to two people who heard the conversation. "We support you and the great job you've done." Soon after, Paulson started campaigning to convince other NYSE directors that Grasso had to go. Grasso has said he can't wait to see Paulson "squirm" during cross-examination. Such a spectacle would not play well with Goldman directors, who prefer the company keep a low profile. "Goldman hates bad publicity," says a former executive. "The Grasso thing could produce a lot of bad publicity." Paulson's second in command, a savvy trader named Lloyd Blankfein, is said to be itching for Paulson's job. His chances improve if Paulson becomes too much of a lightning rod. The storm could still die down, however. Grasso is considering approaching Spitzer with a settlement offer: if the exchange donates to a charity the $48 million he says he's still owed, he will also donate about $10 million.

Paulson, by all accounts, made two critical errors. He played a key role in persuading former Citigroup co-CEO John Reed to take on the role as NYSE chairman. He had assumed the cerebral Reed would focus mainly on governance issues. But Reed hired lawyer Dan Webb to investigate how Grasso cut his deal. Reed then took Webb's report to Spitzer, who saw it as another high-profile case to burnish his rep. Paulson's second mistake was assuming that Grasso would not make the fight so personal. Grasso feels he has nothing to lose, and has no intention of settling. Despite the damage, Paulson says he has no regrets. "If I had to do it again, I would."

Why did Paulson misread the situation? According to laws of the Wall Street jungle, somebody wins, somebody loses and you move on (an avid bird watcher, Paulson's particularly fascinated by birds of prey). He's said he learned during a stint as a White House staff assistant in the 1970s that there should be no limits to aggressiveness. It's a lesson he's repeated to his bankers, and he's followed it religiously. He distinguished himself early at Goldman as a tireless worker. A CEO once confided to another Goldman banker: "If I don't give the business to Goldman, Paulson will call all my board members." He also capitalizes on other's weaknesses. In 1998 he was appointed co-CEO to run the firm with Jon Corzine. A year later he seized on Corzine's decision to help bail out the troubled hedge fund, Long Term Capital Management, and gained full control.

Paulson's relationship with Grasso through the years has been far more complicated. They have helped each other. When Grasso tried to persuade Bill Gates to list Microsoft on the NYSE instead of NASDAQ in 2003, he asked Paulson to make the call (he couldn't close that deal). Paulson also tried to warn Grasso about his decision last year to appoint former Citigroup CEO Sandy Weill to the NYSE board at a time when Weill was under scrutiny by regulators for any role in fraudulent stock research practices (he was never charged). "Let's wait until the fall when the controversy passes," he told Grasso, who ignored the advice, only to pull the nomination later. Paulson and Grasso have battled over the exchange's future, too, with Paulson arguing for electronic trading that could make floor specialists obsolete.

For all their ups and downs, though, it was Grasso who invited Paulson onto the NYSE board in 1999, and was a director when Grasso landed a single-year haul two years later of $30 million. One of Grasso's favorite lines is the old saying: "Keep your friends close, and your enemies closer." For Paulson, his ties to Grasso no doubt feel too close for comfort these days.