Too big to fail survives again

Richard Carnell in CNNMoney.com, June 25, 2010

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The financial reform legislation hammered out Friday morning on Capitol Hill closes many of the loopholes that led to the last crisis. But it stops well short of breaking the bad habit that has fed outlandish risk-taking for almost three decades: too big to fail.

How will they handle the next crisis?

The reform bill does take strides toward a safer financial system. It will create a process for liquidating troubled financial firms, making another AIG (AIG) less likely. It will boost oversight and transparency in the derivatives markets, making the crisis virus less contagious. It will charge a group of watchdogs with keeping an eye on systemic risk, which could keep Wall Street wagers from bubbling over.

"They have made solid progress setting up a system to ensure financial calamities are less frequent," said Raj Date, who runs the Cambridge Winter Center, a nonprofit financial policy consultant. "I would give it a B over all."

But to earn an A grade, reformers in Congress and the administration would have had to go further.

They could have confronted the biggest threats to the taxpayer-funded safety net, and tied their own hands to send the message they won't rush in to save the next big fool that gets in trouble.

Instead, they produced a 1,500-page bill that leaves the biggest financial firms untouched and preserves bailout powers that were infamously exploited in 2008.

So too big to fail, born in the 1984 bailout of Continental Illinois and assailed ever since, staggers forward to the next crisis.

"We need to reinforce the expectation that there will be no bailouts," said Richard Carnell, a law professor at Fordham University who served in the Clinton Treasury. "But the approach used here entrenches the bailout expectations."

Early on, the administration decided it wouldn't defang the biggest risk to financial stability: the giant banks whose size and appetite for risk makes many observers nervous, and the loss-soaked mortgage insurers Fannie Mae (FNM) and Freddie Mac (FRE).

A bill proposed in April by Democratic Sens. Ted Kaufman of Delaware and Sherrod Brown of Ohio would have capped bank size and leverage, forcing behemoths such as Bank of America (BAC) and JPMorgan Chase (JPM) to slim down.

Proponents say they believe the bill was gathering strength in a Congress animated by anti-Wall Street sentiment, but was defeated by the administration's opposition. Wall Street has been a huge campaign contributor, and the White House was loath to be seen supporting a bill that could cost high-paying jobs in a globally competitive industry.

"We were very disappointed in the way that vote went down," said Heather Slavkin of the AFL-CIO.

The new rules do give regulators tools to break up banks should they pose a threat to the health of the financial system. But once a big financial firm runs into problems, the market inevitably gets nervous.

Taking decisive action without either permitting market upheaval or resorting to bailouts "is very painful," said Date. "We still haven't instilled dramatically different debt-market discipline, and that's what we need to do."

To that end, it's distressing that one of the most infamous loopholes of the last crisis lives on: the rule that allows the Fed to lend to just about anyone if their problems threaten to upset the financial apple cart.

The bill would place conditions on the Fed's use of that power, but Philadelphia Fed President Charles Plosser would go further.

This week he proposed that the Fed relinquish that authority, which was used in a potentially costly taxpayer-backed 2008 sale of Bear Stearns to JPMorgan. Plosser said the Fed's bailouts undermined the agency's authority by allowing it to make spending decisions that rightly belong with Congress.

He called for an agreement that "would eliminate the ability of the Fed to engage in bailouts of individual firms or sectors and place such accountability where it rightly belongs — with the fiscal authorities."

But regulators aren't exactly turning cartwheels about anything that would impair their flexibility when the next crisis comes.

This, in turn, reassures creditors who lend freely to giant firms, assuming they will be saved by the taxpayer bell should a calamity develop. The free flow of capital to TBTF firms lets them grow at the expense of smaller rivals.

Until market overseers have a better grip on where the risks lie and show a willingness to act ruthlessly to stamp them out, the mentality that fed the last bubble will live on.

"Short term stability is what's popular," said Carnell. "But you have to be willing to accept some near-term instability for the sake of systemic health, and there is no sign that they are."