Too Big to Fail, Too Big to Bail

It's a tough time to be Ben Bernanke or Hank Paulson. These two economic bigwigs currently rule the glorious land of government bailouts. From Chryster in 1979 to savings savings and loan institutions in the late '80s and early '90s to today's small army of financial companies, the government's often called in to save businesses indisputably too big to fail.

Bear Stearns, Freddie Mac (NYSE: FRE  ) , and Fannie Mae (NYSE: FNM  ) are just the most recent examples. If the credit crunch reaches the magnitude forecasted by NYU professor Nouiel Roubini -- an eventual $2 trillion in debt-related losses -- they might not be the last giants needing a rescue from Uncle Sam.

Who deserves to be saved?
How big is "too big to fail"? It's tough to quantify. Bear Stearns certainly fit the mold: Had it collapsed, the entire global financial system could have gone belly-up overnight. Fannie and Freddie? Of course, we can't let them fail. Not only does housing rely on them functioning properly, but their failure would also demolish foreign investors' confidence.

Few dispute that these companies need to be saved. Bernanke was spot-on when he recently said, "The truth is that the beneficiaries of [the Bear Stearns bailout actions] were not Bear Stearns, and were not even principally Wall Street. It was Main Street.'' Despite the arguments over moral hazards and nationalization, he's right. The ripples from letting Bear Stearns go bankrupt would have spread like wildfire. These firms are simply too big for the government to let them fail.

But for how much longer?
Frustratingly, not only are so many institutions too big to fail, but all of them are also too big to bail. Where does the bailout money come from? Taxpayers, the newspapers tell you, but that's only partially true. Future generations of taxpayers will bear the greatest burden. The government is already running a huge deficit -- money spent on bailouts only adds to the running tab, a facet of government bailouts that rarely gets discussed.

But, hey, what's done is done. No use pointing fingers. Why not try and do something crazy, like preventing more bailouts down the road? If something is too big and complex to fail, perhaps we should make it smaller and less complex.

Time for a diet, big boy
The list of companies too big to fail could be huge: Goldman Sachs (NYSE: GS  ) , Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , maybe even General Motors (NYSE: GM  ) and Ford (NYSE: F  ) , to name a few. Let's stick with financial companies for now, since they're the ones currently bringing down the house.

Now, it would be easy to slam the gavel and break every big bank up, but that's missing the point. Size isn't necessarily the problem; complexity and dependency are causing the ruckus.

We could do a couple of things that might prevent future implosions. One would be reenacting the Glass-Steagall act. In a shotgun summary, Glass-Steagall was a Depression-era law creating a firewall between commercial banks and investment banks, preventing banks that held everyday Joes and Janes' deposits from underwriting things like stocks, CDOs, CDSs, ARSs, SIVs, and other investments no one can understand.

That law was repealed in 1999, increasing financial flexibility and freedom. But the repeal also allowed banks to cook up innovative (read: ridiculous) financial products that are now leaving the banks in which you and I keep our money vulnerable to trouble. Don't get me wrong, I'm all for free markets, but I also think it's possible to take Ayn Rand too seriously. Reinstate Glass-Steagall, and average American's reliance on financial firms looking to hit one out of the park would drop. That would help.

Another tactic would be to start regulating the snot out of derivatives markets, particularly credit default swaps. This disastrous industry, which knots together all sorts of financial firms, could prove systemically deadly; it almost was with Bear Stearns. The scary part is that nobody knows who's holding what, who's relying on whom, and how intertwined one party is with the next. Start regulating CDSs like other securities, and the complexity and entanglement of financial firms would plummet. That would also help.

Let them fail. I dare you.
Bottom line: Banks need to be able to fail. Keeping bad banks alive might prevent catastrophe, but it also forestalls recovery. Need proof? Japan suffered a decade of misery after a gigantic real estate bubble buckled, leaving banks holding loans made to people who couldn't pay them back. (Sound familiar?). The government tried to prop up ailing banks for years to curtail the damage. It didn't work. What finally got Japan on track was letting banks jettison the garbage on their books, letting the bad ones fail, and starting over from scratch.

So please, Ben and Hank, bail when you need to. Just don't forget preventative care. This patient can still be saved.

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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. The Fool has a disclosure policy.  


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