Never Say Never Again With Too Big To Fail

In the financial services industry of the future, too big to fail may be both a bigger understatement and bigger possibility than today—and at no small cost.

The proposed mergerof Bank of America and Merrill Lynch will create a financial colossus whose brokerage unit assets alone total $2.4 trillion, about one fifth of the nation’s gross domestic product.

The takeoverof Fannie Maeand Freddie Macmeans a giant with mortgage liabilities of some $5 trillion dollars. (You do the math, this time.)

If shotgun-wedding consolidation with Uncle Sam in the role of best man is the answer to today’s credit crunch, who'll be big enough and strong enough to absorb the weak in the next crisis.

“Today's solution won't be on the table next time,” says the Cato Institute’s Gerald O’Driscoll, who held senior posts at the Federal Reserve Bank of Dallas and Citigroup.

Bigger Than All Of Us

Recent events, including the Fed’s massive loan packageto AIG, have stoked new, heated debate about the too-big-to-fail argument.

“I’ve never advocated anything is too big to fail," Sen. Richard Shelby, ranking Republican on the Senate Banking Committee, told CNBC. “The market should work itself out.”

“We have to get beyond too big to fail,"added former Treasury Secretary John Snow, now chairman of Cerberus Capital Management. “That is not an operating principle on which you can organize a well functioning economy."

Unfortunately, right now it's arguably all we have; some say that won't change. If the Federal Reserve is the lender of last resort, then a federal bailout is the remedy of last resort. Think of a market where JPMorgan Chase (Bear Stearns), Bank of America (Merrill Lynch) and Citigroup (insert brokerage name of your choice) are in a league of their own, doing business with the equivalent of Uncle Sam’s Mortgage Company and trouble arises.

“I think what the government did with AIG is going to happen when we have big firms in future,” says William Isaac, chairman of the FDIC from 1981-1985. “In the end, if a very big firm gets in trouble it’s going to be the government and taxpayer [that bails it out.]"

Isaac ran the FDIC during the big financial crisis of the 1980s, known as the Latin American Debt Crisis. A relatively small group of money center banks, including the original Citibank, refused to refinance billions of debt held by cash-strapped governments. A full-blown crisis was averted when the banks and US government worked out a discount-repayment plan and wrote off billions of dollars.

Remedy Of Last Resort

“Our concern was that one or two countries defaulted on the debt,” Recalls Isaac. “We had a contingency plan in place to nationalize [the banks]. That's always going to be the answer."

A decade later, despite initial resistance to a government bailout, the savings and loan crisis required one, costing taxpayers around $150 billion, and requiring the creation of a special government entity, the Resolution Trust Corporation, to handle the mess.

“There was a lot of denial,” says former thrift regulator and White House economist, Lawrence White, now a professor at NYU’s Stern School of Business. “It became clear the requirements would overwhelm the system.”

A similar realization is taking place in Washington now with Treasury Secretary Henry Paulson proposing the creation of a government entity to take on "hundreds of billions" of dollars in bad mortgage-based debt.

Going forward, if we’re stuck with a system of too-big-to-fail institutions, a new class of financial giants may have some merit.

Though the current consolidation won’t prevent another crisis, it is easier to deal with one if the risks are centralized, says author and economist William Silber, also of NYU’s Stern School of Business.

He cites the Latin American Debt Crisis, whose players were few in number but large in size, as a positive example.

“I'm not saying you're not going to get into a problem, but you'll have an orderly focus,” says Silver. “You want those risks where you can see them.”

In the credit crunch crisis, regulators and executives have struggled with the breadth of the exposure, its lack of visibilty and the transparency of some of the financial products.

Independent bank analyst Bert Ely welcomes the consolidation. “It's taken market forces to really bring it out,” he says. “Long term it's a very healthy trend.”

Regulatory Puzzle

As long as there's new regulation to deal with it.

The Bank of America-Merrill deal, in particular, creates a “complicated institution,” says O’Driscoll. “Whatever the uncovered parts of this are, the Fed and SEC are going to have to sit down and say this is how we're going to cover this.”

Existing legislation has firewalls, including one separating commercial and investment banking activities, meant partly to protect depositor money insured by the federal government.

Ely isn’t concerned about potential breaches, but others say given the high degree of risk these days, another look is warranted.

“We have a banking system that has a strong regulatory presence,” says Isaac, citing in-house bank examiners and reporting requirements, among other things. “None of that framework exists for the investment banks.”

White says if federal money is going to be at risk then the government needs regulatory tools to limit exposure, what he calls a safety-and-soundness regime for investment banks: “Minimal capital requirements, limitations on activities that may be too risky, managerial competency requirements, and clear powers of receivership for an insolvent institution.”

The absence of the last item has proved both problematic and costly, aptly illustrated by the different ways federal authorities have handled the crises at Bear Stearns, Lehman Brothers, AIG and IndyMac.

“We need to catch up with oversight and regulation and transparency,” GOP presidential hopeful Sen. John McCain recently told CNBC. "We're not going to have the taxpayer assume responsibility for any failures ...