Why Rescue Big Banks?

As the Obama administration reveals its plans for overhauling financial regulation, one question it has never answered squarely is just why Washington has been so concerned, over the last two years, with bailing out large financial institutions.

In August 2007, the U.S. Federal Reserve saw the chaos triggered by the bursting of the housing bubble as a liquidity crisis -- essentially a matter of banks mistrusting one another because of the unknown quantities of dubious assets on their books. So the Fed poured additional liquidity into the system to prevent contagion.

By March 2008, it became clear that the problem was not just liquidity, but solvency. So the U.S. Treasury decided to rescue the troubled investment bank Bear Stearns, forcing it into a shotgun marriage with JPMorgan Chase and providing an extraordinary $30 billion dowry from taxpayers to lubricate the deal.

Then, during the summer of 2008, new threats emerged as two other organizations deemed "too big to fail" veered toward collapse: Fannie Mae and Freddie Mac, the two giant mortgage companies that are "government-sponsored enterprises" with private-sector shareholders. In September, the Treasury felt compelled to step in and rescue them as well.

Soon afterward, to avoid looking like an easy touch, government officials allowed Lehman Brothers to be forced into bankruptcy, but the market reaction to that was so bad that they immediately reversed course, rescuing American Insurance Group with a combination of Treasury and Fed resources and asking Congress to approve a $700 billion Troubled Asset Relief Program. Then Treasury Secretary Henry Paulson initially planned to use the money to buy toxic assets from financial institutions. But that approach ran afoul of political pressures to avoid doing favors for financiers, so Paulson switched tactics and began to provide capital infusions to the financial institutions directly (in order to offset their financial losses on mortgage-backed securities, collateralized debt obligations, and other troubled holdings).

The Federal Reserve, meanwhile, introduced new mechanisms to buy financial assets in the marketplace. With the Term Asset-Backed Securities Loan Facility (TALF) -- the Fed's effort to resuscitate a functioning securitization market -- direct public-sector support for the private financial system will be extended to commercial real estate-related securities, securitized small-business loans, and whatever else the Fed chooses. The Federal Deposit Insurance Corporation, finally, has extended its guarantees of small bank deposits to nearly all bank deposits as well as bond issues of depositary institutions.

All this adds up to unprecedented trillions of dollars of public support for the financial system, an intervention that has generated substantial criticism. Many observers would have preferred to let big banks and financial institutions in trouble fail and be forced to restructure. Other critics accepted the principle of rescue, on the grounds that laissez-faire alternatives would have even worse consequences, but argued for full-fledged nationalization; since the government was going to be responsible for keeping the troubled firms in business, they reasoned, why not take the firms over directly? Even those who generally accept the actions of the semi-divine trinity -- first Paulson-Bernanke-Geithner, and now Bernanke-Geithner-Summers -- resolved to make sure that nothing like this could happen again by pressing for  cutting the banks down to manageable size and barring them from using excessive leverage.

Critics of the bailouts have raised a number of valid points that policymakers have so far shied away from confronting directly. Usually, such behavior means critics are right. But in this case, it doesn't. There are actually several good arguments for why the government's stepping in to preserve large private banks is a good idea -- but few officials have made them, most likely because they think the public wouldn't find the reasoning persuasive enough to justify spending such vast sums and mortgaging the country's future.

1. Big banks finance risk-takers. The U.S. economy needs risk-takers to provide financial services to the majority of citizens and businesses who are risk averse. For example, retirees who want to protect against a sharp downturn in the stock market using put options (contracts in which the buyer acquires the right to sell a financial instrument later at a predetermined price) need financial institutions able to sell them. And a U.S. architectural firm bidding, say, for the right to build a new shopping mall in Brazil, yet unversed in foreign currency risks, needs to be able to rely on a bank or other financial institution with the size, experience, and foreign connections to minimize those risks. Risk-takers such as hedge funds play an instrumental role in all this, and banks need to be large in order to accumulate the talent and facilities necessary to finance them. Small and medium-sized banks have tried but simply cannot do it.

2. Big banks finance deals, especially big ones. Large-scale mergers and acquisitions, as well as transactions involving private equity funds, normally require financing packages that are arranged in advance with complete secrecy. Moreover, even simply advising one side or the other in a big M&A transaction requires an immense array of expertise in a variety of disciplines: legal, regulatory, accounting, government relations, and media relations. Big banks that have been traditionally active in this area have these skills or know how to retain them.