Brendan McDermid / Reuters Snow falls on a Wall St. street sign in front of the New York Stock Exchange, February 25, 2010.

Why Rescue Big Banks?

What the Government Won’t Tell You but Should

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

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