The Banks January 24, 2008, 5:00PM EST

Too Big to Fail

If a major bank slips into deep trouble, Uncle Sam may have to help save it

By David Henry, with Stanley Reed in London and Cristina Lindblad and Paula Lehman in New York

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If a major bank slips into deep trouble, Uncle Sam may have to help save it Scott Menchin

It's the question bank regulators dread: Should they bail out a crucial bank if it collapses?

With economic and market conditions sliding precipitously, risk is rising fast that at least one major institution could implode, endangering the financial system with it. The way the Federal Reserve and other government watchdogs deal with a blowout could determine how much damage is left by the current credit crisis.

With banks getting battered on a number of fronts, the odds of an outright failure are higher than they've been in years. Troubled ones are discovering that the protection they bought from bond insurers, including Ambac (ABK) and ACA Capital, for subprime and other securities is inadequate. Given the problems in that industry, on Jan. 23 New York State regulators met with major investment banks as part of an effort to stabilize bond insurers, which guarantee about $800 billion of complex financial products such as mortgage-backed securities and collateralized debt obligations (CDOs).

Banks may face more pain from commercial real estate loans, credit cards, and corporate loans, all of which show signs of weakness. Loans to highly leveraged hedge funds that bet heavily on global stocks are also in jeopardy. Meanwhile, housing prices remain unstable, a situation that continues to work its way through the food chain of mortgages, mortgage-backed bonds, and CDOs. So there could be more big losses.

With those dangers piling up, it's not hard to imagine the possible trigger for bankruptcy: Worried about all these problems, lenders could easily demand repayment from a big bank, creating a crisis. And if the casualty is any one of about a dozen U.S. commercial banks or a handful of other prominent financial players, regulators would probably feel compelled to fashion some kind of bailout to keep the damage from spreading to the broader financial system.

Although today's rescues aren't likely to be all-encompassing, the basic philosophy is rooted in the bailout of Continental Illinois National Bank & Trust, which failed in 1984 after bad bets on energy loans. In that case, the government agreed to make everyone whole, including stockholders, bond investors, and uninsured depositors. The broad rescue enraged other banks and taxpayers, and prompted a congressional investigation. In the aftermath, a Treasury official admitted he would have made the same deal for any of the 11 biggest national banks in an effort to protect the stability of the financial system. Ever since, analysts have speculated on which banks are deemed "too big to fail"—an implicit government guarantee that factors in the grades that ratings agencies such as Moody's assign the biggest banks.

BREAKING IT UP

If such drastic action is necessary this time, expect a smaller-scale bailout. The government might facilitate private loans or investments from outside players to prop up a bank temporarily, as it did with busted hedge fund Long-Term Capital Management in 1998. Or the feds might simply take over the bank and sell it off in pieces, which shelters depositors and creditors from sudden and complete loss but wipes out equity investors. That's what happened with the Bank of New England, the regional giant that collapsed in 1991 under the weight of bad loans in commercial real estate. Alternatively, some observers suspect, regulators might relax certain capital requirements, allowing a weak bank to stay in business and heal itself.

No matter how, or if, such scenarios play out, one thing is certain: Central bankers hate bailouts. In particular, they loathe helping an individual institution even more than they dislike creating general economic bailouts via interest rate cuts and increased government spending. Both, in effect, ratify the excesses that lead to a bust and encourage more wasteful behavior in the future. But deals for specific banks are especially bothersome because they pardon individuals for bad decisions.

Regulators can take a lot of flak for such moves, too.

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