Legislating 'too-big-to-fail'

(Fortune) -- Last January a freshman senator with a reputation as a thoughtful workhorse assured me that reforming Wall Street would be a bright patch of needed bipartisanship.

But the success of this enterprise, he said over dinner, depended on whether lawmakers could agree on how resolve the "too big to fail" conundrum: How to do you prevent massive, risk-taking financial firms from blackmailing American taxpayers into rescuing them because of their octopus-like entanglement in the U.S. economy?

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Nina Easton, senior editor at large

It took just a few months for an ugly partisan brawl to erupt over this very issue. And that same senator -- Republican Bob Corker of Tennessee -- was suddenly in the position of publicly urging leaders of both parties to act more like "adults." "My role now is to tone down the rhetoric and get people talking about substance," Corker told me Tuesday night.

Tempers are, indeed, cooling and there is talk of compromise on the Senate Democratic bill. But this renewed drive for an agreement -- spurred, in part, by political pressure on Republicans after the S.E.C.'s fraud accusations against Goldman Sachs (GS, Fortune 500) -- shouldn't obscure the importance of getting it right on the "too big to fail" question. Americans want more oversight of Wall Street; they don't want Congressional action that will inadvertently limit credit, favor mega-banks, or produce more bailouts.

And some analysts fear the Senate bill will do just that. "It will change the nature of our financial institutions," says Peter Wallison, senior fellow at the American Enterprise Institute. "Now we have a competitive market. This puts small firms at a disadvantage." Wallison contends that the proposed reforms will produce a "dangerous" partnership between mega-banks and the federal government, specifically the Federal Reserve.

Two proposals raise flags for critics like Wallison. One is a plan to create a $50 billion fund -- paid for by industry -- to cover the costs of liquidating failed companies that are deemed a risk to the broader economy. The fund is an idea that has been pushed by FDIC Chair Sheila Bair, but not fully embraced by the Obama administration. Treasury Secretary Tim Geithner, who fears such an insurance fund could offer the prospect of shelter to risk-taking investors and management prefers a system of collecting fees in the aftermath of a collapse.

For the past several weeks, this fund has been at the center of the Republican leadership's crusade against the Democrat's bill. Wallison argues that the fund will effectively favor creditors to these big firms. While a failing company seized by the FDIC will see its management and investors wiped out, creditors will receive some of that $50 billion. "Creditors are going to look at these designated institutions as the ones they prefer to lend to," he says.

The other provision that worries critics is a plan to limit the Fed's supervisory authority to mega-banks, those with assets worth more than $50 billion. Fed Chair Ben Bernanke opposes this change, arguing that it worsens the too-big-to-fail problem.

"It makes us essentially the too-big-to-fail regulator," he told lawmakers in March. "We don't want that responsibility. We want to have a connection to Main Street, as well as to Wall Street. We need to have insights into what's happening in the entire banking system."

Corker dismisses this argument as an agency chief protecting his bureaucratic turf. But David Hirschmann, president of the Chamber of Commerce's Center for Capital Markets Competitiveness, insists that this change will favor a couple dozen mega-firms -- at the expense of smaller competitors -- because they will carry "the Fed's gold seal of approval which they can then market to customers."

As for $50 billion liquidation fund that, Corker says he's "agnostic," adding that he is trying to amend the bill to put creditors on the hook. Corker never thought GOP leaders should make so much hay over the fund -- "it wouldn't be my lead punch," he says. Even so, the Republican National Committee just released an ad that disingenuously suggests the $50 billion is taxpayer, not industry, money.

For Corker and other lawmakers, though, the real problem with using a new law to tackle the too-big-to-fail issue is that recent history shows that the bailout decisions are political, not legal.

The Bush administration punted on the question of whether General Motors (GM, Fortune 500) was too big to fail; the Obama White House blinked rather than face the wrath of organized labor and the prospect of a worsening unemployment pictures. (Cost to taxpayers so far: $50 billion).

Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) were also deemed too big to fail. A takeover by the Bush administration enabled both to stay in business and operate as a nifty mortgage provider for the Obama administration. (Cost to the taxpayers: $126 billion, and climbing higher.)

Was AIG (AIG, Fortune 500) too big to fail? That's under debate. (Taxpayer cost: $47.5 billion) And Lehman, it turns out, wasn't too big to fail: Its bankruptcy didn't doom any of its counterparties.

These are questions that deserve public debate before Congress rushes a bill into law. With both parties' desperate to capitalize on populist anti-Wall Street sentiment, is it possible Congress is, ironically, producing a new "reform" that favors big firms at the expense of small?