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Will financial reform end big bank bailouts?

Lawmakers are pledging to end bailouts in the financial reform bill that the Senate is considering now. But many experts say bank bailouts can and will occur again.

By / Staff writer / May 11, 2010

AFL-CIO President Richard Trumka (with striped tie) and other union leaders headed up a ‘Main Street to Wall Street’ rally in New York City April 29. Anti-Wall Street sentiment following a string of big bailouts has many insisting on a financial reform bill that ends bank bailouts. But many banking experts say bailouts will happen again.

Mike Segar/Reuters

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"Orderly liquidation." The words appear prominently in financial reform bills to overhaul the way the US government will regulate America's financial system in the aftermath of a near-meltdown in late 2008.

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The idea is that if a large firm gets into trouble in the future, it can't expect any generous taxpayer bailouts, as happened at American International Group (AIG) and other firms. Rather, if a large bank takes big risks that go awry, regulators will preside over its dismemberment with steely resolve.

That, at least, is the simple message lawmakers say they want to send with legislation that's moving into its second week of Senate floor debate.

President Obama, too, has been pledging an end to bailouts. "That's what this reform does," he said recently of the Senate bill.

But regulating the vast financial system is anything but simple, and many experts say bank bailouts can and will occur again, even if Mr. Obama ends up signing a reform bill by midyear.

A basic problem lies in that phrase, "orderly liquidation." In the heat of a financial crisis, that's something very hard to do with a large and interconnected financial firm on the brink of failure.

Orderly liquidation is exactly what did not occur in 2008. During the crisis, most tottering firms – from sprawling Citigroup to insurance giant AIG – received some form of government backing. Then, when Lehman Brothers didn't get a government bailout, credit markets quickly spiraled down toward what could have become a broad and catastrophic collapse. To restore stability, Congress held its nose and created a $700 billion rescue fund.

For regulators and Congress, propping up the economy trumped a distaste for bailouts.

"In a crisis, they'll do the same thing again," predicts Peter Nigro, a finance expert at Bryant University in Smithfield, R.I.

No outright ban on bailouts

The bills in the House (already passed) and Senate (in progress) include tough language designed to make bailouts both less common and less generous in the future.

But some critics of the legislation say it will fail to end bailouts, and that this is a bad thing. The real problem during 2008, they say, was not that Lehman wasn't rescued but that investors had come to expect government aid rather than insisting upon caution and discipline in financial activities. The proposed bills will perpetuate this problem, these critics warn.

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