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How to change too-big-to-fail ethic?

Thirty years ago, the biggest bank in Philadelphia was in deep trouble because of a bad bet on interest rates.

Thirty years ago, the biggest bank in Philadelphia was in deep trouble because of a bad bet on interest rates.

First Pennsylvania, then the oldest bank in the nation, had invested heavily in long-term government securities paying fixed rates of interest. When Paul Volcker, then the chairman of the Federal Reserve, raised interest rates in 1978 to fight inflation, the bank was crushed; it had to pay more to borrow than it earned on the bonds.

Investors and large depositors fled, and in April 1980 the Federal Deposit Insurance Corp. - at the urging of the Federal Reserve and the U.S. Department of Treasury - coordinated a $1.5 billion rescue involving federal and private loans for the bank, which had $8.5 billion in assets.

The bailout was the first large-scale government intervention to protect a bank from failure because it was deemed "too big to fail," said William Isaac, who as an FDIC director in 1980 reluctantly went along with the First Pennsylvania rescue plan, according to news reports at the time.

"Essentially, nobody paid much of a price. The government rescued the bank from its mistakes and established a very bad precedent," Isaac, who was chairman of the FDIC during the tumultuous period in banking from 1981 to 1985, said in an interview last week.

The die was cast

The rescue set the government on a path that culminated in last year's rescue of the Bear Stearns Cos. Inc. in March and the nationalizations of Fannie Mae, Freddie Mac, and American International Group Inc. in September.

Before First Pennsylvania, the FDIC had intervened in big banks, allowing them to fail and then merging them with other banks after shareholders were wiped out, Isaac said. But First Pennsylvania was different. "That was a true too-big-to-fail bank. Shareholders were not wiped out," Isaac said.

The bank recovered and was sold to CoreStates Financial Corp. for $730 million in 1990.

After putting First Pennsylvania on life support, the FDIC went on to the rescue of Continental Illinois with a $4.5 billion injection of capital in 1984. In 1998, to prevent a widespread financial debacle, the Federal Reserve Bank of New York organized a $3.63 billion bailout of Long Term Capital Management, the hedge fund that was brought to its knees by Russian government bond defaults.

Last year's massive bailouts have brought cries from the likes of prominent hedge fund manager David Einhorn, former Federal Reserve Chairman Alan Greenspan, and FDIC Chairwoman Sheila Bair that the too-big-to-fail doctrine has to end or that financial institutions must not be allowed to become so big that the government cannot let them fail.

No end to too-big-to-fail

But Isaac does not see the government ever letting major financial institutions fail under severe financial conditions. "People who say we're going to end too-big-to-fail, that's nonsense. It won't happen," he said.

Eugene N. White, a Rutgers University economics professor who has written on financial crises, agreed. "It's hard to see how we would stop this," White said. "It's almost like a parent having to say no to a child, after you've given in every time."

During boom times, people think, "This time is different," which is the title of a new book by economics professors Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University; it analyzes "eight centuries of financial folly." In the aftermath of the crisis, the corollary of "this time is different" could well be "never again," as many a parent has said after bailing a child out of trouble.

Treasury Secretary Timothy F. Geithner plans to deal with too-big-to-fail firms through better oversight and by forcing them to be ready to unwind themselves quickly in a crisis. Federal regulators last week hit banks with new rules designed to wring risk out of the system. They also raise the prospect of bankers' jumping to firms untouched by the new rules.

White sounded a note of caution: "A lot of times the way we change the rules sows the seeds for the next crisis."