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Uncle Sam Needs YOU for a Bailout: 6 Reasons Another Big Banking Crisis Is Coming Our Way

Rampant financial crime and poor regulation can only mean another blowup, and guess who will be holding the bag?

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That’s a bit like Jesus Christ returning to announce that introducing Christianity was all a big mistake. The reaction from the financial mafia has been appropriately apoplectic.

The net effect of all these rule changes – like the one that enriched Sandy Weill – was that banks became too big to fail. Fear that their failure has led regulators to go soft on the big banks, and to do anything to keep them alive.

2. See no evil, hear no evil

While the financial system was consolidating, another threat was looming: the “shadow banking system“ was being created. Another New Deal reform, the Investment Company Act of 1940, imposed heavy restrictions on investment companies, which were intended to protect investors from excessive risks, fraud and scams.

But regulators decided that sophisticated investors, including the wealthy, pension funds and charities, had enough financial savvy to be allowed to invest in shadow banks that were either lightly regulated, or not at all. Such alternative investment vehicles, including hedge funds and private equity funds, were exempt from investment restrictions.

In the last two decades, there’s been an explosive growth in shadow banks. The size of this unregulated system has increased fivefold and today is larger than the regulated financial system.

The rationale? Sophisticated investors, it’s claimed, can look after themselves, and therefore the largely unregulated funds that cater to them don’t pose any risks to the rest of us. But that’s not proven to be the case. And, surprise, surprise, when such firms fail, guess who pays the price? We do.

3. Calling in the cavalry, but giving them the wrong directions

Once the U.S. decided to deregulate the financial sector, and banks got bigger, it was inevitable that the government would be called in for a rescue. Most of us were aware that in 2008, the government stepped in to bail out big banks that were destabilized by Lehman Brothers’ collapse and by the bad derivatives bets entered into by AIG Financial Products. The world financial system was at the brink, we were told, and the Troubled Asset Relief Program (TARP) was necessary to save the system.

But a decade before this bailout, U.S. financial regulators were involved in a rescue of a shadow bank, which helped set the stage for TARP.  In 1998, the Long-Term Capital Management (LTCM) hedge fund got into trouble by placing heavily-leveraged derivatives bets during the Asian financial crisis. Hedge funds are allowed to operate with scant regulatory supervision on the rationale that they cater only to sophisticated investors who could bear the risk.

The Federal Reserve changed its mind when it realized that LTCM’s failure was a threat to the global economy. So the Fed corralled major banks in a room, and told them to fix the problem. They dismembered LTCM and took its underperforming assets onto their books.

The Fed’s role in this rescue sent the wrong message: that the government would be there to fix problems, and that banks and shadow banks alike didn’t have to work too hard to manage risk and to protect themselves from contagion.

Sometimes you want government intervention to quell a banking panic, and to shore up or reboot a failed banking system. Banks need to be seized, or at minimum assessed by a neutral observer, and their balance sheets cleaned up. Investors, too, must pay a price for making foolish investment choices. Typically, existing shareholders are wiped out, while bondholders see their promises of guaranteed debt payments converted to more speculative shares of stock.

We used to know how to do this. The Depression-era Reconstruction Finance Corporation seized failing banks, cleaned up their balance sheets, and later transferred these institutions back to private ownership. The Resolution Trust Corporation followed similar policies in cleaning up the savings and loan crisis of the 1980s and early 1990s. More recently, the Swedish government nationalized failing banks in the 1990s. Managers were penalized, and shareholders and sometimes bondholders took losses.