Watchdog Says Bank Bailouts Made ‘Too-Big-to-Fail’ Even Bigger

The passing of the Dodd-Frank Reform Act last summer was hailed as the end of ""too-big-to-fail"" and the end of corporate bailouts. But Neil Barofsky, head of the group charged with overseeing the government's handling of the Troubled Asset Relief Program (TARP) says the ""too-big-to-fail"" problem has not been solved; in fact, it's gotten worse. And he warns that federal officials are leaving the door open for further bailout packages should another crisis strike.

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In a ""report to be presented to Congress"":http://www.sigtarp.gov/reports/congress/2011/January2011_Quarterly_Report_to_Congress.pdf Wednesday, Barofsky says the massive bailouts of companies such as ""Citigroup"":http://www.citigroup, ""AIG"":http://www.aig.com and ""Bank of America"":http://www.bankofamerica.com have effectively guaranteed these institutions against failure, encouraged high-risk behavior, and given rescued firms an unwarranted competitive advantage in the form of enhanced credit ratings and access to cheaper credit â€" all thanks to the perception that such companies have an implicit government guarantee.

He also points out that since their bailouts, the nation's five largest financial institutions are 20 percent larger than they were before the crisis. Quoting Kansas City Federal Reserve Bank President Thomas Hoenig, Barofsky says these five companies now control $8.6 trillion in financial assets â€" the equivalent of nearly 60 percent of gross domestic product, and ""like it or not, these firms remain too big to fail.""

In his report, Barofsky said, ""The continued existence of institutions that are ‘too big to fail' - an undeniable byproduct of former Secretary Paulson and Secretary Geithner's use of TARP to assure the markets that during a time of crisis that they would not let such institutions fail

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- is a recipe for disaster. These institutions and their leaders are incentivized to engage in precisely the sort of behavior that could trigger the next financial crisis, thus perpetuating a doomsday cycle of booms, busts, and bailouts.""

Barofsky goes on to liken the recent financial bailout packages to the public-private tug-of-war that's plagued the nation's two largest mortgage companies and has become the next target for reform.

""In many ways, TARP has thus helped mix the same toxic cocktail of implicit guarantees and distorted incentives that led to disastrous consequences for the government-sponsored enterprises (GSEs) - [Fannie Mae and Freddie Mac],"" Barfosky said.

""Institutions such as Citigroup operate in an environment where size matters because the then-explicit and now implicit government guarantee that they will not be allowed to fail results in a gross distortion of a normally functioning market,"" where taxpayers must bear the brunt of poor decisions rather than an institution's creditors, shareholders, and executives, Barofsky said.

""This ‘heads I win, tails the government bails me out' mentality promotes behavior that, while it may benefit shareholders and executives in the short term...increases the likelihood of failure and, therefore, the possibility of another taxpayer-funded bailout,"" Barofsky continued, and he says Treasury Secretary Timothy Geithner has admitted that such action may still be necessary.

In the report, Barofsky discloses the substance of a December 2010 interview his office conducted with Geithner, in which Geithner acknowledged that despite the reforms instituted under Dodd-Frank, ""‘[i]n the future we may have to do exceptional things again' if we face a crisis as large as the last one,"" in reference to the controversial taxpayer-supported bailouts.

Barofsky says ""perhaps TARP's most significant legacy [is] the moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail.'""

Barofsky and Timothy Massad, Treasury's acting assistant secretary for financial stability, will discuss the report and its findings Wednesday at a hearing held by the House Committee on Oversight and Government Reform.