In an interview for the March/April 2010 issue of the Dartmouth Alumni Magazine, Jake Tapper of ABC News asks Hank Paulson about his role as Treasury Secretary during the financial meltdown. Here is one question that caught my attention (page 37):
Should there not be any organizations that are too big to fail?
Well they are as big as they are, so the key question is how do you regulate them and how do you have the proper authorities and tools in place so you can let them fail without taking down the rest of the system? This is something that Ben and I had talked with Congress about before Lehman went down. We saw we needed these powers. There’s no way we could get them, and the president and current Treasury secretary still haven’t gotten them. But I believe that with the right tools no institution needs to be too big to fail. You just need the power to unwind them outside of bankruptcy.
It is true that if you have these powers, then you can shovel taxpayer funding into them so that they don't fail and thus there is no risk of them "taking down the rest of the system." But you don't get the taxpayer's money back -- look at AIG. It is also true that you can "unwind" them in a way that violates the priority that would typically be assigned in bankruptcy -- look at the auto bailout/bankruptcy.
But the taxpayer is entitled to ask, "Couldn't you have gotten me a better deal than that?" and "Couldn't you have done that without institutionalizing moral hazard?" And the debt holder is entitled to ask, "Couldn't you have done that without running roughshod over my property rights?"
There is a difference between saving the financial system and saving the most reprehensible actors in the financial system. I have maintained that the malactors had to be forced to file for bankruptcy as a condition of any special taxpayer assistance being offered. It greatly diminishes the moral hazard, and it allows direct recourse to the malactors' creditors, who have in some cases -- like Paulson's former employer, Goldman Sachs -- made out like bandits as a result of the bailouts.