Oct. 29 (Bloomberg) -- The government wants financial companies, not taxpayers, to pay the tab for too-big-to-fail firms that run into trouble. As good as that sounds, it may not work.

In that case, financial reform legislation unveiled this week would fall short of addressing how to wind up too-big-to- fail firms absent taxpayer bailouts or breaking them up.

The legislation calls for financial firms with more than $10 billion in assets to share the cost of mopping up important firms that fail. The House Financial Services Committee, which unveiled the legislation along with the Treasury Department, came up with the $10 billion cutoff to keep Main Street institutions, namely community banks, from getting stuck with the bill.

The big idea is to make Wall Street clean up its own messes. The threat of such payments, the thinking goes, will also prompt financial companies to impose discipline on peers.

These are laudable goals.

The practical problem is that the failure tab may be too steep for even the largest of the too-big-to-fail club such as JPMorgan Chase & Co. and Goldman Sachs Group Inc.

There are more than 100 financial companies that seem to meet the floor of $10 billion in assets, according to Bloomberg data. They have about $13 trillion in combined assets and total shareholders’ equity of about $1.35 trillion.

That’s a big chunk of change. Yet consider that the government’s commitment to American International Group Inc. stands at about $182 billion, while propping up Fannie Mae and Freddie Mac may require $200 billion.

Costly Fix

While it’s unlikely all that money will be lost, a cost of $400 billion for just three institutions is a lot to shoulder, even for the firms in the 10-plus club. The amount is equal to about 30 percent of their combined equity. It is more than the equity of JPMorgan and Goldman combined.

It may also represent an even higher proportion of assets during the height of a crisis, when a too-big-to-fail firm is most likely to hit the wall. At the end of the third quarter in 2008, right after Lehman Brothers Holdings Inc. collapsed, the combined shareholders’ equity of the 10-plus group was about $1.04 trillion, almost 25 percent below today’s level.

So the commitments for AIG, Fannie and Freddie alone would be equal to almost 30 percent of the group’s combined equity at that point in time.

Also, the equity base of institutions being tapped for the special charge would likely be even smaller if this bailout mechanism were triggered because one of their peers would have failed.

Shock Absorbers

On the plus side, the legislation calls for the government to stop shielding unsecured creditors of financial companies from losses. Having bondholders absorb some of the blow, something that for the most part hasn’t happened during the crisis, would help reduce the bill that gets pushed to other financial firms.

In addition, the Federal Deposit Insurance Corp., which will have the authority to wind up too-big-to-fail firms, may be able to spread the special charges to more institutions, such as hedge funds, that have more than $10 billion in assets.

Still, the bills could get pretty big, and quickly. That’s especially a worry if shareholders and creditors of the firms tagged to pay the special charge get spooked. That may lead to broader sell-offs and losses that further erode equity.

The Next Contagion

This sort of death spiral is just the type of contagion the government is hoping to avoid by overhauling financial regulation and trying to tackle the too-big-to-fail issue.

There’s also the likelihood that if one firm is in trouble, a whole bunch of others are going to be teetering. Last fall, for example, the fear was that the failure of Lehman and subsequent takeover of Merrill Lynch & Co. would be followed by runs on Morgan Stanley and then Goldman.

“If there’s a financial problem that destroys JPMorgan, it is very likely that Citigroup or Bank of America or Goldman Sachs will be in no shape to help,” former Securities and Exchange Commission Chairman Arthur Levitt said during an interview yesterday on Bloomberg radio.

“These are things that don’t generally strike just one company, they’re systemic, they strike the whole community,” said Levitt, who is an adviser to Goldman Sachs and also sits on the board of Bloomberg LP, parent of Bloomberg News.

In response, Congress may suggest that the charge to other financial firms, if it is indeed quite large, be spread over many years, or maybe decades.

Taxpayers Pay Again

The result: taxpayers will still foot the bill for the bailouts as they await payment. Under the plan, the FDIC would initially cover the mopping-up costs by using a line of credit from the Treasury.

And while the public should eventually get paid back, the banks might lobby for forgiveness or use the intervening years to somehow sidestep this obligation.

Making Wall Street pay is a great idea. It will only serve as a deterrent and punishment, though, if it works.

Otherwise, this well-intentioned fix will give a false sense that we’ve reined in too-big-to-fail firms. It would be better to make them small enough to fail on their own.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

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To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: October 28, 2009 21:00 EDT