The Continental Illinois National Bank and Trust Company. Photo: Paola Rosa (flickr)

"Too big to fail." We’ve all heard it. It’s why the U.S. government bailed out some the world’s largest banks in 2008. And the largest U.S. automakers in 2009. But where did we get this idea that our governments can and should bail out private companies in a free market? Here's how the seeds were planted more than 70 years ago that made bailouts not just legal, but seemingly essential. This is Act 2 of our four-part exploration.

In the 1970s and early 1980s, Continental Illinois National Bank and Trust Company was one of the biggest commercial lenders and among the largest major banks in the United States. In 1984, after purchasing bad loans from another failed bank without due diligence, it failed. The Federal Reserve stepped in to bail out the bank, going beyond FDIC obligations to recapitalize the entire bank with public money.

The implication was that some banks were so important to the U.S. economy that the federal government would be willing to save them from failure.

While being grilled in Congress over the action, then Comptroller of Currency C.T. Conover all but stated the new policy of bailouts when he named the 11 largest banks that the U.S. government would provide with a safety net.

When somebody is around to catch you, you’re probably more likely to risk falling. Economists refer to this as ‘moral hazard.’ “If someone pays you for your accidents, you will expend less effort trying to avoid them,” writes George Mason University professor and economist Peter T. Leeson in his review of Too Big to Fail, The Hazards of Bank Bailouts by Gary Stern and Ron Feldman, 2004.

That was exactly what banks were about to do.

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Act Three: The value and perils of deregulation