By Nathan Stovall for SNL Financial

William Isaac served as the chairman of the FDIC from 1978 to 1985, overseeing the resolution of numerous failed banks, including the winding down of large institutions such as Continental Illinois, the nation’s seventh-largest bank prior to its failure in 1984. Isaac is now the chairman of LECG Global Financial Services and Fifth Third Bancorp.

In his recent book, “Senseless Panic: How Washington Failed America,” Isaac provides an inside account of the banking and savings and loan crises of the 1980s and compares that period to the financial crisis of 2008. The book also offers criticisms of past policy decisions and of regulators’ reactions to the most recent crisis and recommends reforms to prevent future crises.

SNL Financial spoke with Isaac the morning before he delivered a speech on his book at the Rodman & Renshaw Global & Investment Conference. In part 2 of this two-part conversation, Isaac criticizes the way regulators dealt with the closures of Washington Mutual Inc., Fannie Mae, Freddie Mac and American International Group Inc.; says “too big to fail” is not necessarily over; and questions how successful recent reforms will be in preventing future crises.

What follows is an edited transcript.

In your book, you criticized the handling of a number of specific resolutions, such as the WaMu resolution, because bondholders and TPG Inc. were wiped out. How do you view that differently than the resolution of Continental Illinois, where shareholders were wiped out?

My complaint about TPG is that when the crisis occurred, the regulators were trying to calm the markets. TPG came to the table just a few months earlier and put $7 billion in fresh equity into a troubled institution. And then the government comes in a few months later and wipes them out. First, why did you let these people put $7 billion into an institution that close to failure? There’s something troubling about that.

Are you saying they should have structured a transaction where the government should have partnered with TPG?

Yes, but it’s troubling to me because it makes the government look like it doesn’t have a clue what is going on. It allowed investors to put $7 billion into the institution, and then, a few months later, they wipe them out.

“The damage that was done to the country by [the government’s] mishandling of the crisis has been devastating, and that’s why we’re stuck in the mud right now. It’s going to be a long, long slog in my opinion. And it was so unnecessary if they just had the courage to take the actions that were needed to stop this crisis. And that TARP legislation was awful.”

Didn’t the deal require regulatory approval?

Absolutely. It really seems like either the government knew what was going on at WaMu and hid it from investors who put $7 billion in fresh money in, or they didn’t know. And you don’t take a lot of comfort from either one of those. It’s the same point I made about Fannie and Freddie. They were saying for months that Fannie and Freddie are OK. So what is it? Are you guys stupid, or are you deceitful? How can you tell us for months that everything is OK and then shut them down?

It makes sense why they failed because they were insolvent.

What doesn’t make sense is for the government to say they were solvent. The government basically shut it all down and froze the markets. If you’re going in there, and you’re trying to contain a crisis, what do you do? You probably don’t wipe out bondholders, you go ahead and take care of them. You probably work out a deal with TPG so they have a continuing position in the bank. The government puts fresh equity in, but senior to the bondholder, but you don’t wipe them out.

So does it look like the AIG deal, which was massively dilutive to existing shareholders, but least they’re not at zero?

I don’t even know why you’d dilute them heavily because they didn’t create the problems. They came into to save it. They spent $7 billion to save it. Why would you wipe them out three months later? Why wouldn’t you work out a deal where the government puts some money in that ensures the government got repaid first and then the TPG group has what it has?

You said in your book that the markets closed up after TPG’s investment went sour. And clearly that happened. But they opened back up after the government’s stress tests of the 19 largest financial institutions results were released. You’ve criticized the stress tests. Even though many people thought the tests were just a political exercise, they did seem to be successful in restoring confidence.

I don’t think the stress tests stabilized the system. I think they were very destabilizing. Look at what happened to the bank stock index in the first month after the stress tests were announced. It dropped by 50%. At the end of the month, Bernanke said during testimony before Congress, “We’re not going to let any of the 19 largest banks fail no matter what the stress tests say.”

You think that calmed everything down.

The markets settled immediately.

That was around the same time that Bernanke went on “60 Minutes,” and JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp. said they were profitable in the first two months of the year.

And around the time that Congress held hearings beating up on mark-to-market accounting. The stress tests were a phony global exercise that almost backfired, and the only thing that saved it in the end was that they declared 19 banks “too big to fail,” which still has repercussions for small banks, who struggle to compete with the largest institutions.

Former Treasury Secretary Henry Paulson said something interesting at the Rodman conference, and you also made this point in your book, saying that we don’t know if “too big to fail” is a dead issue until we get to another point where a large institution almost fails.

We don’t know until we know. I would bet my house that, in the next crisis, none of the five largest banks — we’ll probably go lower than that — but none of the five largest banks will be allowed to fail.

They’ve only gotten bigger. JPMorgan purchased Bear Stearns and WaMu; Wells Fargo & Co. bought Wachovia; BofA buys Merrill Lynch. Citi might have gotten smaller, but the other three largest banks became significantly larger.

When you stop and think about it, the way they handled it, by failing these institutions and tucking them into bigger ones, all they did was make the future problems more difficult to cope with. They further concentrated an already too-concentrated financial system. That’s not the answer. The answer would have been to do something like we did in Continental, which is, take it over. We imposed upon them a requirement to shrink to about 50% of their size within three years, which they did. Then we sold them.

Rather than recapitalizing all the large banks through TARP, the FDIC could have used net worth certificates to inject capital into only the most distressed of the largest banks. The capital infusions would be painful to shareholders, costly to taxpayers and frightening to the public, but eventually the situation would settle, and the walking dead would be separated from the rest of the industry. That didn’t happen, and that seems to be a constant theme in your book — that the government created a negative stigmatism toward the banking industry by grouping all the largest banks together. The government thought they would avoid panic by grouping them together, but by doing so, they made the public question all banks. You made that criticism about TARP.

We’re going to pay that political price for a lifetime. It really was devastating. The damage that was done to the country and the financial industry — I’m a firm believer you can’t have a strong economy without a financial system.

Absolutely. It’s the engine of the economy.

You’re right. The damage that was done to the country by their mishandling of the crisis has been devastating, and that’s why we’re stuck in the mud right now. It’s going to be a long, long slog in my opinion. And it was so unnecessary if they just had the courage to take the actions that were needed to stop this crisis. And that TARP legislation was awful.

Dodd-Frank, Basel III — do they make you feel any better about anything?

No. It makes me feel worse. Dodd-Frank doesn’t deal with any of the issues.

They passed rulemaking down the line?

It picked up regulators who helped make this mess, dusted them off and said: “Now go back and do a better job this time. And by the way, we’re going to create a systemic risk council to evaluate your performance, and we’d like you guys to run that.” [Laughs]

And Basel III and higher capital ratios don’t help?

We don’t know all the details yet, but it appears that every major U.S. bank is already in compliance with Basel III. The markets are breathing a sigh of relief because it means nothing. Banks don’t have to limit dividends; pretty soon they’ll be back to buying back stock, which I think we ought to be more judicious about. It’s so hard to get back capital when you need it. The markets were worried that these guys would actually do their job. And the announcement comes out, and what did the markets do? All the banks immediately jumped because they’re already in compliance with the phased-in rules. The markets said, “These guys didn’t do anything. We’re going to have another party.”