The Senate passed financial industry “reform” yesterday. But one important amendment failed earlier this week: New Hampshire Senator Judd Gregg’s proposal to prohibit federal bailouts of state and local governments.

The Judd amendment would have instructed Washington not to purchase state or local bonds to help out distressed municipal governments, unless the state or local entity in question was suffering through a catastrophe akin to Hurricane Katrina.

This amendment was not a small irrelevancy tacked on to an important matter. The financial industry cannot reform itself unless investors, including many big financial institutions themselves, realize that they face the risk of losses if they lend unwisely to any sector of the economy.

This is the big-picture point of financial reform. If the lenders to any group of borrowers think the federal government protects them from market risk, they’ll make their decisions accordingly, and distort the entire investment world in doing so.

The problem with the financial industry, remember, was too much debt, too much debt created because lenders to the financial industry — bondholders — thought big or complex financial firms were “too big to fail.” Investors, including many financial institutions that lent within the industry, lent too much because they expected bailouts.

Think housing, too, and how much money has flowed into that sector of the economy, because the government, for decades, has made clear its strong support of home ownership.

The same situation holds in the municipal debt market. The problem with “a couple of states in this country that have been irresponsible in their spending, that have not disciplined themselves,” as Judd put it in a floor statement, is that they can continue to borrow to fund their spending because municipal-bond investors and their advisers believe that California, Illinois, New York, and others are also “too big to fail.” That is, the feds would not let them default or come remotely close to it.

When you indemnify bondholders in this manner, you get more debt. “It’s this moral hazard issue that we debated at considerable length when we discussed ‘too big to fail’ in the banking system,” Judd noted.

The fact that the vote was close may seem to be a strong signal to markets. The amendment failed by only a three-vote margin, 47-50, with six Democrats (none of them from a particularly profligate state) voting with the unanimous GOP. (New York’s Chuck Schumer and Kirsten Gillebrand voted to keep the bailout option open.)

But the strong signal to markets may be the wrong one. The fact is, all Gregg wanted was a reiteration of general policy. The feds aren’t supposed to be in the business of bailing out bondholders, whether those bondholders have lent recklessly to states or to banks.

Investors can see now, though: more than half of Senators wanted to keep their options open on bailouts of state and local bondholders, even as Senate passed a bill that supposedly brings the consistent threat of financial losses back to the investment marketplace. And it wouldn’t be too hard to turn over a few more votes in the type of panic environment that surrounded the TARP vote.

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