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Congress is planting the seeds of the next big bank bailout.

Attention is focused on the House-Senate conference on a once-in-a-generation rewrite of the rules of finance. Meanwhile, a provision added, almost unnoticed, to a help-small-business bill that passed the House last week would allow all but the 100 largest banks to pretend they haven't made bad loans. The goal is to prompt them to lend more readily to small businesses.

The provision would permit more than 7,800 banks, with nearly $3 trillion in assets among them, to spread losses on bad real estate loans over six to 10 years instead of recognizing reality immediately.

.This wink-wink accounting, which would allow banks to act as if they have bigger capital cushions than they do, is a remake of an old movie: the savings-and-loan horror show of the 1980s and the Japanese banking monster of the 1990s.

Allowing a bank that is broke or near-broke to pretend otherwise in the hope that temporarily depressed commercial real estate prices will eventually rise sounds nice. But history shows that too many such bankers realize the only survival strategy is to make more risky loans and pray they're paid back. If they aren't, well, the government deposit-insurance fund, not the shareholders, gets the tab.

Treasury Secretary Timothy Geithner thinks this is an awful idea. "Could increase costs for the taxpayer by raising the likely losses from future bank failures," he wrote to House leaders. Federal Reserve Chairman Ben Bernanke thinks this is an awful idea: "Banks that are allowed to carry these losses do not engage in sound lending."

Comptroller of the Currency John Dugan thinks this is an awful idea: "Will undermine the efforts of … regulators to shore up investor confidence in the banking system." Sheila Bair, chairman of the Federal Deposit Insurance Corporation, thinks it is an awful idea: "Encourages … executives to take excess risks with the hope that these bets will pay off. … The taxpayer remains liable for any losses, but the shareholders profit if these investments result in gains."

"When I get a call from Tim Geithner or I hear from Ben Bernanke, you bet I sit up and take notice," says Rep. Ed Perlmutter (D., Colo.), chief sponsor of the provision. "But after all the testimony I've heard—after my own experiences as a lawyer representing banks, insurance companies, real estate companies, which gives me some perspective that maybe they don't have—I think this is an approach that we need for these smaller bankers and smaller businesses, to get everybody back on their feet and creating jobs."

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.Mr. Perlmutter and his allies—Democrats Luis Gutierrez of Illinois, Steve Kagan of Wisconsin and Ron Klein of Florida—don't want to cause a costly banking crisis, of course. They are responding to yelps from small businesses that say they can't get credit and managers of small banks who say they can't make loans because bank examiners are forcing them to value real estate at today's improbably low prices. Small banks, they say, didn't cause the global financial earthquake, but they felt it.

"Those aftershocks are still being felt by small businesses and small banks all across the country," Mr. Perlmutter says.

The administration's response: Put $30 billion in taxpayer capital into these community banks so they have the wherewithal to lend. The House has OK'd this; the Senate hasn't.

That's not enough for the small-bank lobby, whose power derives from the presence of at least a few community banks in every congressional district.

"We're talking about banks that are well run, well managed, victims of their local area where the real estate market has just tanked," says Cam Fine of the Independent Community Bankers of America. "Poorly run banks are going to fail anyway," he says, and this won't change that.

Backers cite precedent, a 1980s analog. But that initiative was restricted to really small banks, deemed "well-managed" by regulators, that lent heavily to farmers. Only 334 banks with total assets of $13.5 billion participated, far fewer than would be eligible under the House bill. (Of those, the FDIC says, 20% failed eventually.)

Here's another precedent: The Congressional Budget Office estimates that more than half the $212 billion (in today's dollars) cost of the savings-and-loan rescue is attributable to letting thrifts live instead of closing them when they became insolvent.

The political dynamic here is clear. Big banks are popular villains; small banks are heroes. Big banks—think Citigroup Inc.—are too big to fail; small banks aren't. Big business arouses suspicions among the public; small business seems friendly and entrepreneurial. Big companies can borrow from the bond market when banks are picky; small companies cannot, and thus can't expand and hire readily if they want to. Elected politicians want to do something, anything, to help.

But pretending helped get us into this mess: pretending that putting enough subprime loans into one security made it AAA, that people without incomes could make mortgage payments, that house prices would never fall across the country, that the CEOs of gargantuan financial institutions could manage risks they didn't fully understand, that supposedly sophisticated investors understood what they were buying.

Pretending that banks haven't lost a bundle on commercial real estate loans does not seem a smart way out of this mess.

Write to David Wessel at [e-mail]
http://online.wsj.com/article/SB10001424052748703900004575324653874620696.html