Hank Paulson (center), the former U.S. Treasury Secretary, walks to the Court of Federal Claims, in Washington, D.C., on Monday, October 6, 2014. Photograph by Andrew Harrer / Bloomberg via Getty

It had been billed as a showdown: David Boies, the famous litigator, grilling Hank Paulson, the former Treasury Secretary, about the September, 2008, bailout of American International Group, which Maurice (Hank) Greenberg, A.I.G.'s former chief executive—and the man who hired Boies—claims illegally expropriated the firm's stockholders, himself included.

In the event, Paulson's appearance in the U.S. Court of Federal Claims, in Washington, D.C., was a bit of an anticlimax. Far from apologizing for the terms of the loan that the Federal Reserve extended to A.I.G., which included the government's taking a large equity stake and charging, for a while, a punitive rate of interest, Paulson repeatedly said that they were entirely necessary, and in the public interest. Drawing on the concept of "moral hazard," which refers to the danger of inadvertently encouraging risky behavior, Paulson explained: "It was important that terms be harsh because I take moral hazard seriously.” And he added: "When companies fail, shareholders bear the losses. It’s just the way our system is supposed to work.”

If Boies landed some hard blows, the court reporters didn't discern them. It may have been telling that Paulson, who was expected to testify for six hours, completed his testimony in about two, leaving court officers scrabbling around for other witnesses to fill out the day. Generally speaking, when a plaintiff's attorney has someone on the stand who is helping his case, he doesn't let him (or her) go home early.

As I noted last week, I've been having a hard time taking the A.I.G. trial seriously. But, if Paulson's appearance didn't do much to help Greenberg's case, it did shed new light on other aspects of the 2008 crisis, and, especially, on the immense sway that too-big-to-fail banks, such as Citigroup and Bank of America, continue to have over politicians and regulators. If there are any folks left who still need persuading that these cosseted financial giants ought to be cut down to size, they should go and read Paulson's testimony.

A key issue is why the Fed and the Treasury Department, having imposed harsh terms on A.I.G., an insurance company, didn't impose similar terms on the big banks that they bailed out during subsequent weeks and months. The Greenberg lawsuit claims that the A.I.G. bailout violated the Fifth Amendment of the U.S. Constitution, which bars the government from seizing property without due process or proper compensation, and that the Fed's actions went beyond its legal authority. If, indeed, the government had singled out A.I.G. for punitive treatment and it didn't have a strong and legal justification for doing so, Boies and his team might be on to something.

Paulson readily conceded that there were apparent inconsistencies in the government's dealings with A.I.G. and with Citigroup, the latter of which was bailed out in November, 2008, but he argued that this was unavoidable. As by far the biggest insurer of junky subprime mortgage securities, A.I.G. was in a unique position, and that dictated how it was treated. “I didn’t see another insurance company that was vulnerable," Paulson said.

The big banks, on the other hand, were virtually all neck deep in the mortgage sludge that they had been warehousing, packaging, and selling to investors. That changed things radically. When Citi's financial problems got so serious that other banks wouldn't lend to it and it had to be rescued, Paulson and his colleagues at the Fed feared that imposing harsh terms—eminently justified on moral-hazard grounds—would encourage short-sellers on Wall Street to attack the stocks of other big banks. And that, in turn, could have led to a generalized collapse.

Paulson didn't say right out that the banks were untouchable, but that was clearly what he meant. Because of the risk of creating a domino effect, he and other regulators had to go easy on the likes of Citi and Bank of America. Paulson said that he advocated “fairness to the extent you can have fairness,” but “to me, stability trumped moral hazard.”

This, surely, was one of the most telling admissions to have come out of the financial crisis, and it illustrates afresh why too-big-to-fail banks are an abomination. Thanks to legislation introduced by the Obama Administration, the federal government now has the legal power to wind up stricken mega-banks and other big financial institutions, supposedly at no cost to the taxpayer. But that doesn't really resolve the problem. In a genuine crisis, the regulators will always be afraid that issuing a winding-up order will cause panic elsewhere. The Paulson principle will once again apply, with the need to preserve stability trumping concerns about fairness.

As long as too-big-to-fail banks are allowed to exist, they will be in a position to extort the government and the taxpayer in a crisis. The only options are to break them up, so that the failure of one of them no longer represents a systemic risk to the financial system, or to regulate them so stringently that they can never pose a public danger. Neither is an easy option, though. Cutting the banks down to size appears to be beyond the American political system. And regulation, while essential, can never be perfect.

In retrospect, maybe I was a bit harsh on Greenberg in my earlier post. I'm not talking here about the merits, or demerits, of his lawsuit. But in hiring Boies to elicit from Paulson a lesson in the logic of financial crises, the eighty-nine-year-old businessman may have performed a public service.