Bailout

A bailout is a colloquial term for giving a loan to a company or country which faces serious financial difficulty or bankruptcy. It may also be used to allow a failing entity to fail gracefully without spreading contagion.^[1] The term is maritime in origin being the act of removing water from a sinking vessel using a smaller bucket.^[2] A bailout differs from the recently coined term bail-in, under which the bondholders (and/or in the case of banks, depositors), are forced to participate in the process, but taxpayers are not.

Overview

A bailout could be done for mere profit, as when a predatory investor resurrects a floundering company by buying its shares at fire-sale prices; for social improvement, as when, hypothetically speaking, a wealthy philanthropist reinvents an unprofitable fast food company into a non-profit food distribution network; or the bailout of a company might be seen as a necessity in order to prevent greater, socioeconomic failures: For example, the US government assumes transportation to be the backbone of America's general economic fluency, which maintains the nation's geopolitical power.^[3] As such, it is the policy of the US government to protect the biggest American companies responsible for transportation (airliners, petrol companies, etc.) from failure through subsidies and low-interest loans. These companies, among others, are deemed "too big to fail" because their goods and services are considered by the government to be constant universal necessities in maintaining the nation's welfare and often, indirectly, its security.^[4][5]

Emergency-type government bailouts can be controversial. Debates raged in 2008 over if and how to bail out the failing auto industry in the United States. Those against it, like pro-free market radio personality Hugh Hewitt, saw this bailout as an unacceptable passing-of-the-buck to taxpayers. He denounced any bailout for the Big Three, arguing that mismanagement caused the companies to fail, and they now deserve to be dismantled organically by the free-market forces so that entrepreneurs may arise from the ashes; that the bailout signals lower business standards for giant companies by incentivizing risk, creating moral hazard through the assurance of safety nets (that others will pay for) that ought not be, but unfortunately are, considered in business equations; and that a bailout promotes centralized bureaucracy by allowing government powers to choose the terms of the bailout.

Others, such as economist Jeffrey Sachs^[6] have characterized this particular bailout as a necessary evil and have argued that the probable incompetence in management of the car companies is an insufficient reason to let them fail completely and risk disturbing the (current) delicate economic state of the United States, since up to three million jobs rest on the solvency of the Big Three and things are bleak enough as it is. In any case, the bones of contention here can be generalized to represent the issues at large, namely the virtues of private enterprise versus those of central planning, and the dangers of a free market's volatility versus the dangers of socialist bureaucracy.

Furthermore, government bailouts are criticized as corporate welfare, which encourages corporate irresponsibility.

Governments around the world have bailed out their nations' businesses with some frequency since the early 20th century. In general, the needs of the entity/entities bailed out are subordinate to the needs of the state.

Bailout vs. bail-in

The difference between a bailout and a bail-in was first realised by the events of the 2012-2013 Cypriot financial crisis. On 25 March 2013, a €10 billion bailout was announced by the Troika (finance)—a loose coalition of the EU, ECB and IMF—in return for Cyprus agreeing to close its second largest bank, the Cyprus Popular Bank (also known as Laiki Bank). The Cypriots had to agree to levy all uninsured deposits there, and possibly around 40% of uninsured deposits in the Bank of Cyprus (the island's largest commercial bank).^[7][8] No insured deposit of 100,000 Euros or less would be affected.^[9][10] The levy of deposits that exceeded 100keuros was termed a "bail-in", to differentiate it from a bailout because of the depositor fund levy.^[11][12] A useful definition can be found at the "Financial Times lexicon".^[13]

This bail-in tool was first brought to global attention in Cyprus, but had been discussed theoretically since at least 2010.^[14] The resolution of globally significant banking institutions (GSIFIs) was a topic of a joint paper by the Federal Reserve and the Bank of England in 2012.^[15] The Government of Canada clarified its rules for bail-ins in the "Economic Action Plan 2013", at page 144-5. This is "to reduce the risk for taxpayers".^[16] The EU financial community symposium on the "Future of Banking in Europe" (December 2013) was attended by Irish Finance Minister Michael Noonan, who proposed a bail-in scheme in light of the banking union that was under discussion at the event.^[17]

Themes

From the many bailouts over the course of the 20th century, certain principles and lessons have emerged that are consistent:^{[18][19][20][21]}

• Central banks provide loans to help the system cope with liquidity concerns, where banks are unable or unwilling to provide loans to businesses or individuals. Lending into illiquidity, but not insolvency, was articulated at least as early as 1873, in Lombard Street, A Description of the Money Market, by Walter Bagehot.
• Let insolvent institutions (those with insufficient funds to pay their short-term obligations or those with more debt than assets) fail in an orderly way.
• Understand the true financial position of key financial institutions, through audits or other means. Ensure the extent of losses and quality of assets are known and reported by the institutions.^[22]
• Banks that are deemed healthy enough (or important enough) to survive require recapitalization, which involves the government providing funds to the bank in exchange for preferred stock, which receives a cash dividend over time.^[23]
• If taking over an institution due to insolvency, take effective control through the board or new management, cancel the common stock equity (existing shareholders lose their investment) but protect the debt holders and suppliers.
• Government should take an ownership (equity or stock) interest to the extent taxpayer assistance is provided, so that taxpayers can benefit later. In other words, the government becomes the owner and can later obtain funds by issuing new common stock shares to the public when the nationalized institution is later privatized.
• A special government entity is created to administer the program, such as the Resolution Trust Corporation.
• Prohibit dividend payments to ensure taxpayer money are used for loans and strengthening the bank, rather than payments to investors.
• Interest rate cuts to lower lending rates and stimulate the economy.

Reasons against bailouts

• Signals lower business standards for giant companies by incentivizing risk
• Creates moral hazard through the assurance of safety nets
• Promotes centralized bureaucracy by allowing government powers to choose the terms of the bailout
• Instills a corporatocratic style of government in which businesses use the state's power to forcibly extract money from taxpayers.

Paul Volcker, chairman of Barack Obama's White House Economic Recovery Advisory Board, said that bailouts create moral hazard: they signal to the firms that they can take reckless risks, and if the risks are realized, taxpayers pay the losses, also in the future. "The danger is the spread of moral hazard could make the next crisis much bigger".^[24]

On November 24, 2008, American Republican Congressman Ron Paul (R-TX) wrote, "In bailing out failing companies, they are confiscating money from productive members of the economy and giving it to failing ones. By sustaining companies with obsolete or unsustainable business models, the government prevents their resources from being liquidated and made available to other companies that can put them to better, more productive use. An essential element of a healthy free market, is that both success and failure must be permitted to happen when they are earned. But instead with a bailout, the rewards are reversed – the proceeds from successful entities are given to failing ones. How this is supposed to be good for our economy is beyond me.... It won’t work. It can’t work... It is obvious to most Americans that we need to reject corporate cronyism, and allow the natural regulations and incentives of the free market to pick the winners and losers in our economy, not the whims of bureaucrats and politicians."^[25]

Costs

In 2000, World Bank reported that banking bailouts cost an average of 12.8% of GDP.^[26] The report stated:

Governments and, thus ultimately taxpayers, have largely shouldered the direct costs of banking system collapses. These costs have been large: in our sample of 40 countries governments spent on average 12.8 percent of national GDP to clean up their financial systems.

Cases

• 1970 - Penn Central Railroad
• 1971 - Lockheed Corporation
• 1980 - Chrysler Corporation
• 1984 - Continental Illinois^[4]
• 1991 - Executive Life Insurance Company, by states assessing other insurers
• 1998 - Long-Term Capital Management, by banks and investment houses, not government (see LTCM page).
• 2003 - Parmalat
• 2008 - The Bear Stearns Companies, Inc.
• 2008 - Fannie Mae and Freddie Mac
• 2008 - The Goldman Sachs Group, Inc. bailed out by the federal government and Berkshire Hathaway
• 2008 - Morgan Stanley bailed out by The Bank of Tokyo-Mitsubishi UFJ
• 2008-2009 - American International Group, Inc. multiple times
• 2008 - Emergency Economic Stabilization Act of 2008^[27]
• 2008 - 2008 United Kingdom bank rescue package
• 2008 - Citigroup Inc.
• 2008 - General Motors Corporation and Chrysler LLC- though not technically a bailout, a bridge loan was given to the auto manufacturers by the U.S. government, this is referred to by most as a bailout
• 2009 - Bank of America to help it absorb known losses that were much greater than revealed to shareholders incurred by its buyout of Merrill Lynch
• 2009 - CIT Group $3 billion by its bondholders in a failed attempt to avoid a bankruptcy. This bailout only delayed the bankruptcy.
• 2009 - Dubai and Dubai World bailed out by Abu Dhabi

Irish banking rescue

Irish banks suffered substantial share price falls due to a lack of liquidity in finance available to them on the international financial markets. Currently, solvency is being revealed as the most serious concern as doubtful loans to property developers, still undeclared in bad debt provisions, come into focus.

Swedish banking rescue

During 1991–1992, a housing bubble in Sweden deflated, resulting in a severe credit crunch and widespread bank insolvency. The causes were similar to those of the subprime mortgage crisis of 2007–2008. In response, the government took the following actions:^[28]

• Sweden's government assumed bad bank debts, but banks had to write down losses and issue an ownership interest (common stock) to the government. Shareholders were typically wiped out, but bondholders were protected.
• When distressed assets were later sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies in public offerings.
• The government announced the state would guarantee all bank deposits and creditors of the nation’s 114 banks.
• Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

This bailout initially cost about 4% of Sweden's GDP, later lowered to between 0–2% of GDP depending on various assumptions due to the value of stock later sold when the nationalized banks were privatized.

U.S. savings and loan crisis

In response to widespread bank insolvency as a result of the savings and loan crisis, the United States established the Resolution Trust Corporation (RTC) in 1989.

US TARP and related programs

In 2008-9 the U.S. Treasury and the Federal Reserve System bailed out numerous very large banks and insurance companies, as well as General Motors and Chrysler. Congress at the urgent request of President George W. Bush passed the Troubled Asset Relief Program or "TARP", funded at $700 billion. The banks have largely repaid the money and the net cost of TARP may eventually be in the range of $30 billion.^[29] The bailout of Fannie Mae and Freddy Mac, which insure mortgages, totals $135 billion by October 2010, and could be much higher, depending on the future of the housing and mortgage markets.^[30]

The issue of federal bailouts of the banks and big corporations became a major issue of the 2010 elections, with the Tea Party movement in particular focusing its attack on bailouts.^[31]

See also

Specific:

• Automotive industry crisis of 2008–2009
• Brown Bailout
• Crédit Lyonnais
• Debtor-in-possession financing
• Emergency Economic Stabilization Act of 2008
• Financial crisis of 2007–2012
• Late 2000s recession
• Subprime mortgage crisis
• Lemon socialism

General:

• Bankruptcy
• Bubble (economics)
• Cash flow
• Lender of last resort
• Financial crisis
• Nationalization
• Recapitalization
• Stock market crash

References

Further reading

• "Financial crisis : Carping about the TARP: Congress wrangles over how best to avoid financial Armageddon", The Economist, September 23, 2008
• "Behind the Bailout" — NOW on PBS 09/26/2008
• Muolo, Paul. $700 Billion Bailout. New York: John Wiley and Sons. ISBN 978-0-470-46256-0. 
• IMF Study Laevan and Valencia September 2008
• Wright, Robert E. ed. Bailouts: Public Money, Private Profit (New York: Columbia University Press, 2009).
• Wright, Robert E. Fubarnomics: A Lighthearted, Serious Look at America's Economic Ills (Buffalo, N.Y.: Prometheus, 2010).

External links

Look up bailout in Wiktionary, the free dictionary.

• The Bailout Reader - A resource against bailouts from a libertarian perspective
• Bailout Bandwagon - Video satire about bailouts and the economic impact on everyday citizens
• Toxic Assets Reduction Plan Release by The Justice Dept: 23Mar2009
• US bailout total-29.616 trillion dollars

United States

• NoBailout.org - An anti-bailout website with an updated list of elected officials in support of bailout
• New Deal in the 21-st Century