Bailout

Categories of
Financial risk
Credit risk
Concentration risk
Market risk
Interest rate risk Currency risk Equity risk Commodity risk
Liquidity risk
Refinancing risk
Operational risk
Country risk Legal risk Model risk Political risk Valuation risk
Reputational risk
Volatility risk
Settlement risk
Profit risk
Systemic risk

A bailout is a colloquial term for giving financial support 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] A bailout can, but does not necessarily, avoid an insolvency process.

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 term bail-in (coined in the 2010s) under which the bondholders and/or depositors of global systemically important financial institutions (G-SIFIs) are forced to participate in the process, but taxpayers supposedly are not. Some governments have the power to participate in the insolvency process: for instance, the U.S. government intervened in the General Motors bailout of 2009–2013.^[3]

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 U.S. government assumes transportation to be the backbone of America's general economic fluency, which maintains the nation's geopolitical power.^[4] As such, it is the policy of the U.S. 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.^[5][6]

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 buck passing 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 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.^[7]

Furthermore, government bailouts are criticized as corporate welfare, which encourages corporate irresponsibility by allowing moral hazard.

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

Basically, a bail-in forces the borrower's creditors to bear some of the burden by having part of the debt they are owed written off. (In the case of Cyprus, the creditors in question were bondholders, and depositors with more than €100,000 in their accounts.) ( Source : The Economist )

Theory

This bail-in tool was first brought to global attention in Cyprus, as discussed below, but had been discussed theoretically since at least 2010.^[8] 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.^[9]

The Financial Stability Board (FSB) published in October 2011 a guideline document entitled "Key Attributes of Effective Resolution Regimes for Financial Institutions" which deals with the current bailout regime.^[10] The scope of this planned bail-in regime for participating countries is not just limited to large domestic banks. In addition to these "systemically significant or critical" financial institutions, the scope also applies to two further categories of institutions, a) Global SIFIs, in other words, cross-border banks which happen to be incorporated domestically in a country that is implementing the bail-in regime, and b) "Financial Market Infrastructures (FMIs)", such as clearing houses. The inclusion of FMIs in potential bail-ins is in itself a major departure. The FSB defines these market infrastructures to include multilateral securities and derivatives clearing and settlement systems, and a whole host of exchange and transaction systems, such as payment systems, central securities depositories, and trade depositories. This would mean that an unsecured creditor claim to, for example, a clearing house institution, or to a stock exchange, could in theory be affected if such an institution needed to be bailed-in. The inclusion of FMIs means that large parts of the global financial system is susceptible to bail-in and could potentially be bailed-in.

Outgoing Deputy Director of the Bank of England Paul Tucker chose to open his academic career at Harvard with an October 2013 address in Washington to the Institute of International Finance in which he suggested that U.S. banks and other institutions were now no longer to be deemed too big to fail and henceforward would be bailed-in.^[11] 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.^[12] Deputy BoE Director Jon Cunliffe suggested in a March 2014 speech at Chatham House that the domestic banks were too big to fail (TBTF), and instead of the nationalisation process used in the case of HBOS, RBS and threatened for Barclays (all in late 2008), could henceforth be bailed-in.^[13]

Economist Graeme Archer noticed in March 2014 that no personal punishment (such as dismissal or incarceration) is required under the latest regulations, and that therefore corrective action is unlikely.^[14]

Legislative and executive efforts

The Dodd-Frank Act Title II now legislates bailout procedures for the United States.^[15][16] A January 2012 the Federal Deposit Insurance Corporation Office of Complex Financial Institutions slide presentation covers the resolution strategy.^[17] The FDIC has drawn attention to the problem of post-bailout governance, and did suggest that a new CEO and Board of Directors were to be installed under FDIC receivership guidance,^[18] but as of January 2012 had yet to resolve the issues. In any case, U.S. legislation only applies to domestic organisations. Title II is aimed at protecting the financial stability of the American economy, forcing shareholders and creditors to bear the losses of the failed financial company, "removing management that was responsible for the financial condition of the company", and ensuring that payout to claimants is at least as much as the claimants would have received under a bankruptcy liquidation.^[16] Claims are paid in the following order:^[16]

1. Administrative costs;
2. The government;
3. Wages, salaries, or commissions of employees;
4. Contributions to employee benefit plans;
5. Any other general or senior liability of the company;
6. Any junior obligation;
7. Salaries of executives and directors of the company; and
8. Obligations to shareholders, members, general partners, and other equity holders.

The Canadian government clarified its rules for bail-ins in the "Economic Action Plan 2013", at page 144-5. This is "to reduce the risk for taxpayers".^[19]

The Eurogroup proposed on 27 June 2013 that after 2018 bank shareholders will be first in line for assuming the losses of a failed bank before bondholders and certain large depositors. Insured deposits under £85,000 (€100,000) are exempt and, with specific exemptions, uninsured deposits of individuals and small companies are given preferred status in the bail-in pecking order for taking losses. This agreement formalised the practice seen earlier in Cyprus. Under this proposal, all unsecured bondholders must be hit for losses before a bank can eligible to receive capital injections directly from the European Stability Mechanism.^[20] A tool known as the Single Resolution Mechanism, which was agreed amongst Eurogroup members on 20 March 2014, is part of an EU effort to prevent future financial crises by pooling responsibility for euro-area banks, a project known as banking union. In a first step, the ECB will fully assume supervision of the 18-nation currency bloc's lenders in November 2014. The deal needed formal approval by the European Parliament and by national governments.^[21] The resolution fund was to be paid for by the banks themselves, and will gradually merge national resolution funds into a common European one until it hits its €55 billion target funding level.^[22] See the EC FAQ on the SRM.^[23] The legislative item was split into three initiatives by Internal Market and Services Commissioner Michel Barnier: BRRD, DGS and SRM.^[24]

Practice

The difference between a bailout and a bail-in was first realised by the events of the 2012-2013 Cypriot financial crisis. Two Cypriot banks were exposed to a haircut of upwards of 50% in 2011^[25][26] during the Greek government-debt crisis,^[27][28] leading to fears of a collapse of the Cypriot banks. Rumours circulated for a time, then in early 2013 matters came to a head. On 25 March 2013, a €10 billion bailout was announced by the Troika — a loose coalition of the European Union, European Central Bank and International Monetary Fund — 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).^[29][30] No insured deposit of €100k or less was to be affected.^[31][32] The levy of deposits that exceeded €100k was termed a "bail-in", to differentiate it from a bailout because of the depositor fund levy.^[33][34] The Bank of Cyprus executed the depositor bail-in on 28 April 2013.^[33]

Themes

From the many bailouts over the course of the 20th century, certain principles and lessons have emerged that are consistent:^{[35][36][37][38]}

• 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.^[39]
• 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.^[40]
• 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

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".^[41]

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."^[42]

Costs

In 2000, World Bank reported that banking bailouts cost an average of 12.8% of GDP.^[43] 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^[5]
• 1991 - Executive Life Insurance Company, by states assessing other insurers
• 1995 - Mexico Bailout
• 1997 - South Korea Bailout
• 1997 - Indonesia Bailout
• 1998 - Long-Term Capital Management, by banks and investment houses, not government (see LTCM page).
• 1998 - Brazil Bailout^[44]
• 2000 - Argentina Bailout
• 2001 - Brazil Bailout
• 2002 - Brazil Bailout
• 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^[45]
• 2008 - 2008 United Kingdom bank rescue package
• 2008 - Citigroup Inc.
• 2008 - Royal Bank of Scotland
• 2008 - Halifax Bank of Scotland
• 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

While the Irish banking crisis of 2008 isn’t much different from other banking crisis, it was unique in that it was the first banking crisis in a country that was a member of the Eurozone. Because of this the Irish government and central bank faced unique constraints when the crisis struck.^[46]

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:^[47]

• 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.

U.S. TARP and related programs

In 2008–09 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 (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.^[48] The bailout of Fannie Mae and Freddie 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.^[49]

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.^[50]

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).
• Estimating government support for Canadian banks during the financial crisis by the Canadian Centre for Policy Alternatives

External links

Look up bailout in Wiktionary, the free dictionary.

• The Bailout Reader - A resource against bailouts from a libertarian perspective
• Bailout Bandwagon on YouTube - Video satire about bailouts and the economic impact on everyday citizens

United States

• US bailout total-29.616 trillion dollars
• New Deal in the 21-st Century