Bailout

For other uses, see Bail (disambiguation).

Bailout in economics and finance is a term used to describe a situation where a bankrupt or nearly bankrupt entity, such as a corporation or a bank, is given a fresh injection of liquidity, in order to meet its short term obligations. Often bailouts are by governments, or by consortia of investors who demand control over the entity as the price for injecting funds.

Often a bailout is in response to a short term cash flow crunch, where an entity with illiquid, but sufficient, assets is given funds to "tide it over" until short term problems are resolved. However, often bailouts are merely delaying the inevitable, as a government or investment structure attempts to avoid putting a large quantity of illiquid assets on the market, which would force other similar entities to write down their assets.

The bailing out of a corporation by government is controversial because bankruptcy can be seen as being caused by the failure to satisfy consumer demand; the bailing out is thus an instance of government intervention on the market overruling the will of consumers. "All this talk: the state should do this or that, ultimately means: the police should force consumers to behave otherwise than they would behave spontaneously." According to the Austrian School of Economics the appearance of monopolies can often be blamed on such acts of government intervention that preserve overstretched and badly managed corporations which market forces would have broken into smaller and more specialized companies.

Government bailouts of corporations are usually reserved for cases when a corporation is considered "too big to fail" - justified by the argument that failure of certain corporations would cause unacceptable short term economic repercussions throughout the economy.

A financial bailout may also describe an external intervention into the economic affairs of a nation, industry, corporation or citizen, typically for the purpose of enhancing their financial circumstances for public benefit. Bailouts have occurred globally and with some frequency since the early 20th century. In general, the needs of the entity bailed-out are subordinate to the needs of the state. Further, a bailout presents the challenge of moral hazard, by rewarding excessive risk taking.

Themes from Bailouts

From the many bailouts over the course of the 20th century, certain principles and lessons have emerged that are consistent:

• Act quickly and decisively
• Let insolvent institutions (i.e., those with insufficient funds to pay their short-term obligations) fail in an orderly way
• Loans help the system cope with liquidity concerns, but bank solvency issues require recapitalization (i.e., new equity investments and debt forgiveness/elimination).
• If taking over an institution due to insolvency, take effective control through the board or new management, wipe out the common equity shareholders, but protect the debt holders and suppliers.
• Government should take an equity interest to the extent taxpayer assistance is provided, so that taxpayers can benefit later.
• A special government entity is created to administer the program, such as the Resolution Trust Corporation.
• Prohibit dividend payments, to ensure taxpayer dollars are used for loans and strengthening the bank, rather than payments to investors.
• Strong oversight.

Bailout Costs

A 2002 World Bank report indicated that bailout costs average approximately 13% of GDP.

Cases

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:

• 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-1989

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.

Other Bailouts

• 1930's - Great Depression
• 1984 - Continental Illinois
• 1990 - Japgr

an

• 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 - Bear Stearns
• 2008 - Fannie Mae and Freddie Mac
• 2008 - American International Group
• 2008 - Proposed bailout of the U.S. financial system

See also

• Bankruptcy
• Bubble (economics)
• Cash flow
• Debtor-in-possession financing
• Economic crisis of 2008
• Financial crisis
• Lemon socialism
• Moral hazard
• Stock market crash
• Subprime mortgage crisis
• Proposed bailout of United States financial system

Further reading

• "Financial crisis : Carping about the TARP : Congress wrangles over how best to avoid financial Armageddon", The Economist, September 23rd 2008

• "Behind the Bailout"-- NOW on PBS 09/26/2008