Bailout

A bailout, in economics and finance, is a fresh injection of liquidity given to a bankrupt or nearly bankrupt entity, such as a corporation or a bank, in order for it 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.

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. The bailout also chooses winners and losers. For example in the most recent bailout by the US government some companies were allowed to fail while other companies were bailed out.

Further the bailout takes money from the people and gives this money to certain failing institutions. The argument is made that since this money is created out of thin air, this will cost the people money at the grocery store in the form of inflation to benefit certain favored wealthy bankers.

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/entities 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.
• 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.
• Let insolvent institutions (i.e., those with insufficient funds to pay their short-term obligations) fail in an orderly way.
• 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.
• If taking over an institution due to insolvency, take effective control through the board or new management, cancel the common stock equity (i.e., 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 dollars are used for loans and strengthening the bank, rather than payments to investors.
• Interest rate cuts, to lower lending rates and stimulate the economy.
• Strong oversight.

Bailout Costs

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

Cases

Irish banking rescue

In 2008 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:

• 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

• 1930s – Great Depression
• 1984 – Continental Illinois
• 1990 – Japan
• 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 – Emergency Economic Stabilization Act of 2008
• 2008 – 2008 United Kingdom bank rescue package

See also

• Bankruptcy
• Bubble (economics)
• Cash flow
• Crédit Lyonnais
• Debtor-in-possession financing
• Economic crisis of 2008
• Financial crisis
• Lender of last resort
• Stock market crash
• Subprime mortgage crisis
• Emergency Economic Stabilization Act of 2008

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

Research papers and historical studies

• IMF Study Laevan and Valencia September 2008