Bailout

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Main Findings

• Bailouts are a form of financial assistance that is provided to failing or distressed entities to prevent their collapse and mitigate their negative impacts on the economy.
• Bailouts can take various forms, such as loans, equity injections, or cash infusions, and can be extended by different actors, such as governments, central banks, or international organizations.

A bailout is a type of financial assistance provided by the government or other financially stable institutions in cash, equity, or a loan to prevent too big to fail companies from going bankrupt or defaulting on their financial obligations.

The government comes to the rescue of influential companies to avoid the consequences of systemic financial risks that would damage the national economy.

The failing firm may or may not get the financial assistance on a repayment basis in a bailout. In addition, interest-free or interest-bearing repayments are possible.

Why Bailout?

Bailouts are typically only for companies or industries whose bankruptcies may have a severe adverse impact on the economy, not just a particular market sector. For example, a company that has a considerable workforce may receive a bailout because the economy could not sustain the substantial jump in unemployment that would occur if the business failed.

Often, other companies will step in and acquire the failing business, known as a bailout takeover. Allowing a company to fail can have significant consequences, both for the company itself and for the wider economy - as in the case of contagion.

Below are some other reasons why letting a company fail may not always be the best option, and why bailouts may be warranted:

Job losses

If a company fails, it may result in significant job losses, which can have ripple effects throughout the economy. Unemployment can lead to reduced consumer spending, decreased tax revenue, and a higher burden on social safety net programs.

Economic instability

When a large company fails, it can cause economic instability, particularly if it has significant ties to other companies or industries. This can lead to a domino effect, with other companies failing and causing even more economic damage.

Loss of investor confidence

Allowing a company to fail can erode investor confidence and lead to a wider loss of trust in the financial system and stock market at large. This can make it more difficult for other companies to raise capital, potentially leading to a downward spiral in the economy.

Legal complications

The process of allowing a company to fail can be complicated and messy, particularly if the company has many outstanding debts or complex legal obligations. This can result in lengthy legal proceedings that can be costly and time-consuming.

Formula for Bailout

There is no universal formula for calculating the amount or terms of a bailout. Each bailout is tailored to the specific needs and circumstances of the failing company and the rescuing entity. However, one possible way to measure the effectiveness of a bailout is to use the bailout payback method.

This method compares the initial investment of the bailout with the expected cash flows and salvage value of the rescued company over time. The bailout payback period is the number of years it takes for the rescuing entity to recover its initial investment from the cash flows and salvage value of the rescued company. The shorter the payback period, the more effective the bailout is.

How to Calculate Bailout Payback Period

The following steps can be used to calculate the bailout payback period:

• Estimate the initial investment of the bailout, which may include cash infusions, loans, bonds, or stocks.
• Estimate the annual cash flows of the rescued company after receiving the bailout, which may depend on its profitability, growth rate, and debt repayment schedule.
• Estimate the salvage value of the rescued company at the end of its useful life, which may depend on its market value, liquidation value, or book value.
• Divide the initial investment by the annual cash flow to get an approximate payback period.
• Adjust the payback period by adding or subtracting fractions of years based on the salvage value.

For example, suppose a government invested $20 billion for a bailout of a failing bank and expected $4 billion cash flow annually from its operations and debt repayments. The salvage value of the bank at the end of 10 years was estimated at $2 billion.

The approximate payback period would be:

Payback period = 20 / 4 = 5

The adjusted payback period would be:

Payback period = 5 + (20 - 5 * 4) / (4 + 2) = 5 + 0.33 = 5.33

This means that it would take about 5 years and 4 months for the government to recover its initial investment from the bailout.

Examples

Some of the notable examples of bailouts in recent history are:

U.S. Government

The U.S. government bailed out several banks and financial institutions during the 2007-2008 financial crisis, such as AIG, Citigroup, Bank of America, and Wells Fargo.

The government also bailed out major automakers, such as Ford, GM, and Chrysler, to prevent massive job losses and economic instability. The total cost of these bailouts was estimated at $700 billion under the Troubled Asset Relief Program (TARP).

European Union

The European Union bailed out several countries that faced sovereign debt crises, such as Greece, Ireland, Portugal, Spain, and Cyprus. The bailouts were conditional on the implementation of austerity measures and structural reforms to restore fiscal balance and competitiveness.

The total amount of these bailouts was over €500 billion under various mechanisms, such as the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM).

International Monetary Fund

The International Monetary Fund (IMF) bailed out several countries that faced balance of payments problems, such as Argentina, Brazil, Indonesia, South Korea, Thailand, Turkey, and Ukraine.

The bailouts were aimed at restoring macroeconomic stability and market confidence by providing short-term loans and policy advice. The total amount of these bailouts was over $200 billion under various arrangements, such as the Stand-By Arrangement (SBA) and the Extended Fund Facility (EFF).

Limitations

Bailouts are not without limitations and drawbacks. Some of the common criticisms of bailouts are:

Bailouts create moral hazard, which is the tendency of bailed-out entities to take excessive risks in the future, expecting that they will be rescued again if things go wrong. This can undermine market discipline and incentives for prudent behavior.

Bailouts distort market signals and create unfair competition, which is the advantage that bailed-out entities have over their rivals who do not receive similar support. This can reduce efficiency and innovation in the market and create barriers to entry for new entrants.

Bailouts impose fiscal costs and burdens on taxpayers, which is the amount of public money that is spent or foregone to finance the bailouts. This can increase public debt and deficits and crowd out other public spending or investment priorities.

Conclusion

Bailouts are a form of financial assistance that is provided to failing or distressed entities to prevent their collapse and mitigate their negative impacts on the economy. Bailouts can take various forms, such as loans, equity injections, or cash infusions, and can be extended by different actors, such as governments, central banks, or international organizations.

Bailouts have been used on many occasions to deal with financial crises, sovereign debt crises, or balance of payments problems. However, bailouts also have limitations and drawbacks, such as creating moral hazard, distorting market signals, and imposing fiscal costs.

References

• Investopedia (2023). Troubled Asset Relief Program (TARP), What It Was, How It Worked. https://www.investopedia.com/terms/t/troubled-asset-relief-program-tarp.asp
• IMF (2020). Opening Remarks at a Press Briefing by Kristalina Georgieva following a Conference Call of the International Monetary and Financial Committee (IMFC). https://www.imf.org/en/News/Articles/2020/03/27/sp032720-opening-remarks-at-press-briefing-following-imfc-conference-call
• Investopedia (2023). Moral Hazard: Meaning, Examples, and How to Manage. https://www.investopedia.com/terms/m/moralhazard.asp
• Profolus (2019). Bailout: Advantages and Disadvantages. https://www.profolus.com/topics/bailout-importance-and-criticisms/

FAQ

The primary purpose of a bailout is to provide financial assistance to a failing company, individual, or government to prevent further economic instability.

A notable example of a bailout is the U.S. government’s intervention in the General Motors crisis in 2009–2013.

Critics argue that bailouts can create moral hazard, as they may incentivize risky behavior by signaling that large companies will be saved if they fail. Bailouts can also be controversial due to the use of taxpayer money.

A bailout can stabilize the economy by preventing the failure of large companies that play a significant role in the economy. However, it can also lead to increased public debt and potential inflation.

Factors considered before granting a bailout include the systemic risk posed by the company’s failure, the health of the overall economy, and the potential cost to taxpayers.