What is a bailout? Reasons why companies are bailed out

In finance, a bailout is the act of giving financial capital to a company that is dangerously close to becoming bankrupt. The aim of the bailout is to prevent the company from becoming insolvent. We can also use the term for saving countries that are in serious trouble.

Sometimes the motive behind bailouts is profit. Investors, for example, may see an opportunity if they buy the super-cheap shares of a failing business. However, the goal may be philanthropic. Philanthropists may resurrect an unprofitable business and then turn it into a non-profit organization.

Governments sometimes bail out failing businesses. Governments will intervene, for example, if the failure of the company could damage the national economy.

Risky behavior from bailoutsDo bailouts encourage so-called ‘too big to fail’ businesses to continue taking excessive risks?

Merriam-Webster has the following definition of a bailout:

“The act of saving or rescuing something (such as a business) from money problems.”

Bailouts for the country’s sake

Governments bail out companies because they say they are ‘too big to fail.’ Whatever those companies provide are vital for society’s general welfare, politicians say. Therefore we need to save them.

In other words, if the ramifications of a company going to the wall cause social distress, that is a signal for the government to intervene.

Historically the US government has bailed out companies deemed vital for the national economy. In fact, most governments globally have acted in the same way.

For example, some companies that transport people and goods such as airlines must not go bust. If major airlines went bust, the effect on people’s lives would be significant, governments say.

Therefore, governments often choose to step in and help these businesses survive through subsidies and low-interest loans.

Above all, in such cases, the bailouts are to protect the country and not the company.

Many economists say there were too many bailouts following the global financial crisis of 2007/2008. The bailouts have resulted in too many zombie companies. In fact, the zombie companies use up resources that productive businesses would put to better use.

Government bailouts – a controversial subject

There has been increasing controversy about government bailouts, especially in the US. During the Great Recession, the American government bailed out the automotive industry.

Many people are against the idea of propping up struggling businesses with government bailouts. Advocates of the free market argue that it is unfair to taxpayers.

Why should the taxpayer help a mismanaged company? We should allow a failing company to die naturally. In other words, every business should exist or die according to the laws of the free market.

Additionally, many see bailouts as a signal for giant companies to be able to lower their business standards. Put simply; they claim that senior management sees the bailout is a safety net and continue with their reckless behavior. If something goes drastically wrong, the government is there to prevent bankruptcy.

We have learned the following lessons and concepts regarding bailouts:

  • When banks are not willing to give loans to businesses, the central banks step in. The central bank steps in by providing loans to protect the system.
  • When a ‘too important to fail’ bank is about to crash, the government provides capital in exchange for shares.
  • The government steps in and becomes the owner of the failing company.  It later re-privatizes the company by selling shares to the public.
  • Governments prioritize taxpayer dollars which they use for loans rather than paying investors dividends.
  • The central bank reduces interest rates to lower lending rates and thus stimulate the economy.

bailout people on boat‘To bail’ or ‘to bail out’ is to remove water from a boat so that it does not sink. We call the container a ‘bail’.

Examples of bailouts in recent history

Below is a list of some well-known bailouts in the United States:

1971 – Lockheed Corporation

1980 – Chrysler Corporation

2008(a) – Fannie Mae and Freddie Mac

2008(b) – Goldman Sachs Group, Inc. bailed out by the U.S. federal government and Berkshire Hathaway

2008(c) – Morgan Stanley

2008-2009(d) – American International Group, Inc. several times

2008(e) – General Motors Corporation and Chrysler LLC; although not technically a bailout.

2008(f) – UK bank rescue package

2008(g) – Citigroup Inc

2009 – Bank of America –  to help absorb losses it incurred by its purchase of Merrill Lynch

2009 – Abu Dhabi bailed out Dubai and Dubai World

Reasons against bailouts

Congressman Ron Paul wrote that bailing out companies amounts to confiscating productive taxpayers’ money and giving it to failing ones.

By sustaining unsustainable or obsolete business models, the government is blocking the better use of the nation’s resources. The liquidation of a failing company, for example, would make resources available to other companies.

The other companies might put them to better use. At least the other companies would have the opportunity to try.

Mr. Paul added:

“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 and 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.”

Bailing out a major bank is no guarantee that it will do well in future. In fact, the bailout often helps perpetuate bad business practices, say many economists.

The UK taxpayer bailed out the Royal Bank of Scotland to the tune of £46 billion ($70 billion). From 2008 to May 2015, the bank posted £50 billion in losses. Many would say it is a classical example of a zombie bank.

The cost of a bailout

The World Bank stated that bailing out banks costs an average of 12.8%.

In November 2014, the Governor of the Bank of England Mark Carney said: “The days of banks that are too big to fail are over.” In other words, he meant that there would be no more bailouts in future.

Video – Bank Bailouts Pros and Cons