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September 22, 2008

Good Bailouts and Bad

David Beim
Professor of Finance and Economics and Bernstein Faculty Leader
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The U.S. government, faced with the country’s worst financial crisis since the 1930s, has announced a $700 billion plan to purchase bad mortgage assets from banks. Is this a good bailout or a bad one? The difference is important, because history shows us that bad bailouts can actually make financial crises worse.

The Japanese government’s handling of its massive bank crisis in the 1990s is an example of bad bailout policy. At first, the Japanese government ignored the problem it was facing, then it decided not to enforce its own rules requiring sufficient bank capital (“forbearance”), then it began investing government funds into insolvent banks through preferred stock and subordinated debt. This caused the crisis to only grow larger, which contributed greatly to Japan’s poor economic performance during the 1990s and for several years thereafter.

A good bailout focuses on liquidity. The government acts appropriately when it helps institutions with liquidity at a time of crisis by lending against collateral or by purchasing bank assets at fair market prices. A bad bailout is one that tries to help with solvency. The government acts badly when it invests money directly into failing banks without closing them. If a bank — even if there is more than one — is actually insolvent (i.e. its liabilities exceed the value of their assets), then best practice dictates that it should be closed.

Closing a bank is less draconian than it sounds. A closed bank is not simply blown up or thrown away; on the contrary, every effort is made to preserve the bank’s franchise value and maintain continuity with customers and employees. Normally, the government cleanses the bank of its bad assets after closure and transfers the cleaned-up business to new owners as rapidly as possible.

Good bailouts wipe out the shareholders of insolvent banks and dismiss their senior management. Why? Because these are the people who created the problem, and they must be seen to pay a high price. Remember that most banks are conservative, well-run and solvent; only a minority get over-extended.

The problem with the Japanese banks in the 1990s was not just the bubble economy of the 1980s but a continuing unwillingness by banks and the government to acknowledge bad lending practices and change them. A few banks were eventually closed; however, one of these names, Long-Term Credit Bank, eventually became Japan’s greatest banking success after it was closed and sold to an American buyout fund, which resurrected it under the name Shinsei Bank.

From 1986-1992, the FDIC closed over 2,300 banks and thrifts. The Resolution Trust Corporation (RTC) was established to move the bad real estate assets back into the economy as promptly as possible. The RTC, much admired for its speed and efficiency, did not try to buoy up failing banks; it handled their assets after the failing banks were closed.

So is the current administration plan a good bailout or a bad one? At this point the proposal is written in a very general way, and the devil is always in the details. The test will be whether the government plans to buy assets at something resembling their fair market value.

Suppose a bank has made a $10 million loan that is actually worth about $6 million. If the government buys the loan at $6 million, then it is providing liquidity assistance, which is fine. But if the government buys the bad loan for $10 million, it is in essence giving the bank a $4 million gift. Handing out gifts to misbehaving banks is characteristic of a very expensive, bad bailout.

Secretary Paulson has spoken of buying the bad assets at a deep discount, but this is not written into his proposal. It should be a requirement. That would minimize the ultimate cost to the U.S. taxpayers and increase the chances that this bailout is a good one.

Photo credit: Adam Fagen

Comments

by Yogik Pitti | September 23, 2008 at 11:15 AM

The above comment made by the author is very true .But in the example made above by the author ignore certain fact.As he said above ," Suppose a bank has made a $10 million loan that is actually worth about $6 million. If the government buys the loan at $6 million, then it is providing liquidity assistance, which is fine. But if the government buys the bad loan for $10 million, it is in essence giving the bank a $4 million gift. Handing out gifts to misbehaving banks is characteristic of a very expensive, bad bailout".Now the problem the which is being faced by every person in industry is How will you value these these mortgage and on what basis u will buy back these bad assets.The more important part to answer is how will you make sure after buying bak these bad assets instituion will survive .The whole root of the problem is getting leveraged and the bigger worry is that you dont know how to value your own assets but you know how value your liability.As one of my senior rightly said by doing this you are tring to cut down the bull cycle of interest rates which is not right at all .What does this implies ? This implies that the value of the currency will fall since you are not lettin to currency to become inexpensive.This has another effect which would lead to a increase in inflation ,speculative price in gold.As a result the impact will be bear by the comman man. Now one of the hurdles which will be faced by the central banks will be in deciding the instituion which will be helped by the central bank .Second question which specially fed will need to answer will be why it is not bailing out companies like ford or gm from there finacial crises.After all this story and drama we should not forget the upcoming elections as well . At the end I would rather support by saying that the central banks have to make sure and maintain the balance between the various factors of the markets .

by Steven | October 01, 2008 at 2:14 AM

The media really seems to be twisting how Americans feel about the bailout and this bill. The media seems to keep repeating that Americans don't want this bill to pass and we don't understand what will happen if it does not pass. That Americans don't understand how the system as a whole will be affected if this bill is not passed. This is not accurate. Most of us Americans are not as ignorant as this current administration and have seen this coming for some time. We are not saying that something should not be done. We are saying that this bill is not right and should not be passed. We want an alternative!!! This bill is insane and really does not involved the average American. We need to come up with a bill that corrects the problems at hand and resolves these issues. The American people need more in return. We need to be helped out. This bill stinks and we need to come up with something better that involves helping out all Americans directly and not just the top of the chain and expect this trickle down effect to work all of the sudden. It hasn't worked what will make it work now? Why are we throwing more wood on a burning fire? Lets let the fire burn out and then build accordingly. We all agree that something needs to be done. But don't let that make us pass this insane bill that is not going to correct the problem or truly help your fellow Americans! Draft a new bill with head economists and have it open for discussion. And by not passing this bill is not what is hurting the market it is the fear that the government that has forced upon this nation that is hurting the market. They are manipulating the market right now with this fear method that they always do to get done what they want. DON'T LET THEM PASS THIS BILL! IT WILL NOT WORK AND IT IS BOGUS. Make congress come up with another option bill that helps out everyone and does not mainly focus on Wall Street and banks. We have to do something but this bill is not the solution and I think everyone knows that. That is why it failed Monday.

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