Piece of the Action: Debt vs. Equity for Bailouts

American citizens often think of their country as a bastion of free-market capitalism. Indeed, the ethos of American economic policy is devoted to minimal government intervention to ensure that private enterprise can succeed. Proponents of this policy argue that businesses do not fail due to bad management; instead, they fail because “big government” will not get off their back. During the good times, the drumbeat of competition by captains of industry and chambers of commerce keeps the economy marching in time.

Yet, as times turn, these same industries turn to Uncle Sam for bailouts, backstops, and handouts. Somehow when the times turn tough, business leaders change their tune and find government intervention critical to their continuity and role as “job creators.” In some cases, the factors that cause the downturn fall outside of what business could control or foresee, but in several other cases, private industry had to come hat-in-hand due to combinations of mismanagement, lack of foresight, and moral hazard that left taxpayers on the hook. In these situations, the supposed “great evil” that is government intervention came to the rescue, often at much better terms than any free-market funding source would have provided. While traditionally these bailouts have come in the form of government-backed debts, modern bailouts have come in terms of at the-market equity offerings, diluting existing shareholders and eventually providing greater returns to the taxpayer. Policymakers must provide taxpayers the upside and remove the moral hazard for systemically important industries. Equity based bailouts force corporate decisionmakers to consider not just jobs and entire industries, but also the risk to their managerial and personal fortunes.

Since the 1950s, the federal government has stepped in as a backstop for railroads, farm credit, airlines (twice), automotive companies, savings and loan companies, banks, and farmers. Every situation has its own idiosyncrasies, but in each, the federal government intervened to stabilize a critical industry, avoiding systemic collapse that surely would have left the average taxpayer much worse off. In some instances, the treasury guaranteed loans, meaning that creditors would not suffer if the relevant industry could not generate sufficient revenue to pay back the loans, leading to less onerous interest rates. A second option was that the government would provide loans at relatively low interest rates to ensure that industries remained solvent. In a third option, the United States Treasury would take an ownership stake in some of these companies in what amounts to an “at-the-market” offering, in which the companies involved issue more shares at their current market price to the government in exchange for cash to continue business operations. The federal government has also backstopped businesses either through direct cash grants or buying goods to hold up market prices. In each of these cases, critical businesses to the U.S. economy survived due to government intervention in a presumably free market, preventing deeper, more dire consequences.

The banking, automotive, and aviation industries have benefited the most from government bailouts in the 21^st century. Each of these provides different lessons and indications for a way forward. All three industries bore varied levels of culpability for the plight they found themselves in and thus each company deserved somewhat different terms. Nonetheless, all three cases point to equity and dilution of shareholder value yielding both the best return for the American people as well as discouraging further bad actions by management.

The bank bailout in 2008, also known as the Troubled Asset Relief Program (TARP), in response to the financial crisis included a mix of debt, equity, and grant funding. Enough books have already covered the genesis of the financial crisis, but the crux of the issue boils down the packaging of increasingly risky mortgages into financial products and further financial engineering. Eventually, the increasingly complicated interconnections between financial institutions led to staggering levels of insolvency in the global banking system. Many of the critical banks in the global financial system lacked sufficient working capital to cover obligations. Ultimately, the federal government stepped in and injected significant capital into the nine largest banks in the United States. Additionally, the start of quantitative easing (QE1) allowed the Federal Reserve to buy an additional $1.25 trillion in mortgage-backed securities and other debt instruments to provide banks more liquidity by removing distressed assets from their balance sheets. Both actions ended up net profitable for the Treasury, with TARP bank support leading to a return of over 12% and QE1 a return of nearly 7%.

The fact that equity bailouts led to a greater return actually hides the larger impact: the Federal Reserve supporting the fixed income securities market allows banks to recoup profits for risks they took and reaped profits. They could take on as much risk as they wanted to with full knowledge that the government would not allow them to fail, given the impact on “Main Street”. The Wall Street bankers could collect their gains and the corresponding bonuses while leaving the taxpayer to hold the bag when the bet went bad. As such, an equity dilution causes the shareholder to pay the price of the bailout and provides the taxpayer with the equity upside.

At the same time Wall Street melted down, the economic collateral damage nearly destroyed an even more iconic American industry: the automotive industry. Within a year of the 2008 collapse, total production at General Motors fell by 47%, Chrysler dropped by 57%, while the total production of all automakers decreased by 34%. Failure for these companies would mean a cascade of bankruptcies in auto suppliers, leading to significant unemployment and pension insolvency that the federal government would eventually need to bail out. The Bush administration extended TARP loans to the aforementioned automakers, as well as their credit financing companies: GMAC and Chrysler Financial. Originally the assistance came in terms of loans, but the Obama administration converted the agreement to equity due to a lack of agreement from stakeholders.

Eventually, the federal government liquidated their shares after the stock price recovered and the businesses recovered solvency. In this case, the auto industry had relatively little to do with the nature of the crisis. While they offered additional credit through their financing companies, which resulted in at least part of their insolvency, automotives suffered due to a greater failure among financial institutions, significantly cutting aggregate demand. Ultimately because of the equity sales, the government would limit the losses to approximately $9.1 billion on a total of nearly $80 billion in loans. The automotive industry lives on and employs more than 2 million Americans as of February 2022. Saddling the automakers with excessive debt would have left them insolvent to continue functioning as interest payments would have exceeded cashflows, forcing them to shut down. Instead, equity investments allowed the industry to continue to grow and consequently employ more workers.

Finally, we need to discuss the one industry that has required two bailouts since the turn of the century: airlines. Running an airline is undoubtedly hard to do in any circumstance, but no one can deny the history of unforeseeable headwinds that the industry has faced. The first government intervention came with the attacks on 9/11. In this case, the federal government stepped in to backstop a critical industry hit by an unprecedented, exogenous catastrophe, passing the Air Transportation Safety and System Stabilization Act, which included $5 billion of grants and $10 billion worth of guaranteed loans to allow them to maintain solvency. Airlines paid back all but one of these loans, with the one exception where the government recovered nearly 80% of funds during the bankruptcy proceedings.

Nearly 20 years later, the airlines again faced an exogenous shock in the face of the COVID-19 pandemic and returned to the American taxpayer hat-in-hand. Again, they requested and received significant loans and grants to the tune of $25 billion each for payroll and loans as well as $10 billion in grants, but perhaps this time we should abandon the loan and grant formula. Inherently, airlines as an industry face highly cyclical economics, as vacation trips and business travel are first on the chopping block in most household and corporate budgets during any economic slowdown. After 9/11, these industries should have realized this fundamental nature of their business and prepared for exogenous shocks so as not to require such steep bailouts just to survive. Instead, per one Bloomberg analysis, airlines spent 96% of free cash flows on stock buybacks to return profits to shareholders instead of stocking up a rainy-day fund. These buybacks concentrated their stock and reduced their ability to face a crisis. Eventually, when the crisis hit, they came begging for guaranteed loans to protect their shareholders from losses. The federal government needs to discourage such irresponsible corporate behavior by providing bailout funds in at-the-money offerings of preferred shares and warrants, which will then dilute the shareholders who benefitted from the prior corporate malfeasance.

Economic shocks, natural disasters, and geopolitical events hit corporations unexpectedly and disrupt even the most carefully thought-out business plans. In these cases, the government can and should step in to prevent systemic collapse and the resulting unemployment. That said, companies that assume such a backstop as part of their business plan, privatize their profits to shareholders and socialize their losses to the American people. Economic history tells us that no boom is permanent and thus every corporation needs to have a plan for the day the music stops. If they fail to do so, then the federal government should absolutely be there to help, but in the form of equity bailouts so that the taxpayer gets just as much of the upside as the investor.