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Are bank bailouts un-American?
Business Horizons (2010) 53, 463—467
www.elsevier.com/locate/bushor
EXECUTIVE DIGEST
Are bank bailouts un-American? Gregory F. Udell Kelley School of Business, Indiana University, 1309 East 10th Street, Bloomington, IN 47405-1701, U.S.A.
1. Tumultuous times As I write this Executive Digest, Congress and the country are debating financial institution regulatory reform. At this point, lines have been drawn in the sand. The Democrats have a proposal that has come out of the Senate Banking Committee with nominal Republican support. Much of the debate has centered on whether the proposal encourages or discourages bank bailouts. Of course, by the time you read this article, the Senate’s proposal–—or some alternative–— may have become the law of the land. Regardless of the legislative outcome, however, it is not likely that the debate about bank bailouts will be over, although it might be deferred until the end of the next business cycle when the banking system gets whacked again. So, are bank bailouts un-American? At first blush, the answer to the question seems so obvious that it hardly deserves an article written about it. ‘‘Of course,’’ you might say, ‘‘bank bailouts are unAmerican.’’ Republicans say this. Democrats say this. Populists and tea-partiers say this. Pundits of all stripes fuel the fires on talk-radio and talk-TV. Interestingly, though, each side in this debate accuses the others of being pro-bailout. So, what gives? Here’s my take: The question itself is nonsensical. But, it’s worse than that. It distracts from serious discourse and it creates the opportunity for mischief. Let me explain why. The problem centers on two key words in the title’s question: un-American and bailout. Both suf-
E-mail address: [email protected]
fer from the same deficiency. Each of them lacks a universally agreed upon definition. Put them in the same sentence and we’ve got trouble right here in River City–—with a capital ‘‘T.’’ Let’s start with unAmerican. U.S. politicians have long applied the term to anyone who opposes their legislative proposal–—and, more generally, their political views. We’ve heard these arguments many times in the past and we’re hearing them now in reference to financial reform. On the one hand, proponents of the war [pick any war in the last five decades] argue that it is un-American to oppose the war. On the other hand, critics of the war [again, you pick the war] argue that it is un-American to favor the war. Same thing with the healthcare debate. What’s the problem here? The problem is that the purveyors of this language assert the right to define what is ‘‘American,’’ and they tautologically define it to include their own policy agenda. Now let’s turn our attention to the other problem word, bailout. Because bailout also lacks a universally agreed upon definition, politicians and pundits can assert all kinds of claims about how their opponents’ policies encourage bailouts. In a world where the complexity of the financial crisis perplexes even the most sophisticated observers, most people have no idea how ambiguous the term really is. What happens when you put these two words in the same sentence? Well, let’s postpone this question for a minute and turn first to an exploration of why the term bailout is so vague and why it is so vulnerable to manipulation in the political arena. In order to demonstrate the ambiguity of the term bailout, let’s consider a banking example. Take the hypothetical case of Underwater Big Bank,
0007-6813/$ — see front matter # 2010 Kelley School of Business, Indiana University. All rights reserved. doi:10.1016/j.bushor.2010.05.007
464 Figure 1.
EXECUTIVE DIGEST Failed bank
tinues to exist, (3) what happens to the old management, and (4) who pays. We’ll work our way down the list starting with the first dimension, which is probably the trickiest.
1.1. Who gets paid out?
whose balance sheet is shown in Figure 1. Underwater has failed because its assets have sunk in value. For the purpose of illustration, let’s assume that the assets have sunk below the value of the insured deposits. That is, the assets have fallen by so much that they are worth less than the amount of insured deposits. (This describes the situation in many failed banks, but not all. The assets only need to fall enough to wipe out the stockholders’ equity for the bank to qualify as economically insolvent.) Listed on the right-hand side of the vertical line (i.e., the right-hand side of the balance sheet) are the bank’s claimants. They are listed in the order of their priority; that is, the claimants are entitled to the (now sunken) value of the bank’s assets based on where they appear in this hierarchy from top to bottom. For example, uninsured depositors are only entitled to a payout after all of the insured depositors (those depositors explicitly covered by the FDIC) are paid out. Non-deposit debtholders are generally entitled to a payout only after the insured and the uninsured depositors are paid out. The subordinated debtholders are only entitled to a payout after the insured depositors, the uninsured depositors, and the non-deposit debtholders are paid out. The stockholders would only be entitled to a payout if there was something left over after everyone else has been paid out. Again, in our example there isn’t even enough asset value in Underwater Big Bank to pay out the insured depositors (setting aside for the moment that the FDIC will pay them out), let alone anybody else. How do we know if government agencies have bailed out Underwater Big Bank? Well, the answer depends on how one defines a bailout. (Warning: be wary of those who claim they ‘‘know one when they see one!’’) There are at least four different dimensions on which a bailout can be defined. They are: (1) who gets paid out, (2) whether the bank con-
Figure 2 shows the different mutually exclusive scenarios in the brackets marked A through E, each one of which could be our definition of a bailout in terms of who gets paid out. In resolving the Underwater Big Bank failure each scenario is a choice variable for the FDIC (and other government agencies like the Federal Reserve and the Treasury). The FDIC could make its choice based on a variety of factors, including which scenario minimizes the FDIC’s costs and whether the liquidation (or discontinuance) of the bank poses a systemic risk to the economy. Let’s start with the most extreme definition of a bailout: a bailout occurs anytime the payout exceeds the value of the bank’s assets. (Remember, the asset value of Underwater Big Bank isn’t even big enough to cover the insured depositors.) You might say, ‘‘That’s impossible, because the FDIC insures the insured depositors, so this would involve reneging on a government promise in the case of Underwater Big Bank. Not even the most extreme politician has advocated going that far–—although their rhetoric sometimes sounds like it.’’ True enough. But, deposit insurance itself was a policy decision made in 1933. So, one definition of a bailout could include the decision to bail out insured depositors that we made as a country when we created FDIC deposit insurance. (Of course, the reason we passed the Banking Act of 1933 that created deposit insurance was because of a massive bank panic during the Depression that ultimately led to the failure of more than a third of all banks in the U.S.) This gets us to the first alternative definition reflected in bracket A. Under bracket A, we cover
Figure 2.
Which one is a bailout?
EXECUTIVE DIGEST the insured deposits but no one else. In this scenario, all uninsured depositors will lose their money in the resolution of Underwater Big Bank, along with other claimants. But, under A, we bailed out the insured depositors. The next alternative definition, B, requires paying off some or all of the uninsured depositors in addition to the insured depositors before a failure resolution would be defined as a bailout. (Note that just paying off the insured depositors does not qualify as a bailout under definition B.) Under definition B, we have bailed out hundreds of banks in the decades since the creation of deposit insurance. But often, though not always, these bailouts were associated with a reduced FDIC loss because the FDIC was able to sell the failed bank’s franchise by merging it into a healthy acquiring bank under a procedure called a purchase and assumption. On the one hand, under this procedure the FDIC absorbs the failed bank’s losses; but, on the other hand, these losses are–—at least partially–—offset because the FDIC receives a fee from the acquiring bank. This procedure also has the advantage of preventing a run on the bank and minimizing any contagion effect where a bank run on the failed bank spills over to other banks. Nevertheless, uninsured depositors receive a payout that they wouldn’t have otherwise gotten. Thus, under this alternative definition B, uninsured depositors are viewed as having been bailed out. The next alternative definition is in bracket C. Under this definition, a bailout occurs in the Underwater Big Bank case when all depositors are paid out along with all non-deposit debt of the bank (i.e., the senior debt). Otherwise it’s not a bailout. By the time we get to bracket D, our definition of a bailout is getting narrow because subordinated debtholders have to get paid out in order for the resolution to be considered a bailout. That is, under D, a bailout occurs only if all of the creditors are paid out (i.e., insured depositors, uninsured depositors, non-deposit debt, and subordinated debt)–—even though the stockholders don’t get paid out. But on the payout dimension, the narrowest definition of a bailout would be E. Under E, it is not a bailout unless the shareholders get to keep their stock. The canonical example here is Citibank–—or, more technically, Citigroup–—where none of the creditors were wiped out and the stockholders did not lose their shares. Note, for example, that this is dramatically different from definition A. Historically, most bank failure resolutions under definition E would not be considered bailouts because in most bank failure resolutions stockholders are wiped out. Nonetheless, in some big bank failures, stockholders
465 have–—fully, partially, or temporarily–—survived. In addition to Citi, consider Continental Illinois Bank, where in 1984 shareholders kept a residual/contingent claim. In contrast, under definition B, the vast majority of failed banking assets since 1933 have been handled as bailouts because the vast majority of banks which weren’t tiny were handled as purchase and assumptions. So which definition is best? From where I sit, they’re all reasonable, even though they are quite different. One definition isn’t inherently more accurate than another. That doesn’t mean that the alternative forms of failure resolution undergirding these definitions are all equal from an economic perspective. That is a much more complicated issue, and one that is beyond the scope of this article. It involves trading off the costs of allowing banks to disappear precipitously versus the costs of allowing them–—or some remnant–—to survive. How we apply the label bailout is far less important than how we analyze this trade-off between financial disruption and incentive effects. My main point in this Executive Digest is that, in our public discourse, we focused far too much on the label issue and not enough on the underlying economic analysis. One last note on the payout dimension: A number of economists, including Paul Krugman, supported nationalizing one or more of the big banks in the fall of 2008. I happened to share that view. Some argued at the time, however, that nationalizing banks was un-American because it was inconsistent with our free enterprise system. Setting the distraction of what constitutes ‘‘un-American’’ aside, it’s worth noting that the choice we ultimately made in the case of Citibank was to bail it out–—even under the narrowest definition (E). That is, not only did we keep Citibank going and preserve all creditor claims, but we allowed the shareholders to retain their stock. But, you might say, the shares were substantially diluted because the government took an equity interest in the bank and additional stock was raised externally. So, some might argue quite logically that we didn’t really bail out Citi because most shareholder value was wiped out. Thus, we could define another category (category F) to distinguish between a complete bailout of stockholders and a partial bailout of stockholders. This gets us to six possible definitions of a bailout under the payout dimension. So, what would nationalization of Citi have looked like in 2008? Of course we don’t know the counterfactual. However, the likely scenario is C, where the stockholders would have been wiped and the subordinated debtholders would have been wiped out. The government would have owned all
466 of Citi’s stock. (The irony here is that the critics who argued against nationalizing Citi because it was unAmerican, settled instead for a type E bailout where everyone survives.) How, then, should we think about our decision to keep Citi afloat? Let me make two related points here. First, when we think about these two alternatives to the Citi problem–—nationalization versus a type E bailout–—we shouldn’t focus on which one is a bailout and which one is not, or which one was more ‘‘baily-outish.’’ This is a distraction and just depends on which definition of bailout you prefer. Second, the better way to think about these two alternatives in the case of Citi is in terms of the economic trade-offs. For example, would the inefficiencies associated with the government running Citi–—even temporarily–—be offset by the long-term improvement in market discipline associated with wiping out the subordinated debt and shareholders’ equity? The answer to this is not obvious and, alas, it is also beyond the scope of this article. But, it is proper to focus on.
1.2. Whether the bank continues to exist Another way to think about our definition is in terms of whether the bank continues to exist. We might consider defining a bailout on this dimension in terms of whether the bank disappears or not. Sometimes banks are simply liquidated, usually small bank failures. If the bank survives, then maybe that makes it a bailout. But what if the bank is merged into another bank, such as in the case of Wachovia and Washington Mutual, or Merrill Lynch and Bear Stearns? Maybe we should define distressed mergers (i.e., purchase and assumptions) as bailouts because the failed bank, sort of, survives. So, on the continuity dimension we have three alternative scenarios: (1) the bank is liquidated, (2) the bank survives as an independent entity, or (3) the bank survives as a melded part of an existing bank.
1.3. What happens to management? Here’s another dimension on which bailout definitions could vary: Does the manager survive? If the manager is fired, then maybe the failure shouldn’t be considered a bailout. What if management doesn’t survive but walks away with a big severance package? Should this factor into our bailout definition? Maybe; think Stanley O’Neal at Merrill and Charles Prince at Citi. We have at least three relevant alternatives under the management dimension: (1) management is fired without severance, (2) management survives, or (3) management is fired but gets a severance package.
EXECUTIVE DIGEST
1.4. Who pays for the bailout? This dimension has become quite controversial. At the time of this writing, both the House and the Senate regulatory reform proposals have provisions for special funds that could be used to support systemically important large banks in the event they get into financial distress; that is, to payout various creditors a ` la Figure 1. Some argue that this is a bank bailout because it is propping up banks that should be dissolved. Others contend these funds are not bailouts because the money is not generated from taxpayers, but rather from a fee charged to the largest systemic banks in good times. Critics counter, however, that it doesn’t matter whether it is taxpayer money or not–—the incentive effect is the same: banks will be able to raise funds from creditors who know that there is a reservoir available to pay them off if the bank can’t. And, this causes moral hazard. Of course, there is an interesting analogue here: deposit insurance. Deposit insurance has the same effect. Insured depositors won’t discipline a bank because they know they are covered. There seem to be two relevant scenarios on which we could define bailouts: (1) a bailout occurs only if taxpayer money is involved; or (2) a bailout occurs regardless of the source of funds used to make the payouts, including funds from the FDIC, purchase and assumption fees, and money from the newly legislated resolution funds.
2. Summary Now let’s return to the original point of this article: Are bank bailouts un-American? I hope that I have convinced you that without a universal definition of a bank bailout, we can’t even begin to think about an answer. Moreover, as we’ve seen, we have a large number of reasonable alternative scenarios which we could use to construct the definition of a bank bailout. We have identified six possible alternative scenarios on the payout dimension (A through F), three alternative scenarios on the continuity dimension, three on the management dimension, and two on the source of payment dimension. So, how many alternative definitions are there? One way to answer this is to simply calculate the combinations that can be constructed from the factors on each dimension. This suggests that there are 108 (= 6 3 3 2) alternative definitions of a bailout! Some of them might be better than others, but most are quite logical and reasonable. For example, we could define a bailout as occurring only when every claimant–—including stockholders –—has been paid off using some taxpayer money and
EXECUTIVE DIGEST the bank survives as an independent institution along with its former management. Or, a bailout occurs anytime there is a payout beyond the value of the assets regardless of whether the bank survives, regardless of whether management survives, and regardless of where the money comes from. Both of these definitions make sense and are logical, but their respective meanings are strikingly different. The problem we have today in the public discourse over financial reform is that politicians and pundits throw around the term bailout without being forced to define it. In this type of world, two politicians can simultaneously argue that a proposal is, and is not, a bailout–—and, they can
467 both be correct at the same time. The reason? They are using entirely different definitions of a bailout. After all, each can choose from the 108 definitions available! This is where the mischief comes in. If an uninformed and overwhelmed public isn’t aware of the ambiguity associated with the term bailout, then they are vulnerable to manipulation. As a result, politicians can avoid the difficult analysis associated with tough trade-offs by diverting attention to some other political narrative by labeling an opponent’s proposal as a bailout. This does not serve us well. Throw in the ambiguity of what’s ‘‘un-American’’ and I think we get double the confusion. . .and mischief squared!
www.elsevier.com/locate/bushor
EXECUTIVE DIGEST
Are bank bailouts un-American? Gregory F. Udell Kelley School of Business, Indiana University, 1309 East 10th Street, Bloomington, IN 47405-1701, U.S.A.
1. Tumultuous times As I write this Executive Digest, Congress and the country are debating financial institution regulatory reform. At this point, lines have been drawn in the sand. The Democrats have a proposal that has come out of the Senate Banking Committee with nominal Republican support. Much of the debate has centered on whether the proposal encourages or discourages bank bailouts. Of course, by the time you read this article, the Senate’s proposal–—or some alternative–— may have become the law of the land. Regardless of the legislative outcome, however, it is not likely that the debate about bank bailouts will be over, although it might be deferred until the end of the next business cycle when the banking system gets whacked again. So, are bank bailouts un-American? At first blush, the answer to the question seems so obvious that it hardly deserves an article written about it. ‘‘Of course,’’ you might say, ‘‘bank bailouts are unAmerican.’’ Republicans say this. Democrats say this. Populists and tea-partiers say this. Pundits of all stripes fuel the fires on talk-radio and talk-TV. Interestingly, though, each side in this debate accuses the others of being pro-bailout. So, what gives? Here’s my take: The question itself is nonsensical. But, it’s worse than that. It distracts from serious discourse and it creates the opportunity for mischief. Let me explain why. The problem centers on two key words in the title’s question: un-American and bailout. Both suf-
E-mail address: [email protected]
fer from the same deficiency. Each of them lacks a universally agreed upon definition. Put them in the same sentence and we’ve got trouble right here in River City–—with a capital ‘‘T.’’ Let’s start with unAmerican. U.S. politicians have long applied the term to anyone who opposes their legislative proposal–—and, more generally, their political views. We’ve heard these arguments many times in the past and we’re hearing them now in reference to financial reform. On the one hand, proponents of the war [pick any war in the last five decades] argue that it is un-American to oppose the war. On the other hand, critics of the war [again, you pick the war] argue that it is un-American to favor the war. Same thing with the healthcare debate. What’s the problem here? The problem is that the purveyors of this language assert the right to define what is ‘‘American,’’ and they tautologically define it to include their own policy agenda. Now let’s turn our attention to the other problem word, bailout. Because bailout also lacks a universally agreed upon definition, politicians and pundits can assert all kinds of claims about how their opponents’ policies encourage bailouts. In a world where the complexity of the financial crisis perplexes even the most sophisticated observers, most people have no idea how ambiguous the term really is. What happens when you put these two words in the same sentence? Well, let’s postpone this question for a minute and turn first to an exploration of why the term bailout is so vague and why it is so vulnerable to manipulation in the political arena. In order to demonstrate the ambiguity of the term bailout, let’s consider a banking example. Take the hypothetical case of Underwater Big Bank,
0007-6813/$ — see front matter # 2010 Kelley School of Business, Indiana University. All rights reserved. doi:10.1016/j.bushor.2010.05.007
464 Figure 1.
EXECUTIVE DIGEST Failed bank
tinues to exist, (3) what happens to the old management, and (4) who pays. We’ll work our way down the list starting with the first dimension, which is probably the trickiest.
1.1. Who gets paid out?
whose balance sheet is shown in Figure 1. Underwater has failed because its assets have sunk in value. For the purpose of illustration, let’s assume that the assets have sunk below the value of the insured deposits. That is, the assets have fallen by so much that they are worth less than the amount of insured deposits. (This describes the situation in many failed banks, but not all. The assets only need to fall enough to wipe out the stockholders’ equity for the bank to qualify as economically insolvent.) Listed on the right-hand side of the vertical line (i.e., the right-hand side of the balance sheet) are the bank’s claimants. They are listed in the order of their priority; that is, the claimants are entitled to the (now sunken) value of the bank’s assets based on where they appear in this hierarchy from top to bottom. For example, uninsured depositors are only entitled to a payout after all of the insured depositors (those depositors explicitly covered by the FDIC) are paid out. Non-deposit debtholders are generally entitled to a payout only after the insured and the uninsured depositors are paid out. The subordinated debtholders are only entitled to a payout after the insured depositors, the uninsured depositors, and the non-deposit debtholders are paid out. The stockholders would only be entitled to a payout if there was something left over after everyone else has been paid out. Again, in our example there isn’t even enough asset value in Underwater Big Bank to pay out the insured depositors (setting aside for the moment that the FDIC will pay them out), let alone anybody else. How do we know if government agencies have bailed out Underwater Big Bank? Well, the answer depends on how one defines a bailout. (Warning: be wary of those who claim they ‘‘know one when they see one!’’) There are at least four different dimensions on which a bailout can be defined. They are: (1) who gets paid out, (2) whether the bank con-
Figure 2 shows the different mutually exclusive scenarios in the brackets marked A through E, each one of which could be our definition of a bailout in terms of who gets paid out. In resolving the Underwater Big Bank failure each scenario is a choice variable for the FDIC (and other government agencies like the Federal Reserve and the Treasury). The FDIC could make its choice based on a variety of factors, including which scenario minimizes the FDIC’s costs and whether the liquidation (or discontinuance) of the bank poses a systemic risk to the economy. Let’s start with the most extreme definition of a bailout: a bailout occurs anytime the payout exceeds the value of the bank’s assets. (Remember, the asset value of Underwater Big Bank isn’t even big enough to cover the insured depositors.) You might say, ‘‘That’s impossible, because the FDIC insures the insured depositors, so this would involve reneging on a government promise in the case of Underwater Big Bank. Not even the most extreme politician has advocated going that far–—although their rhetoric sometimes sounds like it.’’ True enough. But, deposit insurance itself was a policy decision made in 1933. So, one definition of a bailout could include the decision to bail out insured depositors that we made as a country when we created FDIC deposit insurance. (Of course, the reason we passed the Banking Act of 1933 that created deposit insurance was because of a massive bank panic during the Depression that ultimately led to the failure of more than a third of all banks in the U.S.) This gets us to the first alternative definition reflected in bracket A. Under bracket A, we cover
Figure 2.
Which one is a bailout?
EXECUTIVE DIGEST the insured deposits but no one else. In this scenario, all uninsured depositors will lose their money in the resolution of Underwater Big Bank, along with other claimants. But, under A, we bailed out the insured depositors. The next alternative definition, B, requires paying off some or all of the uninsured depositors in addition to the insured depositors before a failure resolution would be defined as a bailout. (Note that just paying off the insured depositors does not qualify as a bailout under definition B.) Under definition B, we have bailed out hundreds of banks in the decades since the creation of deposit insurance. But often, though not always, these bailouts were associated with a reduced FDIC loss because the FDIC was able to sell the failed bank’s franchise by merging it into a healthy acquiring bank under a procedure called a purchase and assumption. On the one hand, under this procedure the FDIC absorbs the failed bank’s losses; but, on the other hand, these losses are–—at least partially–—offset because the FDIC receives a fee from the acquiring bank. This procedure also has the advantage of preventing a run on the bank and minimizing any contagion effect where a bank run on the failed bank spills over to other banks. Nevertheless, uninsured depositors receive a payout that they wouldn’t have otherwise gotten. Thus, under this alternative definition B, uninsured depositors are viewed as having been bailed out. The next alternative definition is in bracket C. Under this definition, a bailout occurs in the Underwater Big Bank case when all depositors are paid out along with all non-deposit debt of the bank (i.e., the senior debt). Otherwise it’s not a bailout. By the time we get to bracket D, our definition of a bailout is getting narrow because subordinated debtholders have to get paid out in order for the resolution to be considered a bailout. That is, under D, a bailout occurs only if all of the creditors are paid out (i.e., insured depositors, uninsured depositors, non-deposit debt, and subordinated debt)–—even though the stockholders don’t get paid out. But on the payout dimension, the narrowest definition of a bailout would be E. Under E, it is not a bailout unless the shareholders get to keep their stock. The canonical example here is Citibank–—or, more technically, Citigroup–—where none of the creditors were wiped out and the stockholders did not lose their shares. Note, for example, that this is dramatically different from definition A. Historically, most bank failure resolutions under definition E would not be considered bailouts because in most bank failure resolutions stockholders are wiped out. Nonetheless, in some big bank failures, stockholders
465 have–—fully, partially, or temporarily–—survived. In addition to Citi, consider Continental Illinois Bank, where in 1984 shareholders kept a residual/contingent claim. In contrast, under definition B, the vast majority of failed banking assets since 1933 have been handled as bailouts because the vast majority of banks which weren’t tiny were handled as purchase and assumptions. So which definition is best? From where I sit, they’re all reasonable, even though they are quite different. One definition isn’t inherently more accurate than another. That doesn’t mean that the alternative forms of failure resolution undergirding these definitions are all equal from an economic perspective. That is a much more complicated issue, and one that is beyond the scope of this article. It involves trading off the costs of allowing banks to disappear precipitously versus the costs of allowing them–—or some remnant–—to survive. How we apply the label bailout is far less important than how we analyze this trade-off between financial disruption and incentive effects. My main point in this Executive Digest is that, in our public discourse, we focused far too much on the label issue and not enough on the underlying economic analysis. One last note on the payout dimension: A number of economists, including Paul Krugman, supported nationalizing one or more of the big banks in the fall of 2008. I happened to share that view. Some argued at the time, however, that nationalizing banks was un-American because it was inconsistent with our free enterprise system. Setting the distraction of what constitutes ‘‘un-American’’ aside, it’s worth noting that the choice we ultimately made in the case of Citibank was to bail it out–—even under the narrowest definition (E). That is, not only did we keep Citibank going and preserve all creditor claims, but we allowed the shareholders to retain their stock. But, you might say, the shares were substantially diluted because the government took an equity interest in the bank and additional stock was raised externally. So, some might argue quite logically that we didn’t really bail out Citi because most shareholder value was wiped out. Thus, we could define another category (category F) to distinguish between a complete bailout of stockholders and a partial bailout of stockholders. This gets us to six possible definitions of a bailout under the payout dimension. So, what would nationalization of Citi have looked like in 2008? Of course we don’t know the counterfactual. However, the likely scenario is C, where the stockholders would have been wiped and the subordinated debtholders would have been wiped out. The government would have owned all
466 of Citi’s stock. (The irony here is that the critics who argued against nationalizing Citi because it was unAmerican, settled instead for a type E bailout where everyone survives.) How, then, should we think about our decision to keep Citi afloat? Let me make two related points here. First, when we think about these two alternatives to the Citi problem–—nationalization versus a type E bailout–—we shouldn’t focus on which one is a bailout and which one is not, or which one was more ‘‘baily-outish.’’ This is a distraction and just depends on which definition of bailout you prefer. Second, the better way to think about these two alternatives in the case of Citi is in terms of the economic trade-offs. For example, would the inefficiencies associated with the government running Citi–—even temporarily–—be offset by the long-term improvement in market discipline associated with wiping out the subordinated debt and shareholders’ equity? The answer to this is not obvious and, alas, it is also beyond the scope of this article. But, it is proper to focus on.
1.2. Whether the bank continues to exist Another way to think about our definition is in terms of whether the bank continues to exist. We might consider defining a bailout on this dimension in terms of whether the bank disappears or not. Sometimes banks are simply liquidated, usually small bank failures. If the bank survives, then maybe that makes it a bailout. But what if the bank is merged into another bank, such as in the case of Wachovia and Washington Mutual, or Merrill Lynch and Bear Stearns? Maybe we should define distressed mergers (i.e., purchase and assumptions) as bailouts because the failed bank, sort of, survives. So, on the continuity dimension we have three alternative scenarios: (1) the bank is liquidated, (2) the bank survives as an independent entity, or (3) the bank survives as a melded part of an existing bank.
1.3. What happens to management? Here’s another dimension on which bailout definitions could vary: Does the manager survive? If the manager is fired, then maybe the failure shouldn’t be considered a bailout. What if management doesn’t survive but walks away with a big severance package? Should this factor into our bailout definition? Maybe; think Stanley O’Neal at Merrill and Charles Prince at Citi. We have at least three relevant alternatives under the management dimension: (1) management is fired without severance, (2) management survives, or (3) management is fired but gets a severance package.
EXECUTIVE DIGEST
1.4. Who pays for the bailout? This dimension has become quite controversial. At the time of this writing, both the House and the Senate regulatory reform proposals have provisions for special funds that could be used to support systemically important large banks in the event they get into financial distress; that is, to payout various creditors a ` la Figure 1. Some argue that this is a bank bailout because it is propping up banks that should be dissolved. Others contend these funds are not bailouts because the money is not generated from taxpayers, but rather from a fee charged to the largest systemic banks in good times. Critics counter, however, that it doesn’t matter whether it is taxpayer money or not–—the incentive effect is the same: banks will be able to raise funds from creditors who know that there is a reservoir available to pay them off if the bank can’t. And, this causes moral hazard. Of course, there is an interesting analogue here: deposit insurance. Deposit insurance has the same effect. Insured depositors won’t discipline a bank because they know they are covered. There seem to be two relevant scenarios on which we could define bailouts: (1) a bailout occurs only if taxpayer money is involved; or (2) a bailout occurs regardless of the source of funds used to make the payouts, including funds from the FDIC, purchase and assumption fees, and money from the newly legislated resolution funds.
2. Summary Now let’s return to the original point of this article: Are bank bailouts un-American? I hope that I have convinced you that without a universal definition of a bank bailout, we can’t even begin to think about an answer. Moreover, as we’ve seen, we have a large number of reasonable alternative scenarios which we could use to construct the definition of a bank bailout. We have identified six possible alternative scenarios on the payout dimension (A through F), three alternative scenarios on the continuity dimension, three on the management dimension, and two on the source of payment dimension. So, how many alternative definitions are there? One way to answer this is to simply calculate the combinations that can be constructed from the factors on each dimension. This suggests that there are 108 (= 6 3 3 2) alternative definitions of a bailout! Some of them might be better than others, but most are quite logical and reasonable. For example, we could define a bailout as occurring only when every claimant–—including stockholders –—has been paid off using some taxpayer money and
EXECUTIVE DIGEST the bank survives as an independent institution along with its former management. Or, a bailout occurs anytime there is a payout beyond the value of the assets regardless of whether the bank survives, regardless of whether management survives, and regardless of where the money comes from. Both of these definitions make sense and are logical, but their respective meanings are strikingly different. The problem we have today in the public discourse over financial reform is that politicians and pundits throw around the term bailout without being forced to define it. In this type of world, two politicians can simultaneously argue that a proposal is, and is not, a bailout–—and, they can
467 both be correct at the same time. The reason? They are using entirely different definitions of a bailout. After all, each can choose from the 108 definitions available! This is where the mischief comes in. If an uninformed and overwhelmed public isn’t aware of the ambiguity associated with the term bailout, then they are vulnerable to manipulation. As a result, politicians can avoid the difficult analysis associated with tough trade-offs by diverting attention to some other political narrative by labeling an opponent’s proposal as a bailout. This does not serve us well. Throw in the ambiguity of what’s ‘‘un-American’’ and I think we get double the confusion. . .and mischief squared!