Bailout
What is it?
Bailout is becoming a very well-used term in financial services, but its underlying meaning has got more to do with sailing than banks.
Long before throwing money at struggling financial institutions became a common occurrence, bailing something out meant employing a bucket to scoop water out of a boat that was in danger of sinking.
Nowadays, bailout is typically used to mean injecting money into a bank which is in danger of becoming insolvent. The entity doing the bailing out is usually the government.
What's it got to do with the financial crisis?
As over-leveraged banks (ie, banks which have borrowed too much) see their share prices plummet and find themselves unable to fund themselves through short-term money market transactions, bailouts are becoming increasingly common.
Bailouts started out small and have got bigger. The first of the crisis concerned Northern Rock, the UK bank which was nationalised by the UK government in February 2008.
The US government upped the stakes massively on 8 September 2008, by investing $1bn in preferred stock in Fannie Mae and Freddie Mac, and making a further $200bn available to help cover their bad debts. On 17 September, it then agreed to lend insurance company AIG $85bn to save it from collapse.
Since then, bailouts have taken on a whole new dimension. Most governments of the world have introduced banking bailouts of some form. Here's a brief summary of what's on offer in the US and the UK:
US bailout includes:
1) TARP: The 'Troubled Asset Relief Programme' - a $700bn fund created by the US government to try and unfreeze the credit markets. Initially intended to buy toxic assets, a portion of TARP was instead used to buy equity stakes in most major US banks. Following proposals to tax bonuses at 90% and otherwise restrict compensation at investment banks with TARP money 10 US banks were allowed to repay the money they'd received in June 2009. For information on how TARP funds have been spent, click here.
2) TALF: the Term Asset Loan Facility - a programme under which the US Federal Reserve issues loans to investors to buy new asset backed securities in an effort to get securitization started again.
3) PPIP - the Public Private Investment Programme - a rather complicated programme in which private investors are encouraged to team up with the government to buy up banks' toxic assets. For more information on the PPIP (also known as the Geithner plan), click here. The PPIP was supposed to be the saviour of the US banking system, but by mid-June the Wall Street Journal reported that it had lost momentum after the government scaled back its funding and banks proved unwilling to participate.
UK bailout includes:
1) A fund to invest two lots of at least 25bn (one now, one later) in the preference shares (shares which don't give their owners a say in how the bank's run, but place their owners before standard shareholders in the queue for dividend payouts and reimbursement if the bank goes bankrupt) of eight of the country's leading banks.
2) Government guarantees that leading UK banks will pay back all their short and long-term debt for up to three years (in the hope that investors might then lend to them and they might even lend to each other).
3) An additional 200bn of cash for the banking system by allowing banks to swap things like AAA rated mortgage backed securities for cash at the Bank of England's discount window.
4) An asset protection scheme in which the UK government promised to pay losses on toxic assets above a specified amount.
5) A Working Capital Guarantee scheme encouraging banks to lend money to small and medium sized companies with the government guaranteeing to pay the money back if companies default.
Why governments are best off buying equity stakes
Using taxpayers' money to buy bank shares and therefore increase their capital base is seen as preferable to spending money buying toxic assets and setting up a bad bank.
This is because for every $1 of new capital a bank has, it will (in normal times) leverage it up and put $10 or more of new lending back into the system.
For example, if the US government were to spend the whole $700bn of TARP on toxic assets alone, based on a leverage of 10:1 it would get the same result as if it put just $70bn of equity into the system. On the other hand, if it spent the whole $700bn buying banks' equity and banks lent against it, it would be the equivalent of putting $7 trillion of new liquidity into the system.
Useful links:
More on US government's bailout programmes (US Gov)
Why Timothy Geithner's latest plan won't work either. (Clusterstock)
Last updated on 26 July 2009.
