A framework for bailout regulation.

• Author: Casey, Anthony J.
• Position: Introduction through III. Case Studies D. 9/11 Airline Bailout, p. 479-506

During the height of the financial crisis in 2008 and 2009, the government bailed out numerous corporations, including banks, investment banks, and automobile manufacturers. While the bailouts helped end the financial crisis, they were intensely controversial at the time, and were marred by the ad hoc, politicized quality of the government intervention. We examine the bailouts from the financial crisis as well as earlier bailouts to determine what policy considerations best justify them, and how they are best designed. The major considerations in bailing out and structuring the bailout of a firm are the macroeconomic impact of failure; the moral hazard effect of the bailout; the discriminatory effect of the bailout; and procedural fairness. Future bailouts should be guided by principles that ensure that the decisionmaker properly takes into account these factors.

INTRODUCTION

Since the financial crisis of 2008, the word "bailout" has become a term of abuse in our political lexicon. The bailouts of numerous financial institutions and two automobile manufacturers were extremely controversial. (1) Congress sought in the Dodd-Frank Act to ensure that bailouts would never take place again, going so far as to write into the preamble that one purpose of the Act was "to protect the American taxpayer by ending bailouts." (2) President Barack Obama agreed that "because of this law, the American people will never again be asked to foot the bill for Wall Street's mistakes." (3) But after his former Treasury Secretary admitted that Dodd-Frank would not end bailouts, Republicans in the House of Representatives issued a scathing report entitled Failing to End "Too Big to Fail": An Assessment of the Dodd-Frank Act Four Years Later A The political unpopularity of bailouts is matched in the academic literature, where the traditional view is that bailouts are almost always unwise, and usually result from political failure. (5)

But the word "bailout" is used in different ways, and it is sometimes hard to understand what people are complaining about. A bailout is, essentially, a transfer of money or other resources from the government to a private agent (or sometimes to another government). Such transfers occur every day and hardly ever cause anyone to lift an eyebrow. The government transfers money or other valuable consideration to solar panel manufacturers, daily farmers, poor people, and research universities. While many people disagree about the wisdom of these transfers, they do not regard them as illegitimate in the same way that they often regard bailouts.

We can make some progress by observing that in common parlance the word bailout refers to a subset of transfers where the transfer is intended to rescue an agent who cannot meet its financial obligations. Even here, however, the source of complaint is obscure. If the government is willing to subsidize a manufacturer of solar power panels by giving it money, making loans to it, or guaranteeing its debt (as it often is), then what's wrong with a policy of paying off an unpaid debt if otherwise it would default? The effect of all these policies is the same: to lower the cost of capital for the beneficiary. The policy justification is also the same: to encourage people to invest in solar power.

Indeed, the government routinely helps agents who are about to default on debts. The Federal Deposit Insurance Corporation (FDIC), for example, insures people against loss of their deposits up to $250,000.6 If a bank fails, the FDIC transfers money to depositors, in this way paying the bank's debts (or some of them) for it. Similarly, if a natural disaster strikes, the government frequently assists victims by supplying them with loan guarantees and other benefits that make it easier for them to pay off their debts while they are rebuilding their lives. (7)

FDIC payments are not called "bailouts"; why not? One reason is that the payouts are part of a regulatory program that puts burdens on banks and depositors. Banks must pay for FDIC insurance, and they must submit to regulations that are designed to prevent them from taking excessive risks. These costs are passed on to depositors in the form of interest rates on checking accounts that are lower than they would otherwise be. Thus, the FDIC payouts seem no more objectionable than payouts made by a private insurance company. In both cases, the insured party pays for the insurance, so when insurance payouts are made, they do not seem undeserved.

Similarly, banks often receive cheap loans from the Federal Reserve System that help them through spells of illiquidity. These discount window loans, as they are called, do not offend public values because the banks can receive them only if they are members of the Federal Reserve System, which requires them to purchase capital in Federal Reserve banks and submit to regulations. Banks must also pay for the loans in the form of interest.

Any reasonable definition of bailouts will need to encompass "good" (or at least uncontroversial) bailouts as well as "bad" bailouts. We are comfortable with the following definition. A bailout occurs when the government makes payments (including loans, loan guarantees, cash, and other types of consideration) to a liquidity-constrained private agent in order to enable that agent to pay its creditors and counterparties, when the agent is not entitled to those payments under a statutory scheme. As we will see, this definition of bailout admits for some fuzzy cases, but it will serve.

The key feature of the bailout--and the feature that makes people so uncomfortable--is that it is ex post. People who operate in the private market are expected to be responsible for their debts when they have not paid for guarantees or insurance. Everyone expects them to take precautions to ensure that they can pay their debt, or not to take on the debt in the first place.

It is for this reason that many people believe that bailouts violate the rule of law or offend other norms of our constitutional system. (8) Bailout recipients have no entitlement to a bailout yet they receive one anyway. Moreover, the prospect of a bailout may encourage firms to engage in risky behavior. Often bailouts occur during emergencies, and it is thought that the beneficiary takes advantage of the press of time to push through the bailout plan. That is why Congress sought to end bailouts once and for all in Dodd-Frank.

Yet, as we will argue, governments should not try to legislate away bailouts. Bailouts are socially desirable because Congress cannot anticipate the contingencies that would make possible an ex ante insurance system that regulates behavior and charges firms in advance for liquidity support or other transfers. The question then arises whether bailouts can nonetheless be regulated in advance so that the worst types of bailouts are avoided and only good bailouts are implemented. In short, can we develop some rules or principles that govern how the government uses bailouts when, by hypothesis, we cannot legislate the specific conditions under which they must or must not be used?

The answer is--yes. Congress frequently regulates the way that the government (including itself, but mainly the President and regulatory agencies) addresses some problem while nonetheless allowing it the discretion to determine whether to address the problem in the first place. A humdrum example comes from law enforcement. Law enforcement officials enjoy enormous discretion whether to respond to a call for help, investigate a crime, file charges, and prosecute. But they face numerous constraints on how they pursue actions once they decide to take them. A police officer can refrain from helping someone pursue a bike thief, but if the officer chooses to help, he cannot make searches without a warrant. A prosecutor can decline to prosecute, but if she prosecutes, she cannot do so in a way that violates the code of ethics.

Moreover, the law already provides a basis for challenging bailouts, albeit a weak and confusing one. Bailouts are "givings" rather than "takings," and thus not directly addressed by the Takings Clause of the Constitution. (9) There is no law that permits people to compel the government to bail them out. Yet both statutory and constitutional law provide some constraints on bailouts. The Fed--the major bailout agency--is governed by a statute that limits who it can bail out, and the terms of bailouts. The Bankruptcy Code puts constraints on bailouts when they take place in bankruptcy. And both the Takings Clause and the unconstitutional conditions doctrine may come into play if the government conditions a bailout on waiver of constitutional rights. (10)

These bodies of law have played a role in significant litigation that has emerged from the financial crisis. In 2013, shareholders of Fannie Mae and Freddie Mac sued the government on the ground that the federal rescue expropriated their property by eliminating their right to the firms' profits. In 2011, automobile dealers brought a lawsuit against the government that argued that during the bailout the government compelled the automakers to terminate contracts with them. Also in 2011, shareholders of the vast insurance company AIG sued the government for diluting their equity when it made emergency loans to AIG. All of the lawsuits argued that the government violated the Takings Clause, and in each case a court was willing to entertain the argument if the plaintiffs could prove the factual predicates of their claims. (11)

Thus, one cannot avoid thinking about the optimal regulation of bailouts--if only to understand and criticize existing law. At the same time, the regulation of bailouts poses some special problems. The source of a bailout is often Congress itself, and so Congress may choose to disregard earlier legislation that seeks to constrain it. Even when a bailout comes from the Fed or another agency, Congress might be reluctant to...