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Bailout

Updated on April 4, 2024
Article bySusmita Pathak
Edited bySusmita Pathak
Reviewed byDheeraj Vaidya, CFA, FRM

Meaning Of Bailout

A bailout refers to the prolonged financial support offered by the government or other financially stable organization to a business in the form of equity, cash, or loan to help it overcome certain losses and stay afloat in the market. It usually happens when a too big to fail company is on the verge of declaring bankruptcy or defaulting on its financial obligations.

Companies having an economic influence on a particular market sector and the economy need immediate capital injection during a financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more. When the government realizes that the collapse of such a firm could damage the national economy, it intervenes to save the business from becoming insolvent. This lending provision may or may not require the failing company to repay the amount lent.

Key Takeaways

How Does Bailout Work?

A market economyMarket EconomyA market economy (ME) refers to a form of economic system where businesses and consumers drive the economy with minimal government intervention. In other words, the laws of demand and supply determine the price and quantity of goods produced in an economy.read more comprises several self-sufficient organizations dominating a particular market sector. Besides ensuring the smooth functioning of the overall markets, these businesses are of national economic importance. However, in times of financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, these self-sufficient entities may find themselves in financial trouble. In such a situation, the government and other financially stable organizations inject capital into failing companies to avoid the consequences of systemic risksSystemic RisksSystemic risk is the probability or unquantified risk of an event that could trigger the downfall of an entire industry or an economy. It happens when capital borrowers like banks, big companies, and other financial institutions lose capital provider's trust like depositors, investors, and capital markets.read more.

Bailout

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A bailout occurs when these corporate behemoths are on the verge of bankruptcy, have defaulted on their financial responsibilities, and are burdened with outstanding debts. The government and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more lend such businesses required capital through cash infusions, loans, bonds, or stock purchases. However, the failing entity must face strict regulations and supervision in exchange for financial rescue. 

This financial support may or may not be available to the failing business on a repayment condition. In addition, the repayment may be interest-free or interest-bearing. Since the money utilized for this purpose comes from taxpayers and should go toward social welfare, the organizations must repay the amount once they have regained financial stability.

Bailout not only prevents the insolvency of too big to failToo Big To FailToo Big to Fail (TBTF) is a term used in banking and finance to describe businesses that have a significant economic impact on the global economy and whose failure could result in worldwide financial crises. Because of their crucial role in keeping the financial system balanced, governments step into saving such interconnected institutions in the event of a market or sector collapse. read more institutions and ensures their continued survival, but it also keeps the financial systemFinancial SystemA financial system is an economic arrangement wherein financial institutions facilitate the transfer of funds and assets between borrowers, lenders, and investors.read more from collapsing. Besides capital assistance, the financial rescue may come in the form of mergers and acquisitionsMergers And AcquisitionsMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.read more. When other reputable market players take over failing enterprises, it is considered a bailout takeover.

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Explanation in Video for Too Big to Fail

 

Where Does Bailout Capital Come From?

Given the multi-billion dollar bailout funds required to save the economy from deteriorating, the obvious question is, where does this money come from?

As already stated, this capital is obtained from the income tax that the countrymen pay. The United States government entities – Federal Reserves and Treasury Department – take care of public financesPublic FinancesPublic finance is the management of the country's public funds through revenue, expenditure, and reserves, and it generally includes the management of tax collection, expenditures, the annual national budget, deficits, and surpluses.read more. While the former acts as the central bank and provides funds for usage in the market economy, the latter collects taxes and manages public funds.

On the one hand, the government and financial institutions attempt to keep the economy afloat. On the other hand, they often become a victim of the developing distrust in public. As the expenditure made on bailouts is massive, the government borrowing increases. It directly affects the interest rates on savings accounts, which decreases over time. Also, monthly charges on individual bank accounts increase. Such repercussions make citizens feel cheated, resulting in trust issues.

The global financial crisis of 2008 is a classic case of the bailout of banks 2008The then-U.S. government led by President George W. Bush introduced the Troubled Asset Relief Program (TARP) under the Emergency Economic Stabilization Act of 2008. This scheme intended to save too big to fail financial institutions from crumbling. The Treasury Department bought toxic assets of banks to avoid imminent economic collapseEconomic CollapseAn economic collapse refers to a severe contraction in the economy led by an extraordinary event (financial or structural) which is not a part of the normal economic cycle. It may lead to a decline in national growth, a rise in unemployment, and sometimes social unrest; therefore, it requires government or monetary authorities intervention.read more.

Practical Examples

Let us look at some of the notable bailout examples in recent history:

Bailout Of Banks

Even a minute instability in financial institutions can have a significant impact on the overall economic system. It has already happened in the past when big banks and financial institutions granted low-credit-score borrowers loans in response to growing residential property prices. Bankers hoped to become wealthy quickly by using subprime mortgagesSubprime MortgagesA subprime mortgage is a loan against property offered to borrowers with a weak or no credit history. Since the risk of recovering is high, the interest rate charged on such mortgages is higher so that the lender can recover a maximum amount at the beginning of the loan.read more and mortgage-backed securitiesMortgage-backed SecuritiesA mortgage-backed security (MBS) is a financial instrument backed by collateral in the form of a bundle of mortgage loans. The investors are benefitted from periodic payment encompassing a specific percentage of interest and principle. However, they also face several risks like default and prepayment risks.read more. However, the subprime mortgage industry collapsed during the global financial crisis of 2008, resulting in a credit crisis.

During the financial crisis of 2008, the housing prices were high, but the number of defaulters was more. The banks waiting for these defaults had multiple housing properties to sell, but there were no buyers. In the process, the most affected were big investors. As they started losing a large amount of money on their investments, they bought mortgage-based securities and invested in Collateralized Debt ObligationsCollateralized Debt ObligationsCollateralized debt obligation (CDO) refers to a finance product offered by the banks to the institutional investors. Such tranches have a complex structure and derive their value from the various underlying assets like loans, mortgages and corporate bonds, which also serve as collaterals in case of default.read more.

Eventually, an insurance program evolved in the form of credit default swaps to back these securities. The American multinational finance and insurance company American International Group, Inc. (A.I.G.) sold millions of these policies to investors only to become a victim of the crisis.

The trading and credit markets faced turmoil, the stock market came to a standstill, and the American economy slipped into a state of recession. Multiple banks filed for bankruptcy; one of them was Lehman Brothers, while some waited for a miracle to save them from this dismay. As part of the government’s bailout of banks 2008, TARP authorized $700 billion to purchase assets of banks and other financial institutions, including A.I.G.

Later, the Federal Reserves stepped in for the financial rescue of banks through its Capital Purchase Program. The Wall Street bailout included the most influential financial institutions, such as State Street Corp, Bank of America Corp., JPMorgan Chase & Co., Morgan Stanley, Goldman Sachs Group, etc. 

Bailout Of Automobile Firms

The TARP program focused on bailing out banks and financial institutions, including the famous A.I.G. bailout. However, it also helped some automotive companies from becoming insolvent. The financial crisis of 2008 made it difficult for people to get auto loans due to strict lending terms, resulting in reduced automobile sales. When coupled with increased gas prices, it affected many automakers.

In December 2008, the Bush administration announced offering financial support to the automobile industry. It offered General Motors $13.4 billion as short-term finance under TARP. In April 2009, Barack Obama-led U.S. government provided a $2 billion working capital loanWorking Capital LoanA working capital loan is a loan taken out by a company to finance its day-to-day operations, such as funds to cover the company's operational needs for a short period of time, such as debt payments, rents, or payroll, rather than for long-term investments or assets.read more to the automotive firm, adding $4 billion to it a month later in May. In July the same year, General Motors exited bankruptcy. By December 2013, the firm had no shares remaining with the government. It sorted out all.

Frequently Asked Questions (FAQs)

What is a bailout?

A bailout is a provision in which the government and other financially stable organizations inject capital into failing companies. It aims at saving too big to fail institutions from collapsing and causing economic instability of a nation. 

Is a bailout a loan?

Yes. When the government decides to bail out a failing business, it offers financial support in cash infusions, bonds, stocks repurchases, and loans, often binding the borrower to repay the same with interest once they regain financial stability.

What would happen if banks collapse?

Banks are the institutions where people deposit money and provide loans to individuals and entities for various needs. The collapse of banks would mean putting a full-stop on the movement of capital, which will directly affect the financial system. As a result, the national economy and the global economy would start crumbling.

This has been a guide to What is Bailout and its Meaning. Here we discuss how bailout works, where bailout capital comes from, along with practical examples. You may also have a look at the following articles to learn more –

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