Research Proposal: Who Does the Government Bailout?

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Bailouts

The issue of bailouts has incited no shortage of controversy in recent months. The first major bailout was the federal government takeover of insurance group AIG in September at a cost of $85 billion (Karnitschnig et al., 2008). The CEO was replaced and a new head brought in to rid the company of its toxic assets and turn the firm around. No sooner had Barack Obama been elected when House Speaker Nancy Pelosi was on NPR calling for a bailout of the U.S. auto industry (Langfitt, 2008). Yet, there are significant differences between these two, their role in the economy and the tactics that the government has used in the course of their respective bailouts. Public sentiment turned on AIG when the company used bailout funds to pay six and seven figure bonuses to its staff. The idea of bailing out automakers has been scorned since the beginning, and by a much larger segment of the public. This paper is going to analyze the AIG bailout and the automaker bailout in an attempt to ascertain the criteria, if any, that the government has used to make decisions with respect to the bailouts.

AIG

The insurance group AIG was taken over in an $85 billion bailout in September, at a time when financial services industry seemed on the brink of collapse. The underlying assessment is that the action was necessary, in order to bring confidence back into the financial markets (Mitchell & Smetters, 2008). AIG was, in essence, too big to fail. The government had just finished allowing Lehman Brothers to fail, rather than buying out the investment bank (Karnitschnig et al., 2008). AIG had a profitable insurance business but was subject to heavy losses from the branch of the business that sold mortgage-backed securities. The move basically bought AIG time to separate the good assets from the bad. This bailout was followed by additional financing, to the tune of $180 billion and counting.

AIG was seen as "too big to fail" in large part because its operations were intertwined with financial institutions the world over. If AIG failed, a wide range of domestic and foreign financial institutions would be put on the brink of collapse. In addition, the company's 70 million policyholders and tens of thousands of employees would also suffer, creating a chain reaction that could cripple the world economy. In some respects, the global implications of an AIG failure provided much of the impetus for the original bailout. The U.S. government may have been worried about the policyholders and other domestic players, but the mortgage-backed security market had become a source for liquidity, as foreign governments and financial institutions leaned on MBSes as a means to hold U.S. dollars.

The AIG bailout was initially subjected to strict terms. The government insisted that its funding be for an equity stake, which gave the federal government majority control of the company. Then CEO Robert Willumstad was forced to step down by Treasury Secretary Henry Paulson to be replaced by former Allstate head Edward Liddy (Karnitschnig, 2008). Yet since then, AIG has spent its money on executive bonuses, which raised the ire of taxpayers and highlighted the lack of oversight with respect to bailout spending. What were initially viewed as strict terms soon began to appear to the public as a blank check. Some claims have been made that the terms were never that strict. AIG was, for example, allowed to transfer funds to overseas banks. The American taxpayers in this scenario are essentially bankrolling the survival and profitability of foreign banks, to no particular benefit to the U.S. taxpayers. This is only partly true. The point of the AIG bailout was so that it could maintain its obligations around the world, avoiding collapse of the global financial system. While it seems somewhat unfair for that entire burden to fall to the American taxpayer, it was America's lax regulatory environment that allowed the problems at AIG to gestate in the first place. Countries whose governments favored tighter regulator regimes, such as Canada and Australia, did not need to bail out their financial institutions.

Automakers

The bailout of the automakers also began in September 2008. Congress approved a $25 billion bailout at the time but by November the automakers were lobbying for another $25 billion (Langfitt, 2008). They, too, found controversy when the CEOs of the automakers flew private jets to Washington, DC to make their plea of poverty (Ross & Rhee, 2008).

Proponents of an automaker bailout suggest that the terms of the bailout make economic sense. The $25 billion bailout -- in the form of reduced interest rates for borrowing -- is less than the cost to taxpayers if the Big Three were allowed to fail. Such a failure could cause a chain reaction throughout the automotive industry affecting everyone from suppliers to dealers to mechanics. The result could be catastrophic -- 3 million jobs and $150 billion in tax revenue lost (Krisher & Thomas, 2008). Proponents point out that if one firm collapsed, it could cause suppliers to collapse, resulting in massive plant closures affecting all automakers.

The automakers' bailout has nonetheless been subject to intense public scrutiny. Opponents point to the failure of the Big Three to develop products that appeal to today's consumers. Foreign automakers like Honda and Toyota do not need bailouts, they argue, because they make better, more appealing cars and manage their money better. Since the initial controversy, Ford has backed away from requesting bailout funds. The government, however, has duplicated its involvement in Chrysler, forcing out CEO Rick Wagoner and giving the firm funding to buy time to make arrangements with Fiat for its survival.

Similarities

The rationale for each bailout is similar. Both the Big Three automakers and AIG were deemed too big to fail. The spinoff effect for the automakers and AIG both would be disastrous for the economy. The automaker spinoff effect could collapse a major industry; the AIG effect could collapse the world's financial system. The government, in both instances, is essentially acting as a rational actor. Despite the costs and the optics of these bailouts, they ultimately are the best financial transaction for the government.

Both bailouts are also subject to similar criticisms. Opponents point out that AIG was about to fail because of the bad debts they had amassed in backing their MBS securities. This poor decision making precipitated the need for a bailout, rather than financial misfortune. Similarly the automakers had made a string of poor strategic choices. They were in their present market position simply because they had been bested by superior competitors. Likewise, executives at both companies had been accused of arrogance and failing to understand that their circumstances were a consequence of their poor decision making.

Differences

Despite similarities between the two bailouts, there are also a few differences. One difference is the strategy involved in the bailout. The sense is that with the AIG bailout the government was working "on the fly" (Mitchell & Smetters, 2008). With the automakers, the bailout is part of an ongoing strategy to prop up an ailing business. AIG happened quickly, forcing the government to take drastic, immediate action to avoid catastrophe. The automakers' problems are the result of years of mismanagement. The sense also exists that the problems at AIG are temporary. Although the company continues to need more bailout infusions, the toxic assets are viewed as finite and the rest of the company's businesses are viewed to be viable ongoing concerns. Thus, there is the prospect for an AIG recovery. The problems at the automakers are viewed as systemic an ongoing. There may not be viable ongoing businesses there, in which case the bailout funds are merely delaying the inevitable.

That recovery would result in gains for taxpayers, pointing to another aspect of the bailouts. The federal government took an equity stake in AIG, which means that when the profitable elements of the company are finally separated from the MBS elements, the taxpayers will have a viable entity on their hands that can be sold. They may yet make back some or all of their investment. The automakers' bailout comes in the forms of loan discounts. Not only does this not leave government with an equity stake, but it increases automakers' leverage, exacerbating their liquidity problems.

Conclusion

The bailouts of the U.S. auto industry and insurer AIG shared more similarities than differences. The U.S. government acted as a rational actor, initiating bailouts that it views as less expensive than the alternative. The conditions attached to each bailout seem similar as well. In both cases, CEOs were fired, but operations were allowed to continue as normal. Even the private jet controversy did not result in a significant change to operations at the Big Three.

The major difference between the government's bailout treatment of the two appears to be with respect to ownership and control. Without any official ownership say, the federal government has been forced to find alternative approaches to compel the automakers. By contrast,… [END OF PREVIEW]

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