By Joseph Santiesteban, J.D. Candidate 2013, U.C. Berkeley School of Law, with contribution by Professor Eric Talley, Rosalinde and Arthur Gilbert Professor of Law; Director, the Berkeley Center for Law, Business, and the Economy
Introduction
In 2008-09, when the government spent $350 billion dollars bailing out corporations that it deemed systemically important, it confronted several issues. First, which companies should be bailed out? Second, what should the terms of the bailout be? And third, how should the program be funded. On March 20th at Berkeley Law’s weekly Law and Economics Workshop, Berkeley Law Professor Talley Eric Talley presented “A Model of Optimal Corporate Bailouts,” a paper he co-authored with UCLA Business School Professors Antonio Bernardo and Ivo Welch, which attempts to confront these issues with a theoretical model and compare their results to the Troubled Asset Relief Program (TARP).
The Who
The government cannot choose to bailout every firm on the brink of failure. This would create an endemic moral hazard problem, in which firms take on too much risk on the assumption that if they fail, the government will bail them out. The other extreme, not bailing out any corporations comes with headaches of its own. Failing companies create costs beyond those of direct contractual participants (such as employees and capital investors). These external costs are typically born by society as a whole in the form of, for instance, economic contagion, greater demand for social services, and offshoring of economic activity. The decision then, on which firms to bailout, must balance these various considerations.
The paper suggests that the optimal bailout recipient meet four preconditions. First, only firms that would not be able to restart without the government bailout should be eligible. Second, the government should be able to generate the revenue necessary to pay for the bailout. Third, the government should provide no more money in a bailout than the bailed out firm plausibly needs to continue operations. Fourth, the social benefits of bailing out the firm should justify intervention. The result is that bailouts should be used sparingly when externalities are great and the necessary capital infusion is relatively modest.
The How
An issue of primary importance in answering this question is the how to deal with management and shareholders. Here, again, the goal is to prevent moral hazard by finding a way to make managers and shareholders internalize the cost of their risk-taking. The paper suggests that firing incumbent managers and wiping out pre-existing equity investors best accomplish this goal. The intuition here is that if management knows they will be given a second chance, they won’t work efficiently in the first place. As the paper points out, however, the threat to fire incumbent management may not be credible for the government if there are not equally productive replacements available, which may limit a bailout’s prospects for success.
The second issue is how much should the bailout be? As noted above, the paper suggests that this should be just high enough to keep the firm in business. If the bailout were any larger, the government would have to raise additional revenue, which creates distortions. Moreover, any excess would go to investors as profits rather than to properly incentivizing management. Finally, the paper suggests that the government should fund bailout programs not by staking claims on the future profits of bailout recipients, but rather by taxing healthy enterprises – a “redistributive” tax.
From Where
In 2008-09, the government attempted to fund TARP largely through loans and taking equity positions in the enterprises that it bailed out. From the perspective of the paper, this was not the best design. Rather, the paper argues that the government should not impose any extraordinary tax on bailed out firms. This seemingly counter-intuitive argument ran contrary to the expectations of the authors. It stems from the fact that the optimal amount of the bailout is just enough to keep the firm going. Thus, taxing the bailed out necessitates an even larger initial bailout in the first place, since the bailout recipient knows that it will not be able to appropriate the full residual value it creates by continuing in business.