Why Certain Corporations Get Bailed Out & What You Might Do About it
With the COVID-19 pandemic and ensuing government-mandated shutdowns of commerce bringing economic activity in many sectors worldwide to a grinding halt, we see adversely affected large corporations seeking what amount to bailouts. Corporate bailouts, of course, occurred during the 2007–2009 crisis and catalyzed public outrage. But perhaps that outrage reflects a misunderstanding about why corporate bailouts occur. I offer one explanation for why they happen and then show how equity capital requirements generally, like those applied to banks (but higher), might work to prevent certain large corporate bankruptcies and bailouts in the first place.
As an example, suppose a large airplane manufacturer with a history of supporting the government expects that it can request a bailout because it’s too important to fail. The government might in turn require that the corporation maintain 20 percent equity capital relative to total assets or total liabilities, or some similar measure, which could prevent that manufacturer from requesting a bailout.
While this idea might not be new, I motivate my discussion by exploring the issue of why we may see corporate bailouts, as they often seem to come from sectors that have the potential to support the federal government during a national emergency, such as a pandemic or war. If so, then for such corporations the government might make bailout eligibility conditional beforehand on their adherence to minimum equity capital requirements.
Which Corporations Get Bailed Out and Why?
Should all corporations be subject to minimum equity capital requirements? Probably not. A number of studies in the corporate finance literature find that decisions about corporate financing reflect the the type of assets held by the corporation. Debt financing makes more sense for corporations that make use of tangible assets, such as airplanes and factories, since those can be used as collateral for debt. When it comes to intangible assets, like the ideas behind innovation or “greenovation”, equity financing makes more sense, the reason being that ideas, unless they’re patented, cannot typically be used as collateral for debt. So if not all corporations, which ones?
If you think about it, corporations in industries that support the government during some kind of national emergency, such as a pandemic or a war, seem to receive certain privileges. Well-known examples in the US include airlines, auto manufacturers, banks and the health sector. To understand why, Earl Thompson pointed out that any privately owned capital benefits the owners but generates an externality by tempting foreign predation. As a result, an optimal policy response might include taxing that capital to fund national defense against that predation. However, for industries that may support the government’s effort during a national emergency, in exchange for that support they may get taxed at a lower rate. Alternatively, rather than a lower tax rate, they might receive other privileges.
Josh Hendrickson has applied this logic to examine the merchant marines and airlines, pointing out that at various times throughout history, the merchant marines and airlines have provided auxiliary capacity during wars. In exchange, the government may offer those industries protection, for instance, through port-to-port shipping requirements (like the Jones Act) and domestic ownership restrictions in the case of airlines, which work like subsidies. Similarly, the government relies on large banks for financing during ordinary times and emergencies.
In exchange for this support, the government may offer protection through a variety of measures including regulation restricting competition and even bailouts/debt guarantees. One problem arising from bailouts/debt guarantees is that the value of the guarantee increases as the corporation funds with more debt, so minimum equity capital requirements might limit that problem.
Holding Everything Else Constant, More Equity Means a Corporation’s Less Likely to Fail
For corporations on the brink of failure, bankruptcy’s an option, but it can be time consuming and expensive as it necessitates having extensive legal work to complete the complex process. Here, the corporation’s old equity shares may get diluted if not wiped out, and some bonds get converted to new equity shares. “Super Chapter 11” speed bankruptcy perhaps offers a cheaper way to address the process, once a large corporation runs into trouble. But what can you do to prevent a large corporation from getting into trouble in the first place?
Earlier this year, in response to calls for banning the practice of share buybacks altogether to address corporate bailouts, John Cochrane instead proposed implementing minimum equity capital requirements for airlines, as we do for banks. After all, share buybacks can have value when limited investment opportunities exist for the corporation, as buybacks can simply reflect a lack of ideas. But as John Cochrane points out, the buybacks increase a corporation’s leverage (the ratio of debt-to-equity). With minimum equity capital requirements in place, an airline can still use share buybacks but not to a point where their debt burden makes them ill prepared to withstand a shock like the economic shutdown during the COVID-19 pandemic.
If the minimum equity capital requirement is 20 percent relative to total assets or total liabilities, then as long as the corporation has more than 20 percent equity, it can engage in buybacks, if 20 percent or less then it cannot. By funding with more equity and less debt, airlines would have more investors primed to take losses under adverse conditions, given that equity investors know going in that they can lose their entire investment.
Robert Merton’s classic work on pricing debt guarantees, including deposit insurance, shows that increasing the amount of equity funding relative to debt lowers the value of the debt guarantee, as the corporation covered by the guarantee caries a lower debt burden and likelihood of default. A bailout also implies a debt guarantee and essentially works like a put option on the corporation’s equity, which is a financial contract that gives the writer the right to sell the underlying asset to the buyer of the financial contract (see here for a relatively non-technical discussion). You can use a debt guarantee as an estimate of the cost to the taxpayer. If the government serves as the proximate guarantor, then the taxpayer serves as the ultimate guarantor, and minimum equity capital requirements may limit certain corporate bailouts.
To understand why, with a debt guarantee, once it matures, if the corporation’s assets exceed the debt owed the corporation remains solvent, the creditors get paid in full and the shareholders get the residual between the value of the assets and the debt owed. But if the value of the corporation’s assets falls below the amount owed to creditors, then the corporation’s insolvent. The guarantee assures that the creditors still receive the full amount of the debt they’re owed, and the guarantor assumes the corporation’s assets, with the shareholders getting nothing.
Based on Robert Merton’s original framework for valuing a debt guarantee, the figure below illustrates that the value of the guarantee varies as a corporation funds with more debt. For simplicity, I assume that the corporation has $100 in assets, and I vary the corporation’s debt from $0 to $100, which means the equity ranges from $100 to $0, as the corporation’s equity equals the difference between corporate assets and debt. I also assume that the guarantee lasts one year and that the risk-free interest rate equals 2 percent. Lastly, I assume the volatility of the corporation’s assets equals either 20 percent or 40 percent.
In the graph, as you move to the left, the corporation moves toward being an all equity-funded corporation (like Apple), and the cost of the guarantee to the guarantor goes to zero. As you move to the right, the corporation funds with more debt, and the value of the debt guarantee increases. For a corporation with a higher asset volatility (the gray lines), the cost of the guarantee begins rising earlier as the corporation’s proportion of debt funding increases than it would with a lower asset volatility (the black lines). Lastly, the dashed lines show how the cost of the guarantee increases if you allow the corporation in question to increase debt funding beyond 80 percent of total assets, meaning that the corporation’s equity falls below 20 percent of total assets. The solid lines show how a minimum equity capital requirement effectively caps the cost of the guarantee to the taxpayer.
When asset volatility equals 20 percent, the cost of the guarantee maxes out at $0.96 as debt financing cannot exceed $80, instead of $6.94 if the debt financing were allowed to reach $100. When the asset volatility equals 40 percent, the cost of the guarantee maxes out at $5.84 as debt financing again cannot exceed $80, instead of $14.72 if the debt financing were allowed to reach $100.
When wars or other national emergencies result in the government seeking support of corporations, in exchange for that support they likely extend certain privileges to those corporations, which could include bailouts/debt guarantees. Corporate bailouts can be costly to taxpayers and can spur public outrage, especially if the bailed out corporation got into trouble by relying on more debt, knowing that it could result in insolvency. That outrage may often arise from a misunderstanding about why certain corporations seem to get them. For corporations called on to support the government during a national emergency, minimum equity capital requirements could serve as a policy to limit corporate bailout requests.
Why Certain Corporations Get Bailed Out & What You Might Do About it was originally published in FinRegRag on Medium, where people are continuing the conversation by highlighting and responding to this story.