Thread by @ThomasPHI2

(1/N): Some economic principles for bailouts.

The US is contemplating a bailout of unprecedented scale -- $1Trillion and up -- and lobbyists are busy grabbing as much of the pie as possible.

How can we prevent abuse?

(2/N): First let's be clear about what we mean. The government/Fed should provide as much liquidity support as needed. That is not a bailout.

A bailout is an alternative to debt restructuring. Standard reorganization in bankruptcy is always an option.

(3/N): What have we learned from previous bailouts?

Answer: bailouts in times of crisis can be incredibly powerful but abuse is rampant and design is key.

Two key questions are then:
1/ who should get a bailout?
2/ what should be the terms of the bailout?

(4/N) Let's start with some historical data. Many countries made money on loan guarantees to big banks in 2008, but some lost a lot (IRL). The failure in banking was more a failure in regulation pre-crisis than a failure in loans during the crisis.

(5/N) Car manufacturing is a mixed bag. The US bailed out GM and lost money but saved many jobs; FR bailed out Peugeot and made money.

Bottom line: bailouts can work but design is key. Moreover, scale of current problem requires a principle-based approach.

(6/N) Who should get a bailout? There are three key factors:
A: systemic risk
B: deadweight losses
C: strategic concerns (in the defense industry)

(7/N) systemic risk happens when bankruptcy/debt restructuring create large losses and strong negative externalities.

This is the prime reason to support banks. Because depositors and short term creditors can run, traditional bankruptcy does not work well.

(8/N) deadweight losses happen when an industry has lots of soft capital that would get destroyed in bankruptcy.

Airlines do NOT qualify. They are plain-vanilla businesses with hard assets and can operate in bankruptcy just as well as in normal times.

(9/N) Boeing is a mixed bag here: if the defense part can be isolated, then we could let the commercial part file for Ch. 11., with the caveat that the large network of suppliers needs to be protected as well.

Let's move to the design of bailouts...

(10/N). Design principles if a firm is bailed out
(i) all dividends, buybacks and exec stock options are cancelled;
(ii) creditors take haircut;
(ii) Government gets a mixture of preferred stocks and warrants (options).

(11/N). Why preferred stock? Because it is senior to common stock but does not create debt overhang and credit risk going forward. The goal of bailout is to create room for employment and investment, not saddle the firm with more debt

(12/N): Warrants allow tax payers to share the upside after the crisis is over. In this paper we show why the mix of preferred stock and warrants (options) is optimal.
pages.stern.nyu.edu/~tphilipp/pape…

(13/N): that's it for the high level summary. I might post more technical pieces if people find it useful.