Why Bailouts Scare Stocks

In essence, these bailouts give bondholders more protection than they’d otherwise see — at stockholders’ expense.

It’s probably true that “something had to be done” in the case of AIG, the nation’s largest insurance company with operations in 130‐​plus countries. But doing something could have meant doing something else — such as offering a secured bridge loan while AIG engaged in some orderly asset sales.

As it is, the US government is charging AIG an interest rate above 11 percent for a well‐​secured two‐​year loan of $85 billion. That rate properly includes a fat risk premium above the Treasury’s two‐​year borrowing cost (about 2.2 percent) — but the government is also greatly diluting AIG stockholder equity by taking a 79.9 percent stake in the company.

The nation’s largest insurance company has been virtually nationalized, surely a draconian solution.

These surprises are always rationalized as a means of “stabilizing markets” or “restoring confidence” — yet the AIG deal is not the first “bailout” to inspire more terror than calm.

Left alone, financial markets usually work out the best possible deals among competing interests. Whenever the feds have gotten involved, by contrast, they’ve taken sides in the tension between stockholders and creditors — invariably throwing stockholders overboard.

Owners of common stock are supposed to be last in line during an actual bankruptcy, getting leftover scraps after creditors pick a firm’s assets to the bone. But in anything short of that, patient stockholders stand a decent chance of eventually seeing some recovery in the share price, if and when the firm gets back on its feet.

And in the recent crises, bankruptcy was involved only in the case of Lehman — the one time the feds kept their hands off.

From Treasury Secretary Hank Paulson and Fed chief Ben Bernanke on down, top officials have shown too little confidence in markets and too much confidence in themselves. As a result, anyone who’s still holding stock in a financial firm now faces a big new risk premium — because these companies are now subject to compulsory mergers on unfavorable terms (as with Bear Stearns, where the feds initially tried to force stockholders to take just $2 a share) or quasi‐​nationalization.

This new risk of forced mergers or a government takeover artificially depresses the stock prices of vulnerable firms. And Standard and Poors incorporates equity prices into its credit ratings — so the risk can also bring a downgraded credit rating. And a credit‐​rating drop triggers regulations that oblige the company to increase its capital — while simultaneously making it nearly impossible to raise capital.

Heavy‐​handed federal bailouts started this mutually reinforcing spiral rolling downhill by scaring anyone still holding stock in similar firms. And other regulations make it more likely to end badly.

What regulations? Here are two obvious ones:

Capital standards: These are supposed to discourage more debt than a firm can handle (excess leverage), most obviously by making sure it doesn’t have too much debt relative to equity (the market value of its shares). But the new Basel standards try to dictate which sorts of debt are least risky and which sorts of capital are most secure — by looking backward at irrelevant history. The Basel rules have often proved harmful and rarely helpful.

Mark‐​to‐​market accounting: This means that you have to write your assets down to what they’re worth today. Yet putting a market value on securities backed by a bundle of mortgages is nearly impossible right now.

Those assets do have value, because most mortgages are paid. But they’re very hard to sell in a market now obsessed with playing it ultra‐​safe.

So mortgage‐​backed securities are illiquid: They can’t quickly be converted to cash without taking a big loss. Firms holding too many hard‐​to‐​sell but solvent securities may likewise be illiquid, but not truly insolvent. Mark‐​to‐​market, in other words, is artificially turning a big problem into a disaster.

So let’s be careful about looking to more government regulation as the solution — and ponder the unintended consequences of “bailouts” of foreign creditors at the expense of domestic stockholders.

Every blunder of government regulation invites an understandable impulse to give failed regulators more money and power. Yet financial markets invariably notice looming financial problems (e.g., Enron) months before credit‐​rating agencies notice anything amiss — regulators even lag behind the rating agencies.

In the process of turning US taxpayers into involuntary stockholders in AIG, Fannie Mae and Freddie Mac, federal bullies shoved the voluntary stockholders into the ditch. Bear Stearns stockholders weren’t treated much better.

If you’re still brave enough to own stock in other financial firms not yet blessed with such enlightened assistance from the feds, those precedents should make you nervous. So how could anyone possibly expect these “bailouts” to improve market confidence?