A bailout takeover refers to a scenario where the government or a financially stable company takes over control of a weak company with the goal of helping the latter regain its financial strength. The acquiring entity takes over the weak company, usually by means of purchasing a controlling amount of the company’s stock shares. Share exchange programs may also be used.
The goal of the bailout takeover is to help turn around the operations of the company without liquidating its assets. The acquiring entity achieves this by developing a rescue plan and appointing a manager to spearhead the recovery while protecting the interests of the investors and shareholders.
Companies considered for a bailout takeover are typically those whose collapse or bankruptcy would be detrimental to the industry they are a part of and/or to the country’s economy as a whole. For example, a company that employs a very large number of individuals, especially if the company is a major employer for the geographical area it is located in, may be considered “too big to fail”.
The bailout comes in the form of stock, bonds, loans, and cash that may require reimbursement in the future. In the case of stock shares, the struggling company would need to re-purchase the shares from the acquiring entity once it regains its financial strength.
Legislative and Executive Efforts on Bailout Takeovers
The Dodd-Frank Act was signed into law by President Barack Obama in July 2010. The act was a response to the financial crisis of 2007/2008 when many major US companies were facing collapse due to the financial crisis. While the government moved in to rescue the troubled companies, the Dodd-Frank Act also sought to protect consumers from bearing the cost of bailouts when rescuing mismanaged companies. The law established regulatory bodies such as the Financial Stability Oversight Council, the Office of Financial Research, and the Bureau of Consumer Financial Protection.
The Dodd-Frank Act was aimed at promoting the financial stability of the United States financial system by requiring accountability and transparency among US companies. Title II of the Dodd-Frank Act legislates bailout procedures for struggling companies. It requires shareholders and creditors to bear the losses of a failed company.
Financial Industry Bailout Takeover
The 2008 bailout takeover of numerous financial institutions by the United States Government was the largest in history. The government moved in to rescue financial institutions that suffered large losses from the collapse of the subprime mortgage market.
At the time, financial institutions had provided mortgage loans to borrowers with low credit scores, and when large numbers of these mortgages went into default, the lending companies were unable to absorb the massive losses.
Troubled Asset Relief Program (TARP)
The Emergency Economic Stabilization Act (2008) authorized the creation of the Troubled Asset Relief Program (TARP) to provide a bailout fund of $700 billion distributed to large US companies that qualified for the program. It was one of the measures that the government took to address the subprime mortgage crisis.
Authorities used the TARP to purchase toxic assets from financial institutions as a way of strengthening their financial position and helping to stabilize the balance sheets of struggling companies. In the end, the TARP disbursed more than $426.4 billion to financial institutions and recovered approximately $441.7 billion in repayments.
In 2008, PNC Financial Services purchased $5.2 billion in National City Corp.’s stock to acquire it. National City suffered massive losses as a result of the subprime lending crisis. PNC used money from the TARP fund to bail out NCC. After the takeover, NCC became the fifth-largest bank in the US, even though the bailout led to the loss of many jobs at National City’s headquarters.
Another notable bailout takeover was the US government bailout of two automakers, Chrysler and General Motors. The two companies needed a bailout to stay afloat due to the decreasing number of SUVs and large-vehicle sales. Consumers were unable to obtain auto loans from financial institutions during the financial crisis and that situation worsened the two companies’ financial status.
Allowing such large companies in such a key industry to fail would’ve put a massive dent in the economy. Under the takeover deal, the government loaned the two companies $17.4 billion from the TARP funds, on condition that they cut their debts, reduce wages and salaries, and create a restructuring plan. As the lender, the government retained the right to call off the loans if the companies failed to honor the agreement.
Reasons Against Bailout Takeovers
1. Creates a moral hazard
According to Paul Volker, former Chairman of the Federal Reserve, the practice of offering bailouts for large companies creates a moral hazard because they may be more inclined to engage in risky business decisions if they expect that they will be bailed out of any possible trouble. During the financial crisis, the government bailed out large financial institutions, even those that provided mortgage loans without conducting due diligence on the borrowers.
The practice of offering bailouts is seen by many economists and market analysts as setting a bad precedent by taking money from productive taxpayers and using it to reward failing companies. Some market analysts have also argued that the bailouts prolonged, rather than shortened, the recession, and that, in fact, the economy would’ve recovered more quickly if the companies had simply been allowed to fail.
2. Disadvantages competition
A government bailout for struggling large companies also discourages those firms that have been prudently managed. The government’s intervention makes the markets less efficient and, in the end, it is the consumers/taxpayers who bear the biggest burden. Bailing out companies puts them at an advantage over their competitors. It reverses the gains made by productive companies and individuals since the proceeds from these companies are given to failing companies.
The argument is therefore made that the government should allow the market to operate freely and allow both successes and failures to occur as they are earned. Supporting unsustainable business models prevents liquidated assets from being put to better use by better-managed competitors and other companies with sustainable business models.
CFI is a leading provider of the Financial Modeling & Valuation Analyst (FMVA)™ certification program for finance professionals looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: