2. Bankruptcy and bailout: enterprise versus systems levels of analysis

We will begin our analysis at what we call the “enterprise” level. At the enterprise level, we are concerned merely with whether these two methods of corporate reorganization transform failing concerns into going ones. We show that at this level of analysis both methods of reorganization transform failing concerns into going concerns. This is not to say that the methods of transformation are equivalent, for they surely are not. The methods are equivalent in that they eliminate negative capital value, but they differ in the entitlements and obligations that are attendant to redistributing that negative capital value.

For an enterprise whose liabilities exceeds its assets and has no plausible prospects for reversing that situation, bankruptcy presents an extra-commercial path along which the enterprise's assets can again engage in useful commercial activity. The rules of bankruptcy establish rules of precedence among a firm's creditors, and with the creditors in conjunction with a judge working out a mutually agreeable arrangement for apportioning capital losses among the creditors to reestablish a going concern. All the firm's creditors have a common interest in bearing the least possible capital loss, but they have a divergent interest due to their holding different positions in the scale of precedence. A creditor high in that scale might favor a quick sale of assets to recover debts the firm owes it. In contrast, a creditor lower on that scale might oppose a quick sale, hoping instead to secure a higher price that would enable more recovery for those lower in the chain of precedence.

While such secured creditors as financial institutions generally take precedence over such unsecured creditors such as employees, any increase in the proceeds from liquidation will redound to the expected distribution to unsecured creditors, as well as to shareholders who stand last in the order of compensation. Typically, some potential acquirers also exist who will seek to purchase some or all the firm's assets. Presumably, they would prefer to acquire as few of the liabilities as possible, but might take on the liabilities if they believe the assets they obtain can be deployed in a profitable manner. The judge, in conjunction with the rules of bankruptcy, referees a relatively orderly process among the firm's creditors that apportions capital losses in a relatively understandable fashion according to rule-of-law principles. Bankruptcy provides a well-established set of procedures and conventions, along with a specialized bar, that facilitates the reorganization. Within this institutional framework, the reorganization must be agreeable to the firm's various creditors who must bear the capital losses necessary to restore solvency to the enterprise after reorganization.

At the enterprise level of analysis, bailout is just a different name for bankruptcy. In either case, an insolvent firm is in a commercial hole from which it cannot escape through ordinary commercial activity, no matter how deftly the firm might manage its activities. With bailout, the distribution of capital losses necessary to restore solvency is the province of political calculation and not the law of bankruptcy. What kind of redeployment of corporate assets might be required through bailout will likewise be the province of political calculation. For instance, a government agency or even a central bank could buy some corporate debt instruments to move the firm toward solvency. It would also be possible for the government agency to acquire an ownership position in the firm. To be sure, the agency does not have the capital necessary to acquire ownership, and so must obtain that capital either through taxation via budgetary appropriation or by the central bank's creation of money. Either way, some of the capital losses that would be borne by a firm's creditors under bankruptcy are transferred to taxpayers under bailout. Those creditors whose ranking in the chain of precedence was low under bankruptcy might gain by bailout, at least relative to the position they would have had under bankruptcy.

At the enterprise level, bailout accomplishes the same outcome as bankruptcy: it transforms a failed enterprise into a going concern, and does so by distributing capital losses over some subset of the population. An aggregate capital loss is distributed in some fashion throughout the economy sufficient to eliminate the insolvency. To illustrate the point, suppose a firm entering bankruptcy is insolvent by $50 (add as many zeroes as you like to fit your sense of realism). Suppose the judge determines that the best reorganization would leave secured creditors with a $20 capital loss, with the remaining $30 being borne by unsecured creditors. While bailout likewise will restore solvency to the enterprise going forward, it is not legitimate to assume the same data for secured and unsecured creditors. For if the data were the same with bailout as with bankruptcy, there would have been no reason for anyone associated with the failing enterprise to seek bailout. The presumption that aggregate insolvency under bankruptcy is $50 is the result of the bankruptcy process that includes possible sales of assets or divisions of the enterprise, subject to concurrence among creditors.

Bailout must still leave the reconfigured enterprise as a going concern, but this does not mean that a $50 capital loss will have been distributed between secured and unsecured creditors. A firm that acquires a division of the failed firm under bankruptcy might agree to take on the $20 owed to secured creditors as part of the transaction. In contrast to bankruptcy, bailout follows a political calculus that need not duplicate the outcome under bankruptcy. The firm that acquires the division of the failed firm might take on only $10 of secured debt, perhaps with the remaining debt bought by a government agency or a central bank. Furthermore, bailout might take on the unsecured debt, perhaps by getting an acquiring firm to accept that debt as part of a deal whereby the acquiring firm is also granted exemptions from restrictions on the use of some of its lands. It is accurate to say that, at the enterprise level, bankruptcy and bailout are identical in that each method converts a failing firm into a going concern. It is not accurate, however, to assert that the two methods accomplish this outcome in the same way with the aggregate capital loss distributed in the same manner.

More importantly, bankruptcy and bailout differ at the systemic level of analysis, and that difference stems from differences in the transactional details that are likely to emerge from inside the different processes. Bankruptcy is governed by the need for the affected parties to reach some agreement on the bearing of capital losses in the presence of a code of rules and the concurrence of a judge. Bailout is governed by the desire of some political agency to transform a failing firm into a going concern in a politically satisfactory manner, which will entail a quite different pattern of reorganization and distribution of capital losses than under bankruptcy. With bankruptcy, the firm's creditors must agree to the capital losses that bankruptcy distributes, and with that agreement framed by bankruptcy law and the concurrence of a judge. These laws and procedures are not pertinent for bailout.

With bailout, a political calculus comes into the foreground. That calculus is not governed by rule-governed consensus among creditors, but is governed by agreement among key political participants and interest groups. The difference between bankruptcy and bailout is not fundamentally about converting a failing concern into a going concern, for this is a simple matter of cancelling a sufficient amount of obligation. Rather, that difference is fundamentally about the operating properties of different systems of political economy, with bankruptcy operating inside the rubric of a rule of law and with bailout standing apart from that rubric.

3. Political economy in corporate restructuring

Ayotte and Skeel (Reference Ayotte and Skeel2010) provide a useful explanation of two important mechanisms available to insolvent firms through bankruptcy law. First, there is debtor-in-possession (DIP) financing. DIP financing allows “firms to issue senior, secured claims that take priority over other creditors.” Such financing affords the firm time to restructure its operations and negotiate with creditors or to seek out a willing buyer. Another mechanism is the ability to “sell assets free and clear of liens and liabilities.” The acquirer uses the proceeds from the sale to compensate creditors. Ayotte and Skeel note that this is a particularly popular route, as roughly two-thirds of all large bankruptcies use it.

Underlying these various bankruptcy procedures is a common incentive. Stakeholders desire to resolve the reorganization quickly and to get as much out of the reorganization as they can. The failed firm must list all its outstanding obligations and must meet with its creditors. Debtor and creditor meet as equals and haggle over the best possible deal. The deal reached is publicized, and all stakeholders must agree to it. The courts act as referees and not as players. If the owners of the firm decide to sell some or all the assets, competition for the failed firm's assets will happen in an open and rivalrous process. All comers are free to place a bid. Given that this competition happens through the market process, there is good reason to believe that the assets are being reallocated into more profitable uses. Within the bankruptcy process, the owners of failed firms generally have an incentive to minimize their losses from liquidating failed enterprises so long as they can expect to receive some return from liquidation, promoting economically efficient liquidation due to their positions as residual claimants over their assets (Wagner, Reference Wagner2012).

Skeptics of the bankruptcy process have argued that bankruptcy moves too slowly, at least in some instances. Bankruptcy might be able to accomplish restructuring eventually, but “eventually” might entail an unnecessarily high cost that can be reduced through bailout. During the time that a failed company is being restructured, other firms connected to the failed company will be constrained in their operation while they await the outcome of bankruptcy, and might even fall into bankruptcy themselves. Krueger and Goolsbee (Reference Krueger and Goolsbee2015: 3–4) argue that this type of concern motivated the auto bailouts. Although a willing buyer for GM and Chrysler might have been found, such a buyer was not going to materialize quickly enough to alleviate the systemic consequences that would have rippled through the economy. However, expediency is not without its own costs.

For one thing, some creditors might have good reason to think they can fare better under public ordering. For instance, contracts with labor unions cannot be breached under labor law, which leaves bankruptcy as the only institutional remedy to escape labor costs that are not warranted by labor productivity. A labor union that supplies labor to a failing firm might oppose bankruptcy and seek a bailout instead as a straightforward matter of rational calculation. Landowners might likewise support bailout over bankruptcy, depending on the implications for rental values at the site of the failing enterprise. If that enterprise were a significant user of land and if restructuring under bankruptcy were likely to shift the geographical location of the reorganized firm's activities, landowners might think that bailout would maintain the rental value of their lands.

Moreover, there is good reason to think that bankruptcy would operate in a relatively speedy manner under private ordering because all participants will gain by clearing away the commercial debris associated with the failing firm, so they can move forward in their commercial activities. A delay in securing reorganization is costly to market-based enterprises because possible new profit opportunities cannot be pursued until the debris from the failed undertaking is cleared away. Furthermore, it is not necessary for a bankruptcy to be concluded before new commercial configurations can be created. If the failing firm has valuable assets that other firms want to acquire, they will want to acquire those assets sooner rather than later. Key assets can be moved to productive uses long before the bankruptcy is concluded. For instance, Ayotte and Skeel (Reference Ayotte and Skeel2010: 477–81) highlight how Drexel, a failed financial institution that filed for bankruptcy in 1990, redeployed its most time-sensitive assets almost immediately even though the company's reorganization would not be concluded for another two years.

To be sure, we do not live in a world of purely private resolution. Even aside from bailouts, government agencies intervene in a variety of ways in the restructuring process, as Zywicki (Reference Zywicki2015) explains. In doing so, the state ceases to be a simple referee, and becomes a player in the economic process. The most obvious example is anti-trust law. The Federal Trade Commission can block mergers and acquisitions when it claims that such actions will hinder competition in an industry. For instance, the FTC recently blocked struggling office-supply company Staples from merging with the rival, Office Depot (Kang, Reference Kang2015). Some observers believe that the FTC's decision to block the merger will lead both companies to resort to bankruptcy (Thalman, Reference Thalman2016).

In bailouts, the state becomes an active player in the corporate reorganization process, giving it some unique qualities, as Moberg and Wagner (Reference Moberg and Wagner2014) explain. That activity can be relatively modest, as in providing liquidity. It can also be substantial, as in managing the entirety of the restructuring process. In between these two options, the political agencies may also provide liquidity conditional on certain stipulations. The most recent instances of public restructuring were handled by executive task forces that possessed unilateral decision-making power. Although we can conceive of other ways in which a government might handle corporate restructuring, it is likely that something like executive task forces will always appear to be an attractive vehicle for reasons of expediency. A small group of regulators with unilateral power can more easily marshal support from politically influential groups whose positions would weaken under bankruptcy.

When a government agency provides liquidity, the restructuring process runs the risk of subsidizing the very behaviors that brought the company to failure. Afonso et al. (Reference Afonso, Santos and Traina2014) found that banks rated as more likely to receive government support were also more likely to engage in riskier lending. In addition, when companies come to view the government as a source of funding, they might reorient their activities away from pleasing consumers and toward pleasing regulators. Several studies have discovered that firms with political connections are more likely to receive financial support from a government than their less-connected counterparts (Blau et al., Reference Blau, Brough and Thomas2013; Faccio et al., Reference Faccio, Masulis and McConnell2006; Yu and Lee, Reference Yu and Lee2016). Competition through political means tends to solidify established enterprises at the expense of new entrants, since regulators, given their time constraints, will typically support established over more nascent enterprises. Even the expectation of a bailout can pervert the firm's incentive to handle the restructuring on its own. Ayotte and Skeel (Reference Ayotte and Skeel2010: 481) note that Lehman Brothers expected a bailout since Bear Stearns had previously received one. This expectation encouraged Lehman Brothers to forgo preparing for bankruptcy, and left them in a vulnerable position once the Treasury Department decided not to provide them with liquidity. When executive task forces handle the restructuring process, the restructuring tends to occur underground and behind closed doors. The regulators can exercise unilateral control over the restructuring decisions. To the extent we can say that the regulators bargain at all with the firm, its creditors, and potential acquirers, they do so from a privileged position.

In trying to reorganize failing firms, regulators face both incentive and knowledge problems. The incentive problems arise because the regulators are not themselves the firm's residual claimants. Thus, rather than making the profitability of the firm their chief concern, regulators will seek to secure political goals. These goals will depend on the context of the reorganization, but might include keeping the firm in the same place to appease interest groups, giving certain creditors favorable deals, selling the restructured firm's assets to other parties who agree to the goals laid out by the administration, or making the dispersal of liquidity contingent on following certain stipulations that expand the executive agency's oversight. Additionally, although regulators are not directly concerned with the profitability of the restructured enterprise, for political reasons they will want to see the restructured firm be successful. If the restructured firm fails after the bailout, it will be a stain on the administration's record. Thus, there is an incentive to keep the firm afloat and structured in a way to preserve some semblance of the status quo.

But keeping the firm alive and redeploying assets in a socially useful manner are two distinct endeavors. Even if we assume away the incentive problem, the knowledge problem remains. There are nearly an infinite number of technologically feasible production plans. Market signals help entrepreneurs to sort out those technologically feasible plans that are also economically feasible from those technologically feasible plans that are not also economically feasible. Without access to market data, regulators handling the restructuring process will be unable to judge the economic feasibility of the various restructuring plans possible (Hayek, Reference Hayek1945).

Thus, even if they are concerned with trying to convert the failed firm into a going concern, they cannot answer questions like whether the failed firm should continue to exist and what the alternative value of the failed firm's assets are. The entrepreneurial process of discovery, propelled by the failures of past entrepreneurs, is thus precluded by the bailout process since the regulators have no access to market data that might inform them about alternative configurations (Kirzner, Reference Kirzner1973). The possibilities for reconfiguration that would have been explored by market actors are replaced by a plan generated by a group of political actors acting without the aid of genuine market data. The political actors restructuring the firm must necessarily recur to political considerations.

The following section will examine the process that generated the recent bailouts in the American finance and auto industries. In describing these examples, we will explore the political considerations that made the bailouts possible, and must necessarily play a role in any restructuring conducted through political means. Many of the transactions that are part of a bailout will have an underground character to prevent political opposition from surfacing. To some extent, the depth of those underground transactions will vary with the extent of governmental participation in promoting the bailout. Governmental participation that is basically limited to providing liquidity, as with the American financial industry in 2008, entails relatively low intrusiveness. In contrast, governmental participation that manages the entirety of the restructuring process, as with the bailouts of the automobile firms, is highly intrusive and will take place more deeply underground.

4. Bailout as underground restructuring: the financial services industry

Wagner's (Reference Wagner2016) approach to entangled political economy is especially instructive in the analysis of bailouts. Specifically, the legislature or relevant administrative agency serves to intermediate between those who are seeking support for their enterprises and people who have the means to support those enterprises, even if they might not choose to offer such support. In this case, those seeking support include ownership, management, as well as the creditors and potential acquirers of failed firms. Those with the means to support these enterprises include regulators at the Treasury Department and the Federal Reserve, and taxpayers who provide the means with which government agencies work. Those seeking the bailout also have champions within the legislature. These champions work to convince their colleagues that funds should be allocated toward the bailout, when the legislature might spend the bailout money in a variety of other ways. Those legislators who were initially hesitant must have acquired something of value to them in exchange for authorizing the bailouts, possibly support for pending pieces of legislation.

In the case of bailout in the financial sector, there were several benefits that legislators reaped. These benefits did not come in the highly venal form of direct bribery, but in the form of policies that would strengthen the electability of the legislators otherwise reluctant to approve the bailouts. First, many legislators at the time were concerned about the perception that the government was assisting corporations at the expense of the common citizen. Thus, firms wishing to receive Troubled Asset Relief Program (TARP) funds were mandated to limit executive compensation and were prohibited from giving “golden parachutes” to outgoing executives. These conditions are a way of enabling legislators to become more amenable to accepting the bailout.

A second way in which reluctant legislators were compensated was by allowing TARP funds to be used to further objectives important to those legislators. As might be expected, logrolling featured prominently in the passage of TARP (Buchanan and Tullock, Reference Buchanan and Tullock1962). For instance, TARP funds were used to support the “Making Homes Affordable” plan, which allowed for the refinancing of mortgages held by Fannie Mae and Freddie Mac, and allocated money toward foreclosure mitigation (Solomon, Reference Solomon2009). Such programs would provide relief to the voters to whom those legislators were accountable. Renewable tax credits for the energy industry were added to the Emergency Economic Stabilization Act of 2008 (the Act authorizing the TARP funds – EESA) by the Senate to encourage members of the House to vote in favor of the bailout. After the addition of these tax credits, the EESA was finally able to pass a vote in the House. In general, measures that could be added to the bailouts to improve the chances of electoral success for the reluctant legislators enabled these legislators to view the bailouts more favorably than otherwise.

Bargaining between private and public enterprises did not end with the approval of the bailout. Hundreds of financial enterprises were competing for a limited amount of funding that was being distributed by the Department of the Treasury. On the surface, funding decisions were subject to an impartial standard. Initially, TARP funds were to be used to purchase “toxic assets” from insolvent financial institutions. However, after TARP funding was approved by Congress, the Treasury's first decision was to distribute $250 billion in TARP funding to nine of the largest financial institutions by purchasing preferred stock and warrants.Footnote ² It could be argued that subsidizing these nine institutions first was necessary to prevent negative systemic effects.

However, several of the banks subsidized were financially strong. Some banks such as Wells Fargo even objected to receiving TARP funds (Kovacevich, Reference Kovacevich2014). The reluctance of some banks to accept TARP funds prompted Secretary of the Treasury Paulson to threaten them with more regulation if they did not comply (Lander and Dash, Reference Lander and Dash2008). It seems to be that the motivating factor behind these funding decisions was not so much a concern for systemic effects as it was recognition that TARP funding would enable the Treasury to gain new powers over the financial industry (Zwyicki, Reference Zywicki2015). As Smith et al. (Reference Smith, Wagner and Yandle2011) point out, by buying shares in these large financial institutions, the Treasury could make “demands on how TARP-controlled firms would set loan policies and compensate executives. Furthermore [buying shares of these companies] enabled further discretion over repayment practices.” Moreover, by giving funds to solvent banks the Treasury could be assured that those funds would be paid back in a timely manner, thus making the bailouts appear more successful than they really were.

The Treasury used TARP in other ways to increase its importance within the network of entangled enterprises. For instance, the Treasury also used TARP funds to purchase senior stocks in American Insurance Group (AIG). AIG, being an insurance company, was not initially a candidate for TARP funding. However, the Treasury argued that, since AIG was systemically important, the use of TARP funds was justified. The dubious veracity of that argument notwithstanding, as Smith et al. (Reference Smith, Wagner and Yandle2011) point out, that decision set off a chain reaction within the insurance industry. Several other insurance companies – including Lincoln National, Hartford Financial Services Group, and Genworth Financial – moved to position themselves to receive TARP funding by becoming thrift-holding companies. This anecdote illustrates how bailouts change how firms compete; for the insurance companies, competition for a certain status became paramount.

In this analysis of the 2008–9 bailouts of the financial industry a few lessons can be drawn regarding the transactions that made the bailout possible. First, in order to convince legislators to move forward with the bailout, the bailed-out firms had to accept certain conditions regarding the structure of their organization, most prominent of which was the limitation of executive compensation. Although this might have been a stipulation that soothed populist fears, it is difficult to see the economic rationale. Second, since executive agencies are not residual claimants, their profit is usually expressed in terms of increasing their importance and functions. This point is illustrated by the Treasury's use of the TARP funds in ways not prescribed by the law. Moreover, firms negotiate with executive agencies from a position of subservience; unlike in bankruptcy proceedings, in which the insolvent firm has some room to haggle with its creditors, the insolvent firm must often submit to the executive agency or face coercion. As expected, political agents will use their position of privilege to direct resources to their favored interests (Mahoney, Reference Mahoney2016; Zywicki, Reference Zywicki2015). While bailouts might make the restructuring process more expedient, it also places faith in the wisdom of a few regulators to come to prudent decisions, and not abuse their power, rather than relying substantively on the input of all parties involved.

5. Bailout as underground restructuring: the automotive industry

On November 19, 2008, the Big Three auto manufacturers (GM, Chrysler, and Ford) asked Congress for a $25 billion bailout to avoid bankruptcy. Opinion in Congress was divided largely along party lines: most Democrats favored some sort of bailout while most Republicans favored bankruptcy so that the Big Three could be freed from union contracts. Both parties were worried that the Big Three would “take the money and run” so to speak, so any bailout that had been approved would have had to include significant restructuring. The following month, the Big Three submitted restructuring plans to Congress. Nevertheless, the Senate rejected the bailout. The Senate rejection prompted President George W. Bush to use an executive order to redirect TARP funds to the Big Three – a decision of questionable legality since the Big Three are not financial institutions, as Lawson (Reference Lawson2010) points out. Upon entering office, President Barack Obama organized the Presidential Task Force on the Auto Industry, an ad hoc group composed of cabinet-level officials. This task force would guide GM and Chrysler through their respective bankruptcies in the coming months.

The bailouts of American auto manufacturers GM and Chrysler were characterized by a more significant degree of political entanglement in the restructuring process than the bailouts of the financial industry (perhaps more so than any other bailout in American history). Government regulators were not simply placing certain conditions on the bailed-out firms, but actively managing the restructuring. The task force ensured that certain conditions were met, that liabilities were distributed in a certain way, and even decided who could acquire the assets of the failed companies.

The deep entanglement between polity and market in the case of the automotive industry bailouts implies that much of the restructuring occurred underground. The presidential task force, in deciding how to restructure Chrysler and GM, could not make decisions based on monetary calculation of the value of alternative asset configurations. Resources had to be allocated through some alternative decision-making process that would avoid direct comparisons of alternative monetary valuations. This section sketches the underground transactions that enabled the auto bailouts to proceed. Although the bailouts would not make it successfully through Congress, the debates regarding the bailouts are noteworthy. For instance, many Republicans, in opposing the bailouts, did so in the belief that going through bankruptcy would allow the Big Three to renegotiate their contracts with the labor unions. It seems plausible then that Democrats, long supported by United Automobile Workers (UAW), wanted a bailout to protect the union.

Nevertheless, it was politically unpopular at the time to bail out firms without asking them to restructure. In attempting to convince Congress to pass the bailouts, the auto companies agreed to make certain concessions. On December 2, the auto companies submitted plans for restructuring to Congress in which they agreed to executive pay restrictions, adherence to an oversight committee, and protections for the taxpayers who would ultimately be funding the bailouts, among other stipulations. There are two important points to highlight here. The first is that these conditions reflect a form of exchange between the firms and pivotal members of Congress. By agreeing to obey certain politically stipulated conditions, the firms increased their prospects for receiving a bailout. The second point is that the time and effort the auto firms spent drafting restructuring plans for Congress was time and effort they did not spend preparing for bankruptcy. Instead of searching for potential acquirers or drafting plans that would allow the firms to pass market tests in the future, those firms were participating within the political process to generate support for a bailout.

Ultimately, the bailout would fail to make it out of Congress, being rejected by the Senate on December 11. However, on December 19, President Bush would side-step Congress by using an executive order to redirect TARP funds toward the auto industry. Although TARP funding was intended for financial institutions, Bush claimed that TARP funds could be used in this instance because the funds were being used to prevent a financial crisis. In the following year, President Obama established the Presidential Task Force on the Auto Industry that would handle the bailout. On April 30, 2009, Chrysler filed for Chapter 11 bankruptcy. Unlike traditional bankruptcy, the government was an active player in this process. Indeed, the eventual buyer was “New Chrysler,” an entity owned jointly by Fiat, the autoworker's union retirement trust (VEBA), and the Canadian and US governments. The government also provided DIP financing in addition to the funding originally given to Chrysler in the last days of the Bush administration.

Skeel (Reference Skeel2015: 124) argues that the government managed the sale so that “a favored arrangement” could be insulated “from market interference.” Essentially, the government hoped to protect the unionized employees who would have had to renegotiate their collective bargaining agreement had Chrysler gone to bankruptcy. The Task Force, while it was a part owner of New Chrysler, was not a residual claimant; it could not collect any profit from selling the firm in an economically sensible manner. Instead, it profited by furthering the aims of the administration by assisting the labor unions and pushing the administration's goals with respect to building more fuel-efficient vehicles. Very few companies, except those willing to adhere to the Task Force's demands, would be able to acquire the company. As Skeel (Reference Skeel2015: 134) adds, a significant “chilling effect probably came from potential bidders’ knowledge that the government's motives were not economic.” Thus, when political enterprises handle restructuring they seek not to sell to those who offer the best bid in economic terms, but to those who are willing to carry out the administration's plan.

Enter Italian auto manufacturer, Fiat. The Obama administration hoped to use the restructuring as a means of promoting more fuel-efficient vehicles. Fiat, already known for producing fuel-efficient vehicles, was well positioned to take advantage of the opportunity. In January 2009, Fiat agreed to provide Chrysler a platform for producing more fuel-efficient vehicles in exchange for 20% stake in Chrysler (Schultze, Reference Schultze2014). By agreeing to further the administration's objectives, Fiat could acquire partial ownership of the company. A 55% stake in New Chrysler's ownership was given to the UAW for similar reasons. By giving the UAW such a large stake, Chrysler would be compelled to meet its healthcare obligations to the UAW (de la Merced, Reference De la Merced2009). Once again, restructuring decisions were made based on the willingness of the acquiring entity to follow the administration's objectives. In typical bankruptcy proceedings, employees are treated as unsecured creditors and can be compensated after only secured creditors. In the case of the Chrysler restructuring, labor was compensated before secured creditors. While it is laudable to protect employees, the decision appears to be based more on favoritism than economic prudence. Other acquiring entities that might have been interested in Chrysler's assets could have been deterred from bidding, since they might have also been unwilling to uphold the old labor contracts.

The restructuring of General Motors proceeded along a similar path. Like Chrysler, GM was sold to a “new” version of itself – “New GM.” New GM was owned by the US and Canadian governments as well as the UAW and other unsecured creditors. GM was sold to New GM in July 2009; no other firms attempted to acquire GM. Skeel (Reference Skeel2015) argues that the chilling effect that prevented firms from bidding on Chrysler also prevented firms from bidding on GM. The administration's contention that the labor unions had to be protected discouraged firms from bidding. As Skeel (Reference Skeel2015: 1420) writes:

Skeel concludes that the GM and Chrysler auctions were not genuine auctions. Zywicki (Reference Zywicki2011a) adds that the sales from old GM and Chrysler to their new versions violated “the longstanding bankruptcy principle that an asset sale should not be functionally equivalent to a plan of re-organization for an entire company,” because such a sale precludes creditors from approving the reorganization plan. The analysis in this paper supports a similar point: that when administrative agencies handle the reorganization of a firm, decisions are made based not on commercial calculation, but on furthering administrative objectives, of which a redistribution of wealth toward favored activities and groups looms large. The transactions that make the restructuring possible manifest themselves as promises by the acquiring entities to further these administrative objectives.

6. Bailout or bankruptcy: what might it matter, and to whom?

In considering the differences between bailout and bankruptcy we must keep in mind that the negative capital value that pertains to the insolvent firm will not simply disappear. Those losses must be placed on specific people within the economy. A firm that is insolvent by $10 billion means that specific individuals within the economy will undergo a reduction in their net worth by $10 billion, regardless of whether this occurs through bailout or bankruptcy. The point of both restructuring methods is to decide who will bear those losses. If the distribution of capital losses differs under bankruptcy as opposed to bailout, this must be because bailout establishes a different de facto pattern of ownership rights to the firm then than does bankruptcy, which operates within the de jure pattern of ownership. In other words, the bailout solution could not have been reached through bankruptcy because bailout uses political power to rearrange property rights. When certain creditors invest in a firm, they are also entitled to certain rights if that firm becomes insolvent, because they become secured creditors and must be compensated before other creditors. Secured creditors will often “gift” a part of their payout to unsecured creditors; however, such gifts are usually a portion of the secured creditor's payout, and certainly not enough to give unsecured creditors a large stake in the reorganized firm, as was the case with Chrysler. Given that the distribution of losses differs from bankruptcy to bailout, we can only suspect, and as our analysis has shown, that bailouts come about because certain interest groups believe they would fare better under bailout than under bankruptcy.

When a governmental entity becomes involved in the restructuring and chooses to compensate unsecured creditors at the expense of secured ones, the government has essentially taken some of the ownership rights of the secured creditors. Moreover, the use of taxpayer money to finance the insolvent companies means effectively that taxpayers have become involuntary creditors of those firms, only with agents of the state acting on their behalf. As one might expect, such a relationship is subject to principal–agent problems. Legislators used TARP funds to push their favored policies while executive agencies used the funds to gain new powers over the financial industry.

In “A Retrospective Look at Rescuing and Restructuring General Motors and Chrysler,” Krueger and Goolsbee (Reference Krueger and Goolsbee2015) argue that the auto bailouts were successful because GM and Chrysler survived when many commentators thought they were doomed. Yet this is surely no measure of success, because the bailout process forcibly distributes the firm's negative net worth throughout the economy in pursuant of some political calculus. A bailout must be successful in eliminating negative net worth because that is what it is designed to do at the enterprise level. Both bailout and bankruptcy are identical in this limited respect. What happens afterwards is where success must be judged, and it is here where bailouts and bankruptcy diverge. The mentality exhibited by Krueger-Goolsbee and other defenders of the bailouts leaves little room for consideration of the alternative arrangements that could have materialized had they allowed bankruptcy to occur. While it might ease our minds to see a failed firm rescued, especially firms as culturally prominent as GM and Chrysler, the bailout might have prevented reorganization that could have redirected those assets into what would have been uses of higher commercial value.

Krueger and Goolsbee do note that Chrysler and GM were subjected to a lengthy restructuring process that accompanied the bailout. Chrysler and GM exited bailout with different management and capital structures than what had previously existed, and with Chrysler and GM now taking on public utility characteristics. However, restructuring through political channels leads to different substantive outcomes than does restructuring through bankruptcy and its channels of private ordering. Restructuring through market channels allows for an open process in which debtor and creditor must haggle and bargain to reach a mutually beneficial agreement. In contrast, restructuring through political channels tends to reward those who further the administration's political objectives. By predetermining the outcomes sought through the restructuring, political restructuring necessarily precludes the entrepreneurial discovery process. As Hayek (Reference Hayek2002: 9) once pointed out, the purpose of the competitive process is to discover “facts which, if the procedure did not exist, would remain unknown or at least would not be used.” These facts are left unexplored by political restructuring.

In addition, when firms, both insolvent ones and potential acquirers, believe that restructuring can occur through political channels, their behavior will also change. Insolvent firms, as Ayotte and Skeel (Reference Ayotte and Skeel2010) showed was the case with respect to Lehman Brothers, will forgo preparing for bankruptcy if they believe a bailout will be forthcoming. Rather than trying to act wisely and swiftly to retain as much value for creditors as possible, the insolvent firm will rely on taxpayer support to compensate creditors.

The expectation of a bailout also leads to an uneven playing field. Evidence from Varmaz et al. (Reference Varmaz, Fieberg and Prokop2015) suggests that the doctrine of “too big to fail” tends to assist big banks, who are usually better connected to key political actors, at the expense of smaller banks. Furthermore, potential acquirers will tend to be rewarded in their dealings with political enterprises if they are already connected to influential political actors or willing to further the objectives of the political actors overseeing the bailouts. If it becomes expected that the government will restructure firms that are deemed “too big to fail,” other firms in the economy will come to recognize that there are gains to be had from forging relationships with legislators and political enterprises. Rather than trying to exchange property rights through corporate restructuring, potential acquirers will try to leverage political support to amend property rights in their favor during restructuring proceedings. This recognition yields the plausible expectation that the use of bailouts will generate support for future bailouts, unless bailouts generate negative political reaction of significant intensity. Firms deemed “too big to fail” will be reluctant to invest in measures to prevent insolvency; investors will be reluctant to finance such firms; potential acquirers might find it in their interest to make a deal with legislators or executive agencies rather than try to acquire insolvent firms through bankruptcy proceedings; said legislators and agencies might find that new powers can be acquired through bailouts. The combination of these various forces increases the probability that bailouts will occur in the future.

To assuage these fears, the creators of the Dodd–Frank Act established the Financial Stability Oversight Council (FSOC), tasked with monitoring excessive risks to the financial system (Markham, Reference Markham2011). The Council was designated with three powers:

1. (1) identify the risks to the financial stability of the United States from both financial and non-financial organizations;

2. (2) promote market discipline, by eliminating expectations that the Government will shield them from losses in the event of failure;

3. (3) respond to emerging threats to the stability of the US financial system.

Whether this task force will prevent future bailouts remains in question. The FSOC is essentially trying to solve what Casey and Posner (Reference Casey and Posner2015: 62–3) refer to as “the paradox of bailout regulation”: attempting to commit to not giving out bailouts and simultaneously promising to give out bailouts only when they are necessary. Resolving this paradox might prove to be a more difficult task than getting a camel to pass through the eye of a needle. What we know to this point is that it has created more opportunities for contention between market and political enterprises. One of the FSOC's principal powers is the ability to label firms as “too big to fail.” The label allows the FSOC to impose safeguards on firms such as forcing them to set aside funds to prevent insolvency. We have already seen firms fight to avoid the label. In 2014, MetLife was given the dubious distinction and only after a lengthy legal battle was the company able to shed it (Merle, Reference Merle2016).

7. A concluding remark

The preceding discussion foreshadows the likely long-run consequences of bailouts. Since the decision to bail out some firm rests largely on the political connections the firm has made, bailouts will tend to have an ossifying effect on the economy. As Zywicki (Reference Zywicki2011b) argues, adhering to the rule of law during times of economic crisis is particularly important because emergency actions tend to excite the attention of special-interest groups who are well positioned to influence policymakers. A bailout, at its very core, is a decision to fund the known at the expense of the unknown. First, the funds used to bail out the dying firm must come from somewhere else in the economy. Second, the bailout subsidizes the existing pattern of enterprises in the economy, thereby displacing investors who might have bought the bailed-out firms, input suppliers who could have redirected their resources toward new entrants, and new entrepreneurs who might have entered the market. A game of political maneuvering and status seeking displaces the process of entrepreneurial discovery.