Bank Bailouts: The New Entitlements That Aren't So New

Last Updated Oct 10, 2011 9:51 AM EDT

When it comes to bans and their often gargantuan mistakes, the Invisible Hand that Giveth and Taketh Away is gone, replaced by what is effectively a guarantee system, as fund manager John Hussman notes. Bailouts of financial institutions were actually bailouts of bondholders who kept their investments, no matter how risky the banks' actions.

What's interesting is that this is nothing new. The country has spent decades on a merry-go-round, watching banks wreak economic havoc, hammering the average citizen who then has to pony up money to bail out the banks and their investors.

When is a failure not like other failures?
Hussman's most important point is that people commonly misunderstand what bank failure actually means:

When Wall Street talks about the "failure" of a bank or other financial institution it means the failure of the company to pay off its own bondholders. It does not mean that depositors, counterparties or other bank customers lose money...
That's because insolvency really means that the bank can't make payments to the owners of the bonds it has issued.

Could there be pain and inconvenience for people and institutions doing business with the bank? Of course. That's life. But banks don't go bankrupt in the way most companies do. Here's what actually happens in a bank failure:

  1. Regulators take a bank into receivership.
  2. The regulators put to the side what is owed to the people and organizations that own shares of the institution's stock or bonds that the bank issued.
  3. The regulators bundle up the remaining assets and liabilities and sell them to some other institution, which is how customers of failed banks suddenly find themselves doing business with another bank.
  4. The money raised through the sale goes to the bondholders, who get some fraction of what they were owed (like the vendors to a bankrupt company).
  5. Shareholders are screwed.
At least, that's how the system is supposed to work.

The first thing we do, let's protect all the bankers
Had investors watched their banks-behaving-badly closely enough, they could have sold their investments and avoided the big loss. But this is where the system has broken down. As economists Robert Hall and Susan Woodward (via Hussman) stated in 2009, members of their profession found government treatment of bank failures to be puzzling. I think that is academic-ese for "completely bizarre":

The doctrine is widely accepted that institutions in this state are a danger to the economy (because their incentive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that regulators should take prompt, aggressive action to return them to sound financial condition. This doctrine calls for institutions to be reorganized or recapitalized so that they are unambiguously solvent and the consequences of risk-taking are mainly their own. ...By contrast, the government's current policy for all large financial institutions is to dribble taxpayers' funds into the institutions so that they can meet their stated obligations to all parties, including debtholders, but just barely. The government injects funds into AIG, Citigroup, the Bank of America, and many other institutions to keep them just above water.
Limping along doesn't mean just staying in business, by the way. It means bondholders continue to get paid while leaving enough funds necessary to continue operating the bank (otherwise the bondholders might not get paid tomorrow). And by keeping the banks up and running, shareholders often avoid the bath they would otherwise take.

Seems like old times
Why? Because we've developed a culture in which profit off an investment in a financial institution has become a real form of entitlement. As Black Swan author Nassim Nicholas Taleb has noted, bailouts for banks is hardly new. The early 1990s real estate collapse, which came after rapid speculation and over development of commercial properties, took a more than $500 billion bailout of savings and loan institutions. (What helped set off all this? Bank deregulation in 1980. Sound any more familiar now?)

Hey, even George Bailey (of It's a Wonderful Life) needed a bailout. How American is that?

How can you lose what you didn't have in the first place?
What has made profits from investing in banks an entitlement? Generally it's the argument is that keeping the bondholder whole is are necessary to maintain confidence in the system. But ... why?

The banks that are well-run will remain and people can have confidence in them. It's the poorly-run banks that risk a loss of reputation. However, the bankers don't want to look bad, no matter how incompetent they've been (not good for their careers, after all) and the investors don't want to lose money.

It's become a running con game. What bailouts actually do is use public funds to subsidize private profits in an inherently risky undertaking and to undermine stability of the sector because bankers know historically that they can be foolish and transfer the loss to the public.

This is nothing less than massive wealth redistribution, only from those who have less to those who already had more -- a form of reverse socialism, if you will, that many conservative politicians would scream about if it occurred in the form of people seeing mortgages, which they really couldn't afford in the first place, reduced.

Banks and many politicians insist that consumers shouldn't get breaks on their mortgages because the rules seem to apply to everyone else. Fine -- apply the prescription evenly. Let the badly run banks fail. Let the bondholders lose money. Only then will the system begin to promote prudent business.

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    Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.