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Should Bondholders be Bailed Out?

CAMBRIDGE – A year after the United States government allowed the investment bank Lehman Brothers to fail but then bailed out AIG, and after governments around the world bailed out many other banks, key question remains: when and how should authorities rescue financial institutions?

It is now widely expected that, when a financial institution is deemed “too big to fail,” governments will intervene if it gets into trouble. But how far should such interventions go? In contrast to the recent rash of bailouts, future government bailouts should protect only some creditors of a bailed-out institution. In particular, the government’s safety net should never be extended to include the bondholders of such institutions.

In the past, government bailouts have typically protected all contributors of capital of a rescued bank other than shareholders. Shareholders were often required to suffer losses or were even wiped out, but bondholders were generally saved by the government’s infusion of cash.

For example, bondholders were fully covered in the bailouts of AIG, Bank of America, Citigroup, and Fannie Mae, while these firms’ shareholders had to bear large losses. The same was true in government bailouts in the United Kingdom, Continental Europe, and elsewhere. Bondholders were saved because governments generally chose to infuse cash in exchange for common or preferred shares – which are subordinate to bondholders’ claims – or to improve balance sheets by buying or guaranteeing the value of assets.