Government bailouts and what they mean for shareholders

US airlines finally got something to cheer about.

Earlier this week, US senate leaders came to an agreement on a US$2 trillion (S$3 trillion) stimulus bill. A whopping US$60 billion of that will be used to bail out struggling US airlines.

Airlines, in return, must forgo layoffs until the fall (sometime in the fourth quarter of 2020), accept limits on executive compensation and dividends, and maintain certain routes. Despite the limitations, I think this is a deal the airlines will happily take to save themselves from bankruptcy.

Bailouts are nothing new though. The US has a long history of bailing out companies that were deemed too important to fail. These companies either provided essential services, accounted for a decent chunk of the economy, or employed a large number of people.

But bailouts take different shapes and forms. The ways that the government injects cash into companies (or individuals), the kind of industries the government tries to save, and the impact on shareholders differ every time.

In light of the latest bailout, I decided to take a short trip down memory lane to see the different kinds of bailouts that have occurred.

The Great Depression

One of the greatest economic catastrophes of modern history occurred from 1929 to the early 1940s. It was the longest, deepest, and most widespread depression of the 20th century.

In 1933 US President, Franklin D. Roosevelt took the oath of office and started implementing solutions to bring the economy out of the recession.

One of the things he did was to bail out struggling homeowners. At that time, the national unemployment rate was around 25 per cent, so many Americans who lost their jobs were unable to pay off their home mortgages and were left homeless.

The Home Owners' Loan Corporation was set up to solve the problem. The newly formed government agency purchased defaulted mortgages from banks and refinanced them at lower rates, allowing about a million homeowners to benefit from lower mortgage rates.

This bailout was targetted at individuals at that time and kept people off the street. However, it was not until World War II ended that the depression was officially over and the post-war boom began.

The Great Financial Crisis

The next most important economic crisis occurred much more recently in 2007-2008. Known as the Great Financial Crisis, the collapse of Lehman Brothers amid the bursting of the housing bubble culminated in a global financial crisis.

However, this time, the US government's response was swifter and the bailouts introduced saved banks, restored confidence, allowed banks to lend again, and eventually led to the 12-year bull market that ended this year.

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So what did the US government do in 2008? The Emergency Economic Stabilisation Act of 2008, often called the "bank bailout," was signed into law by then-President George W. Bush.

The new law led to the creation of the US$700 billion Troubled Asset Relief Program (TARP) to inject capital into banks. But these funds were not given as grants, rather they were used to purchase toxic assets from the banks.

A key part of the US federal government's plan was to buy up to US$700 billion of illiquid mortgage-backed securities. These were essentially a bundle of home loans packed into one.

On top of that, the US government injected cash into banks through the purchase of preferred stock. Citibank needed a particularly big injection of capital, with the government purchasing US$45 billion in preferred and common Citigroup stock.

Selling stock when your share price is down 80 per cent is never going to be pretty and Citigroup shareholders learnt that the hard way as they were diluted almost six-fold. Till today, Citigroup's share price is still more than 80 per cent off the high it reached in 2007.

However, what the bailout achieved was to save Citigroup from insolvency and shareholders could at least survive to fight another day.

Overall, TARP improved the balance sheet and reduced the potential losses of banks and financial institutions.

The net effect for the government was also positive as it was reported that TARP recovered US$441.7 billion of US$426.4 billion invested, earning a US$15.3 billion profit when everything was done and dusted.

Covid-19 crisis

Fast forward to today and we are once again seeing a massive bailout, this time with the aviation industry.

As mentioned earlier, struggling US airlines are getting an early Christmas present this year, to the tune of US$60 billion.

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According to a draft of the legislation, airlines will receive up to US$25 billion in direct grants. That's practically free money for the airlines as long as they promise not to layoff workers till the fourth quarter of 2020, accept limits on executive compensation and shareholder dividends.

Additionally, the bill also grants US$25 billion in loans and loan guarantees for passenger airlines and US$4 billion for cargo air carriers. The promise of loans will help struggling airlines raise much needed new capital even if the banks won't lend to them.

The news is, of course, great for shareholders and employees. Employees get to keep their jobs while shareholders don't have to worry about potential bankruptcies. The injection of cash will tide airlines through this challenging period. Airline shares have been creeping up since rumours of a bailout began.

The Good Investors' conclusion

Bailouts may seem like a bad word but they are great for shareholders. The injection of cash into a company can tide them through when all hope seemed to be lost.

However, bailouts also bring to light that the company was not managing its finances well enough. Overleverage, bad investments, and in the case of Airlines, overspending on share buybacks destroyed their balance sheets to the brink of collapse.

Although bailouts can eventually save the day, they are one-off special situations and investors should never rely on them to get them out of trouble.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.