Bailouts, takeovers, and liquidations

The news reports say that the federal government will soon "bail out" Freddie Mac and Fannie Mae. However, reading them it is not clear that there is any bailout involved. A bailout means that the government gives aid to a company so that it can continue to survive with stockholders and perhaps management intact. The alternative would be a failed company with shareholders losing everything. With the bailout they continue to own the company, and their shares are worth whatever the company is worth. In the late 1970s the government bailed out Chrysler by guaranteeing its loans.

With a government takeover the government assumes control and ownership of the firm. The stock of the shareholders becomes worthless and almost always the management is replaced. We see government takeovers when banks fail. The FDIC will then quickly merge the bank with another, taking a loss on the transaction.

The government, at least in the form of the Federal Reserve, has also forced liquidations of companies. It did this in the case of Long Term Capital Management (LTCM) in the 1990s. There were no government funds used. The Fed help organize an injection of new money into LTCM from banks that would have been seriously injured if LTCM had failed to meet its obligations. With the additional funds, it was able to proceed to an orderly shut down.

It will be interesting to see what will happen with Freddie Mac and Fannie Mae. My guess is that it will not be a bailout, but a takeover. The government needs to protect the debt holders, but not the stockholders. But to the press it seems to be all the same--they use the term bail out when they mean takeover or forced liquidation.

(Greg Mankiw had an interesting post on these agencies recently.)