Bailouts: Not Just Corporate Welfare

Whether it's taxpayers or private investors writing the check, someone is betting that there's value in keeping floundering companies afloat

by John Tozzi

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In these days of distress for large banks, hot money is showing up from all over the world, as if there's a Black Friday sale on financial firms. No sooner had Swiss giant UBS (UBS) announced $10 billion in subprime writedowns than Singapore's state investment fund and an unnamed Middle Eastern investor appeared with $11.5 billion to buy a 9% stake in the bank. Citigroup (C), racked by a cash squeeze in its structured investment funds, received a similar infusion of $7.5 billion from Abu Dhabi last month. The emirate's sovereign wealth fund could wind up with a nearly 5% stake (BusinessWeek.com, 11/27/07) in the bank.

Pulling out these helpful checkbooks is hardly an act of charity. Bailouts play a crucial role in the market whenever one party, be it an investor or government, sees more value in helping a sinking company out of deep water than in watching it go under. "These are investment opportunities for somebody," says Benton Gup, a professor of finance and banking at the University of Alabama and author of Too Big to Fail: Policies and Practices in Government Bailouts.

Investment Opportunities and Risks

While companies like UBS and Citigroup are suffering short-term hits from subprime writedowns, both are widely seen as sound investments for the long haul. For investors with the cash to buy big stakes, particularly when share prices are depressed, meeting firms' short-term liquidity needs promises to pay off. "The American dollar is cheap compared to some of the foreign currencies," Gup says. "There's an opportunity for them to come in and buy some companies."

As the moves by Singapore and Abu Dhabi signal, the problems stemming from the subprime debt crisis have only increased the opportunities for sovereign wealth funds. But some U.S. investors are capitalizing on the situation as well. Private equity firm Blackstone Group (BX) announced this month that it raised $1.3 billion to invest in debt now being sold at a loss, including collateralized debt obligations and leveraged buyout loans. In November, Goldman Sachs (GS) unveiled a similar $1.8 billion fund for distressed debt assets, known as GS Liquidity Partners.

While Blackstone and Goldman attempt to profit from broad investments in distressed debt at a steep discount, other recent deals appear riskier. Citadel Investment Group purchased a 20% stake in E*Trade Financial (ETFC) for $2.55 billion in late November. The agreement took $3 billion in bad debt off E*Trade's books, but the online brokerage still holds $12 billion in home equity loans, and it's unclear what losses related to that portfolio are still in the offing. Of course, distressed assets are cheap for a reason, and a bailout can't always cure a company's financial ills.

When Taxpayers Foot the Bill

Much more controversial corporate rescues come when public money is involved. The U.S. government has stepped in to walk foundering firms back from the brink, usually by guaranteeing loans. It did so for companies such as Chrysler and the former Lockheed, and for domestic airlines facing bankruptcy after the 2001 terror attacks. "Any time they think a large entity is going to do serious damage to the economy, the government's going to step in and bail it out," Gup says.

That was the case nine years ago, when the hedge fund Long Term Capital Management nearly collapsed. The highly leveraged fund, run by an elite team of investors and economists, placed complex bets on futures contracts and derivatives—bets that were estimated to be worth $1.25 trillion just before the fund's crisis, in August, 1998.