Financial Bailout

INDEX
Financial Bailout - Examples ..............................................................2

Financial Bailout Examples

Bear Stearns Founded in 1923, Bear Stearns flourished through the stock market crash of 1929 and the Great Depression. Yet the subprime mortgage disaster of 2007-2008 caused the giant investment bank and brokerage firm, with billions of dollars in assets, to collapse. In April of 2008, the U.S. government, through the Federal Reserve Bank of New York, rescued Bear Stearns by lending $29 billion to JPMorgan Chase to buy the financially troubled firm.

JPMorgan Chase, another huge financial services firms specializing in banking, investments and insurance, among other areas, bought Bear Stearns at about $10 per share. The 52week high of Bear Stearns stock was a lofty $133.20, and so the rock-bottom sale price represented a huge loss for shareholders.

Nevertheless, both Treasury Secretary and Fed Chairman defended the sale, predicting devastating damage to the U.S. economy if the firm - one of the world's largest securities companies - were allowed to go bankrupt.

Financial Bailout Examples

Fannie Mae and Freddie Mac In the late summer of 2008, the U.S. government committed up to $200 billion to save these two giant mortgage lenders from collapse. The federal government seized control of these private, yet government-sponsored, enterprises and guaranteed $100 billion in cash credits to each of them to prevent their bankruptcies. Both were also victims of the subprime mortgage disasters. When Fannie Mae became a private enterprise in 1968, its charter permitted it to sell shares to public investors, who assumed that it had government backing. Fannie Mae was therefore able to borrow money at very favorable rates only slightly higher than the rate afforded U.S. Treasury debt. Freddie Mac, created in 1970 to market mortgages offered by federal savings and loan institutions, was also eventually permitted to sell shares to the public in an arrangement with the government similar to that of Fannie Mae. What brought down both these giants were mortgage loans to unqualified borrowers who secured inexpensive credit with minimal oversight by the lenders and, in too many cases, without income verification. When these loans became delinquent or defaulted, Fannie and Freddie sank deeper into financial trouble, and eventually the government had to bail them out.
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Financial Bailout Examples

The American International Group Bailout In mid-September 2008, the U.S. government took control of American International Group (AIG), one of the world's largest insurance companies. Private lenders declined to loan money to the financially troubled firm, prompting the federal government to take control of the company and guarantee to loan it up to $85 billion. In return for the two-year, interest-bearing loan, the government took a 79.9% equity position in AIG. Collateralized by AIG assets - principally the company's hefty insurance revenues - the government's risk was somewhat diminished. Provisions of the loan also require AIG to sell several of its marginal or unprofitable businesses, boosting the company's cash position and divesting it of some nonperforming debt. The federal seizure of AIG represents the first time ever that a private insurance firm was controlled by the government. This historic "first" was implemented when the Federal Reserve invoked a provision of the Federal Reserve Act, which authorizes loans to nonbanks in certain specified emergency or unusual situations. The CEO of AIG was forced to leave the company under the conditions of the bailout.

Understanding of Bailout
Financials of Bank A : Liabilities Loan A 10B Loan B 10B Loan C 3B Equity 3B (Assets Loans) 26B Assets US Govt. Bonds 1B Corp. Bonds(AAA) 10B Commercial Motrg. 10B Residential CDOs 4B Cash in Hand 1B 26B

Bank A had 500M shares. Book value per share is 3B/500M = $6 per share Currently the Financials of Bank A looks very healthy. Loan A matures : Bank A will sell off the Corp Bank AAA mortgage for $9B (loss of $1B to be bear by Equity shareholders) and also sell the US Govt. Bond for $1B to repay the loan.
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Understanding of Bailout
 Revised Financials of Bank A after maturity of Loan A : Liabilities Loan B 10B Loan C 3B Equity 2B 15B Assets Commercial Motrg. 10B Residential CDOs 4B Cash in Hand 1B 15B

Current Book value per share is 2B/500M = $4 per share

Loan B matures : Bank A will sell off the Commercial mortgages at $10B to repay the amount for Loan B.

Understanding of Bailout
 Financials of Bank A after maturity of Loan B : Liabilities Loan C 3B Equity 2B 5B Assets Residential CDOs Cash in Hand 4B 1B 5B

Current Book value per share is 2B/500M = $4 per share Loan C matures : Bank A is liable to make payment of $3B on the maturity of Loan C. Bank A is holding an asset in form of residential CDOs worth of $4B, but Bank A is not able to sell these CDOs in market because these are considered to be a risky assets, as default happened on the residential mortgages which are collateral against there residential CDOs. As a result of this although the assets had a book value of $4B but there is external buyers to purchase these CDOs . Bank A will approach Hedge Funds or Pvt. Equity firms to sell these CDOs. They have sell these CDOs at loss , as they only get $1B against these investments.
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Understanding of Bailout
 Bank A now had Cash of $1B along with $1B which is realized from the sale of CDOs which comes to $2B but they have to make payment of $3B to Loan C and they didnt had any other assets in there balance sheet which can be sold to make payment to there creditors.

Options available with Bank A to repay his liability are :

 Capital/Equity Infusion.  To file a bankruptcy  Internal Restructuring

Understanding of Bailout
 Scenario I - Capital/Equity Infusion Bank A will look for some external customer, who can invest some funds to save the institution from filing the bankruptcy. One vendor from Japan ( ABC Ltd) was interested in taking equity stake in bank A . This Japanese company believes that Bank A is in bad shape only due to there bad investment policies , but Bank A had a brand in US market and if they work strategically they can generate big gains out of this in future. ABC Ltd. is ready to buy 2B shares of Bank A @ $1.5 per share leads to the capital infusion of $3B. Now ABC Ltd had a major shareholding stake in the Bank A . New Financials for Bank A will be as follows : Liabilities Loan C 3B Equity 5B 8B Assets Residential CDOs Cash in Hand

4B 4B 8B
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Understanding of Bailout
 Scenario I - Capital/Equity Infusion The book value of share = $5B/2.5B = $2 per share In this case the existing share holder i.e. 500M shareholder will be at loss, as the book value of share has been moved from $4per share to $2 per share after the capital infusion. One good thing for existing shareholders is that Bank A is out of liquidity crisis now and able to avoid the situation of Bankruptcy which might have bought big losses for them.

Understanding of Bailout
 Scenario II - Insolvency Filing of Bankruptcy Now lets think of a scenario in case, Bank A didnt get any customer who can make the capital infusion and you are able to get only $1B for Residential CDOs . Financials of Bank A : Liabilities Loan C 3B Equity 2B 5B Assets Residential CDOs Cash in Hand

4B 1B 5B

Now , Bank A might approach FED for getting the Financial Bailout. FED will evaluate the financial impact on the US economy, if the Bank A files bankruptcy. If FED believe that it might give rise to a systemic risk in the economy ,they will come with a bailout option. But in this case no Systemic risk will turnaround , if Bank A defaults . So FED will not come with any bail out option. Now, as Bank A is insolvent ,as his equity is eroded i.e. ( Cash + CDOs Loan C= -$1B). The had a negative Equity , the only option they are left with is to file a Bankruptcy under Chapter 11.
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Understanding of Bailout
 Scenario II - Insolvency Filing of Bankruptcy The Dissolution of Bank A will be done. Liquidators are appointed who will take