Why the Bank Bailouts Were Necessary

"Let them go bankrupt!" These words were recently screamed at me by a well-known “tea party”, anti-bailout pundit. He was telling me that all of the banks should have gone bankrupt, that any small business stupid enough to use Citigroup (C) or Goldman Sachs (GS) for their financing should have gone out of business, and that AIG should have gone out of business, as well. “The market would have come right back,” he said, “and unemployment would only be at 5% right now instead of all those Wall Street guys getting rich.”

I get it. People are angry about the bailout. They hate the fact that the government used taxpayer money to pay off a bunch of rich Wall Street fat cats while Main Street suffered. There’s a lot of anger because now there’s 10% unemployment, Wall Street executives are still getting big bonuses, foreclosures are still rising, and the list goes one.

But I am glad that the government spent a trillion or so dollars bailing everyone out.

The main question is: what would have happened if we didn’t do the bailout?

• All of the banks would have gone bankrupt. Forget about fault for a second. (Was it the change in mark to market accounting rules in November 2007? Was it the aggressive subprime mortgage lending? Was it the shortsellers? Was it the run on the banks? Who knows.) Morgan Stanley (MS) would have definitely gone bankrupt. Then Wachovia. Then Citigroup. Then Goldman Sachs, Bank of America (BAC), etc.

Would this have been a good thing or a bad thing? Very bad. Read on.

• Many major Fortune 100 companies would have gone bankrupt or had to scale back all of their operations drastically. General Electric (GE) is a prime example. They would have had zero access to the commercial paper and short-term financing that they had used to finance their business on a daily basis for decades. The entire commercial paper market was frozen and would have stayed frozen for months, too long for a company like GE to survive in its current form.
• Most small businesses of 20-1000 employees would have gone bankrupt. I ran a small business in the 90s. Because we were growing, we were often hiring employees to do new jobs for new clients well before those clients paid us. This is normal. Big companies typically pay in up to 20-60 days. But before they paid, I had to complete work for them. Which meant that because I was growing fast, I had to hire employees. Banks would offer short-term financing based on my contracts with companies so that I could then hire the new employees. Well, if the banks went bankrupt, there would be no short-term financing anymore (because my bank, Citigroup, would have gone out of business), which means no new employees, which means that I probably would have had to fire most of my then-current employees (If we were still in business in 2008) and effectively I would have been out of business. Most small businesses are like this, using short-term financing to make payroll. My friend suggested that businesses should have a “rainy day fund” set aside for these occasions. Else, they are poor businessmen. My monthly payroll back then (1998) was six times greater than my annual salary. There was no way that I, or any growing business, could have put aside that type of rainy day fund. Capitalism depends on leverage to grow.
• Millions of people would have lost their insurance. Companies like AIG would have gone out of business and millions of people would have been without adequate healthcare coverage. Not to mention life insurance, property insurance, and other insurances that would have been lost, and obligations that would never have been paid or would have taken years to settle in bankruptcy courts. Sure, AIG’s competitors could have picked up the leftover business. But anyone with an outstanding obligation or a preexisting condition would have been in trouble. Pain would have occurred to tens of millions of people.
• Unemployment would have instantly gone to 20-25% or much higher. Not this mythical “U6” that everyone keeps talking about but real unemployment, as 50%+ of businesses would have had to close down or drastically scale back.
• If the above situations occurred, what would have been the chance for violence and civil unrest? Probably quite high.

We don’t know how the stock market would have behaved. My guess is that the S&P 500 would have gone below 400 (as it stands, it went as low as 666). What we do know is that the market has now rallied up over 50% from the lows. Although, with the financial system mostly stabilized, we are still a good 200 points lower on the S&P 500 than we were the day before Lehman collapsed.

This article is not about solutions or causes or about how we could have reacted even better than we did. The article came about because a well-known TV host “tea-bagger” was screaming at me in a phone conversation about how “his America” has changed forever because of this bailout. Well, it's my America as well and I’m thankful we didn’t plunge into the chaos that almost certainly would have caused much pain and suffering.

Disclosure: Author holds a long position in C