How Do Bailouts Work?

The world is suffering from the worst pandemic in modern history. The U.S. GDP shrank by 9.5% in Q2 2020. Yet the S&P 500 has increased by about 5% YTD!

How is it that big corporations continue to make profits while your favorite local restaurant is struggling to keep its lights on?

Short answer – Bailouts!

Before we can understand how bailouts work, we need to know how the government and corporations get funding, what the Federal Reserve is, and what primary dealers are.

How Does The U.S. Government Get Funding?

U.S. government runs on borrowed money. The government borrows money by issuing debt securities such as Treasury Bill, Treasury Note, Treasury Bond, and Treasury Inflation-Protected Securities.

Investors consider U.S. debt securities very secure because the U.S. government backs them with their full faith and credit. Foreign governments, corporations, and individual investors from all over the world buy these securities.

How Do The Big Corporations Get Funding?

Big corporations issue debt securities called corporate bonds. Corporate bonds vary in maturities and yields. High yielding bonds are generally referred to as “junk bonds” because they are very risky.

Corporations also raise money by issuing stocks. A corporate bond is essentially a loan, whereas stock is a small ownership in the corporation.

What Is The Federal Reserve?

Federal Reserve (Fed for short) is perhaps the most powerful financial institution in the world. USD is the reserve currency of the world. Fed is the only institution that can print USD. They also set the interest rates for borrowing USD.

What Are Primary Dealers?

Primary dealers are select financial institutions authorized by the Fed to buy government debt securities directly from the government and sell in the open market for profit. Some of the well-known banks who are also primary dealers are Barclays Capital, Citigroup, JP Morgan, and Wells Fargo.

How Do Bailouts Work?

The Fed prevents big corporations from bankrupting by providing necessary financial assistance. Fed cannot directly give money to the corporations. Fed offers financial aid to big corporations through primary dealers.

Primary dealers bailout corporations by buying their bonds, including junk bonds, regardless of how weak fundamentals are. Fed repays primary dealers in the form of loans at meager interest rates in exchange for junk corporate bonds as collateral. Primary dealers lend this money out at a higher interest rate and make easy profits.

A similar dance happens when the government wants to send out thousands of $600 checks, suspend loan payments, and doesn’t want to raise taxes. Primary dealers buy government debt securities. Use it as collateral to get cheap loans from the Fed.

The Consequence – Artificially High Stock Market!

The stock market is increasingly becoming less correlated to the financial fundamentals of the corporations, and more to the interventions of the government and the Fed. As a result, the price-to-earnings ratio (P/E) of the S&P 500 is about 30 when the world economy is taking an unprecedented hit.

An average person wouldn’t buy ownership in a struggling small business at a price of about 30X of its earnings. But has no problem purchasing a stock of big corporations at a similarly inflated price. Such uninformed speculations in the stock market further inflate it.