The morals of bailouts

By Felix Salmon
December 1, 2009
pointed out the contrast between the expected actions of Sheikh Mohammed bin Rashid al-Maktoum in Dubai, on the one hand, with those of normal homeowners in the US, on the other: while American individuals are ceaselessly told that they have a moral obligation to pay their debts, the ruling family in Dubai is simply defaulting on its non-recourse underwater loans in accordance with the amoral principles of capitalism.

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Sudip Roy has gone me one further today. I pointed out the contrast between the expected actions of Sheikh Mohammed bin Rashid al-Maktoum in Dubai, on the one hand, with those of normal homeowners in the US, on the other: while American individuals are ceaselessly told that they have a moral obligation to pay their debts, the ruling family in Dubai is simply defaulting on its non-recourse underwater loans in accordance with the amoral principles of capitalism.

Sudip, however, goes so far as to say that Dubai is morally obliged to reject a possible sovereign bailout. I’m not sure where he finds this moral obligation, especially since Dubai is not a democracy and its treasury has no fiduciary duty to the citizenry as a whole. But I can see where he’s coming from: there is something morally dubious about throwing good money after bad, given all the other things that any of us, be we citizen or ruler or corporate entity, can do with our cash.

In general, a government has the right — but emphatically not the obligation — to bail out absolutely any company it wants, anywhere in the world. Some such companies carry an implicit government guarantee, even in the face of explicit denials that such a guarantee exists — that was the case with Fannie and Freddie. Some companies (Citigroup, AIG) are considered too big to fail, and the implicit government guarantee is replaced by a very similar moral-hazard play. Other companies are just so politically important that government ultimately steps up with a bailout: think GM and Chrysler. But it’s crucial that all such determinations are made on a case-by-case basis, and that the government at least retains the option to say no to a bailout in each case.

That’s why I was happy that Dubai left Dubai World to sink: defaults at state-owned companies are rare things, and we need a few more of them to underline the fact that such companies are not, just by dint of being state-owned, vastly more likely to get bailed out than anybody else.

Sudip talks about the precedent of Naftogaz in the Ukraine, where the government negotiated a restructuring where creditors took a haircut in return for a sovereign guarantee on the remaining debt. (How much a Ukrainian sovereign guarantee is worth, of course, is another matter entirely.)

But it’s also worth remembering in this context that even when there is an explicit sovereign guarantee, it’s to all intents and purposes unenforceable in the event of default. Sovereigns are, by definition, sovereign, and it’s very, very difficult to sue them — which is one reason why some creditors end up settling for three cents on the dollar. Even if Dubai World did have a sovereign guarantee, the Dubai government could still have let it go into default, while remaining current on all other debt — and there’s almost nothing that Dubai World’s creditors could do about it.

This financial crisis has been one of commercial debt rather than sovereign debt, but there have been sovereign debt crises in the past and there will be more in the future. So anybody thinking that a sovereign-debt play constitutes some kind of flight to quality would be well advised to think again. Sovereigns can and will do whatever they like, including defaulting on state-guaranteed obligations. And they’re prettymuch the hardest entities in the world to sue if you want to attempt a legal strategy for getting your money back.

Update: John Carney adds that “guarantees on debt are prohibited by the shariah” — maybe that’s the moral obligation that Sudip is referring to.

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