During the 2008 financial crisis, interim Assistant Secretary of the Treasury for Financial Stability Neel Kashkari — who oversaw the Troubled Asset Relief Program — reportedly asked about a trillion-dollar rescue package to prop up distressed corporations.
“We’ll get killed,” said Treasury Secretary Henry Paulson. “Okay,” replied Kashkari, “How about $700 billion?”
The conversation illustrates how useful it could be to have “real-time” estimates of government, and ultimately taxpayer, funding necessary to assist distressed corporations during crises. This information might also have come in handy during the more recent failures of Silicon Valley Bank and its ilk. Future debates about whether to assist distressed corporations, including New York Community Bank, could be better informed by more educated guesses about costs.
Enter the “Estimated Debt Guarantee Expense,” or EDGE database, which uses Nobel laureate Robert Merton’s option theory insights on debt guarantee valuation. The EDGE database provides preemptive estimates of the cost of bringing an underwater corporation back to solvency, such as when the market value of its assets falls below the face value of its liabilities or the volatility of these assets rises. That’s not to say the government should do so.
The estimates derive from 90-day Treasury yield data, representing as a proxy the return on a risk-free asset, and three corporate data inputs. The first is total debt for non-banks or total deposits for banks since the federal government seems to guarantee not only insured deposits but also uninsured ones. The other inputs include market capitalization data (the share price multiplied by the total common shares outstanding) and equity return volatility estimates.
EDGE currently spans 1971 through 2022 and will be updated to include the most recently available data as corporations submit quarterly SEC filings.
In new research, I analyze more than 730,000 quarterly observations. Among other things, I find that in the average quarter since 1971, the aggregate estimated cost of returning all corporations to solvency equals about $30 billion. However, during crises, this estimate can rise considerably, peaking during the aforementioned financial crisis ($983 billion in the first quarter of 2009), the pandemic ($285 billion in the first quarter of 2020) and the Russian default ($190 billion in the fourth quarter of 1998).
The findings suggest that the “Too Big to Fail” bailout problem is a temporary but recurring one. That’s because, for most corporations, the cost equals zero since they remain in, or regain, good financial condition. It’s the relatively small number of large financial and non-financial corporations that face greater or longer-term distress which may periodically lead to positive direct or indirect costs for the taxpayer.
Because the EDGE database reports end-of-quarter estimates, it may miss corporations that go underwater within a given quarter. That happened with Silicon Valley Bank, Signature Bank and First Republic Bank, which all failed in Spring 2023, although you could see problems already in 2022. Recently, New York Community Bank has faced trouble. It’s still possible to apply the idea behind the database to estimate these “before-the-fact” costs.
For the banks that closed or failed in 2023’s first quarter, I use total deposits from the fourth quarter of 2022, which equaled $161.48 billion and $88.61 billion for Silicon Valley Bank and Signature Bank, respectively. For First Republic, which failed in the second quarter of 2023, I used the total deposits from the end of 2023’s first quarter, which equaled $104.47 billion. I also estimate the market value of equity and equity return volatility up to the day they failed.
With these inputs, the ex-ante estimated cost of guaranteeing total deposits for Silicon Valley Bank and First Republic Bank equaled $25.33 billion and $15.99 billion, respectively. The FDIC’s reported ex-post estimated losses were $21.82 billion and $16.66 billion. While Signature’s estimate and reported cost might appear more disparate at first glance — $194 million versus $1.83 billion — the scale is smaller and they differ by a similar margin as the others. That means this method can give a rough idea of what kind of losses you might expect from a future bank failure.
That brings us back to New York Community Bank, with about $77 billion in total deposits. The estimated ex-ante cost of a bailout as of April 12 would be about $6.7 billion.
The EDGE database aims to bring some clarity about the official costs of crises in real time. My analysis highlights how a corporation’s leverage, more than the volatility of its assets, tends to drive the largest costs.
This is one reason why a suggestion by John Cochrane — that airlines be subject to similar minimum equity-to-asset leverage ratios as banks — makes sense for other bailout candidates, like auto manufacturers or defense contractors, which the government would like to keep around.
Stephen Matteo Miller is a senior research fellow with the Mercatus Center at George Mason University and the author of the new study “How Much Would It Cost to Guarantee Debt for All US Corporations?”