What is a 'Bailout Bond'

A bailout bond was a debt security issued by the Resolution Funding Corporation to help fund the reorganization of the hundreds of savings and loan associations that became distressed during the American banking crisis of late 1980s and early 1990s. The bailout bonds were guaranteed by zero-coupon Treasury bonds, making the instruments a safe investment.

BREAKING DOWN 'Bailout Bond'

Bailout bonds were sold to the public by the Resolution Funding Corporation, which was established by Congress to facilitate the rescue of the savings and loan industry. The proceeds of the sale of the bonds were used to make depositors whole, who lost their savings following the failure of savings and loan institutions. The bonds appealed to investors because they were collateralized by U.S. Treasury bonds, which in turn are backed by the full faith and credit of the United States government.

The savings and loan crisis itself was the result of a confluence of factors that grew in strength throughout the 1970s and 1980s. One important factor was an environment of rising interest rates. Starting in the 1970s, the Federal Reserve steadily began raising interest rates to fight growing inflation. This culminated in the chairmanship of Paul Volcker, who plunged the U.S. into recession in 1981 by setting the federal funds rate as high as 19 percent. 

These high interest rates were particularly tough on U.S. savings and loan institutions, which funded their operations with short-term deposits, but then used those deposits to make long-term, thirty-year mortgages. The mismatch between very short-duration deposits and the thirty-year loans they were issuing to home owners meant that as interest rates rose, depositors demanded higher interest payments, while the savings and loans were stuck earning relatively low returns on the mortgage loans they issued. In response to these mismatches, many savings and loans companies began investing money into the newly created junk bond market, or bonds sold by companies which are below investment grade.

The Savings and Loan Crisis and Bailout Bonds

Following the implosion of the junk bond market, hundreds of savings and loans across the country became insolvent as a result. The nation’s existing deposit insurance system wasn’t robust enough to make all the depositors at these institutions whole, and Congress had to step in with additional measures to bail out these banks. One strategy was the establishment of the Resolution Funding Corporation, which was authorized to issue bailout bonds in order to fund the reorganization of failed banks.

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