The current financial bailout, which involves having the U.S. government spend up to $700 billion buying distressed financial assets (mostly collateralized mortgage securities) have several possible justifications.
1. The market is undervaluing these assets.
The trouble with this is that we don't usually consider the federal government to be better at valuing sophisticated derivatives than the private sector. If the private sector isn't buying at the price that the government is willing to pay, there may be a good reason for this reluctance.
2. Failure in one institution drags down others.
There are two versions of this argument.
One is that ordinary people will be hurt because pensions and other institutional investments that they benefit from indirectly are hurt by making bad investments, impacting them. This is true, but usually, we don't bailout companies simply because they made bad investments. The whole point of buying stocks and bonds not insured by the government is that you get returns greater than Treasury bonds in exchange for taking the risk that their value may decline. Investors in these kinds of investments are expected to evaluate the creditworthiness of the transaction in advance. Also, the willingness of the government to let many of these investments lose most of their value, suggest that this isn't a real motive.
The other version of this argument is that the failures will bring down the financial system itself. This is essentially an argument about payment systems, short term loans and trade credit. It argues that if day to day business cannot continue, that otherwise only slightly impaired companies will collapse, because these short term transactions can't afford to be delayed by being tied up in the Chapter 11 bankruptcy process.
Most publicly held companies and big financial institutions that deal with them have stockholders, people who have made long term bond and bank loans on an investment basis, and a variety of short term payments that haven't cleared, trade credits and short term loans. In theory, none of these transactions can take place in a Chapter 11 bankruptcy without court permission, because they could dissipate cash stockpiles of a company, although permission to engage in these transactions is usually granted right away. These kinds of creditors such as customers, suppliers, and operations creditors rarely evaluate institutions from a credit perspecitve with care, because individually they have small transactions for short periods of time.
But, even the risk of a bankruptcy can discourage people from doing business on anything but a purely cash basis with a company in financial peril, for fear that they will take a loss if they are unlucky and the company goes under on them. This reluctance to do business, moreover, can cause the very bankruptcy that is feared. This is essentially what forced Frontier Airlines into bankruptcy. A trade creditor, its credit card processor, tightened its trade credit terms for fear that the company would go out of business and leave it burned through customer chargebacks.
Since almost all dealings of financial institutions involve some kind of extension of credit, this is a real concern. From a financial institution's perspective, insurance policies and customer deposits are just one more liability.
The solution to this problem lies in the preferences section of bankruptcy code. In a bankruptcy, secured creditors (mortgage holders in real and personal property) get paid first, then preferred creditors (taxes due, the FDIC, recent wages and costs of conducting the bankruptcy and post-decree operations are important prefered creditors), then general creditors, then subordinated debt, then preferred stock, and lastly (and usually never) common stock. These default rules can only be overriden with the consent of creditors who are impaired by a deviation from the default rules.
Typically, in a successful Chapter 11 bankruptcy (i.e. one that doesn't convert to a liquidation), secured creditors and preferred creditors get paid in full or very nearly so, while subordinated debt and stockholders get nothing. Typically, general creditors get some percentage on the dollar payment, unless the plan specifically provides otherwise. Often, but not always, trade creditors are singled out for special treatment since they can cease to do business with the bankrupt company, and force a liquidation otherwise in many cases. But there is no assurance of this up front, so everyone who deals with a financially troubled company needs to protect themselves somehow, such as requiring payment in cash.
One solution would be to give trade creditors and similar creditor formal preference over long term investment creditors in bankruptcy proceedings. Yes, these short term business creditors could still get burned. But, it is rare for a companies that are still operating to be so deeply insolvent that there is not enough money to pay most of the trade creditors, even if long term investors get nothing.
There would also be less reason to object to allowing business as usual to continue in cases where trade creditors were almost sure to get a 100% payout.
The definition of trade creditor could be tied to a definition already in the bankruptcy code of a "preference" which is a payment to a creditor of more than its fair share on the eve of bankruptcy. If it payment in full of a debt prior to bankruptcy wouldn't constitute a preference (perhaps with a slightly broadened definition of preference), those payments should also be preferred in an ultimate payment. Creditors should'nt be penalized simply for not receiving favored treatment from the managers of a bankrupt company.
This tweak in a fairly obscure part of the bankruptcy code would make the fall of one company far less threatening to the system as a whole, which would allow business as usual to go on with basically viable businesses, while the long term financing of these businesses was rearranged.
With the risk of one company brining down an entire web of related companies greatly reduced, this in turn, would reduce the need for any kind of bailout, and allow the bankruptcy system to do its job of salvaging value while holding investors who made bad decisions accountable.