By filing for Chapter 11 bankruptcy Wednesday Delta Airlines and Northwest Airlines should finally have made it clear to all that fixed-asset-rich businesses combine with a lax U.S. bankruptcy code to create a uniquely unpleasant money pit for investors, in which long term investor profitability is impossible. Corporate bankruptcy reform is essential for the survival of these businesses, enabling them to access the capital they need to build a sound future.
Businesses with high levels of fixed assets that operate in heavily competitive markets have always had difficulty making money. Once the huge infrastructure to provide the product or service has been put in place, the additional cost of providing an extra unit of output is small, so the seller is forced by competition to price the output at a level that does not cover fixed costs. To the extent those fixed costs have been financed by equity, an inadequate return on capital is earned; to the extent they have been financed by debt, default is inevitable in some future downturn, when little debt has been repaid and the remaining indebtedness cannot be serviced from either operations or asset sales.
In modern times, this was first evident in the railroad business. Nineteenth century financiers were paranoid about the dangers of “watering” stock – issuing stock to a value in excess of the hard assets being financed. There was a reason for this: if stock in a railroad had been watered, it was possible for a competitor to build a new railroad parallel to the first, while issuing a smaller amount of bonds and stock and thereby incurring lower capital costs, thereby being able to undercut the first railroad’s passenger and freight rates. To investors, generally located across the Atlantic in Britain or Europe, watered stock led almost inevitably to the entry of ruinous competition on the route in which they had invested, and a cutthroat rate war leading to bankruptcy.
At that time, if a railroad had not issued watered stock, it was relatively safe from cut price competition. The costs of railroad construction, once the initial technical hurdles had been overcome, were more or less the same for everybody (because wages and material and equipment prices did not vary much, and there was no inflation). Hence a railroad’s capital charges were fixed, and could not be reduced by financial chicanery. Any attempt to file for bankruptcy in difficult years, and thereby reduce capital charges for the future, resulted (before the Chandler Act of 1938) in management losing control over the railroad’s operations, with its administration being transferred to a bankruptcy trustee. Bonds in a soundly financed U.S. railroad were thus relatively secure assets, even though the U.S. economy overall was highly cyclical.
The U.S. political system has always favored debtors over creditors; for example one of the major economic effects of U.S. independence was a mass default by merchants such as John Hancock and landowners such as Thomas Jefferson on their debts to British creditors. The Pennsylvania Bankruptcy Act of 1785 allowed convicted bankrupts to be flogged while nailed by the ear to the pillory, after which their ear was removed, but this wholesome rigor was alas short lived. The Bankruptcy Act of 1841 decriminalized bankruptcy, and allowed debtors to file for it voluntarily; its result was defaults totaling 27 percent of Gross Domestic Product, according to a paper by Joseph Pomykala published by the Cato Institute. While that Act was soon repealed, the principle of voluntary filing for bankruptcy remained, and bankruptcy law was gradually loosened, until by the 1938 Chandler Act’s Chapter 10 provision, and its loosening under the 1978 Bankruptcy Act’s Chapter 11 provision, the bankrupt company’s management was allowed to control the bankruptcy process.
In a situation such as railroads and airlines, where the majority of costs are incurred as fixed assets in the initial construction of the route system, the ability to file for bankruptcy voluntarily introduces a huge element of moral hazard into the system. Airlines or railroads which file for bankruptcy immediately reduce their capital costs and are thereafter enabled to undercut the costs of their competitors that are still paying their debts on schedule.
This problem was exacerbated by the creation in 1974 of the Pension Benefit Guaranty Corporation, which guarantees workforce pensions of companies that file for bankruptcy, thus encouraging high-fixed-asset companies to pay their employees as far as possible in the form of deferred pension arrangements, which can be offloaded onto the PBGC if things go wrong. In the case of Delta and Northwest, approximately $45 billion of debt have been taken into bankruptcy proceedings, while an additional $16 billion of pension obligations have been offloaded.
PBGC itself will pick up only $12 billion of those pension obligations, because the legislation caps the maximum pension guaranteed by PBGC, thus leaving senior and middle management, pilots and the most senior mechanics to fend for themselves. However, combined with PBGC’s existing deficit of $23 billion from prior bankruptcies, the Delta and Northwest filings must make a large taxpayer bailout of PBGC inevitable, even without a downturn in stock and bond markets from their present exalted levels. Further airline or (for example) automotive bankruptcies can only make the problem worse.
Apart from creating a potential taxpayer money-pit along the lines of the 1980s savings and loan bailout, the Delta and Northwest bankruptcies have greatly worsened the competitive pressure on other airlines. Neither company plans to reduce its capacity significantly, and the price competition from Delta, Northwest and the “bankrupt” (Chapter 11) UAL Corporation (United) and US Airways will provide subsidized competition for American and Continental, the two largest traditional carriers still outside bankruptcy (in Continental’s case between bankruptcies; the company has already made several trips through the Chapter 11 balance sheet cleansing process.) More damagingly Southwest Airlines, the success story of the airline business, which has built its growth on efficient operations and avoidance of the union problems that bedevil traditional carriers, must be severely threatened by competitors that never shrink significantly, but only slough off their excessive costs onto third parties.
As has frequently been noted, the airline industry has failed to make money overall since the Wright Brothers took off in 1903, and in the United States has lost more than $30 billion since the 9/11 attacks. Abuse of the bankruptcy system is the principal reason for this. If companies are able to gain a competitive advantage by filing for Chapter 11, then the only means of survival for major airlines lies in repeated filings for Chapter 11. Provided capital continues to be attracted to the industry, the result is chronic overcapacity and a pricing structure that fails to return an adequate level of profits to equity investors, or to service airline debt.
If chronic overcapacity in the airline business is never corrected, because bankrupt airlines have little incentive to scale back their operations, let alone to liquidate, the only thing that could prevent the creation of a gigantic money pit would be a refusal by investor groups to continue financing the airline industry. In economic theory, a “buyers’ strike” of airline securities should take place, after which airline expansion or even continued operation would become impossible until capacity had been removed from the market and long term profitability restored.
In practice, however, as with a number of other pleasant Panglossian “best of all possible worlds” theoretical outcomes of the free market, no such buyers’ strike has occurred except in the short term, nor is it likely to. Airlines depend little on the equity markets for finance, though an aggressive broker sales campaign at the top of the operating cycle can generally get a deal done. However, equipment manufacturers depend critically on the airlines to keep buying, and governments are quite prepared to subsidize equipment manufacturers to preserve exports, employment and national prestige. Since banks get commissions from arranging debt and equity finance, while rapid rotation of bank executives means that the resulting defaults come on somebody else’s watch, huge amounts of subsidized debt finance, including in recent years that from tax based leasing schemes, is normally available for the aircraft industry. Market downturns simply create an aircraft park in Arizona (which has a dry climate and no political risk) full of temporarily unused passenger jets.
Airlines thus operate under grossly excessive financial leverage for an industry with such high operating leverage, capacity in aircraft and routes is never in the long term reduced, and profitability fluctuates between marginal profits in good times and gigantic losses in bad. The result is an industry that tends to fly geriatric aircraft, and cuts corners on service and, more alarmingly, on security and safety.
Chapter 11 is a good deal for investment bankers, airline top managers (who retain their large pay and perquisites while investors are scalped) and above all for the legal profession. It is a very bad deal for investors and, even including its beneficiaries, for the economy as a whole. By placing a top priority on continued operation of the business under existing management, the Chapter 11 system encourages management to act in its own interests at the expense of debt and equity investors, thereby grossly distorting the free market’s operation.
As with most failures of the free market, the difficulty is to find a solution to the problem that does not itself create equal or greater distortions. Bankruptcy law needs reform so that a bankruptcy produces a sharp reduction in the industry’s operating capacity, without relieving the bankrupt company of so much of its capital cost that it can undercut competitors. Through reducing capacity (of both aircraft and routes) in the market and reducing pricing pressures from the bankrupt, an airline bankruptcy under a reformed system would strengthen rather than weaken the bankrupt company’s competitors, making them more able to face the rigors of market downturns.
A reformed bankruptcy law would remove existing management from control of the company, and vest control instead in a committee of creditors, who would appoint a Trustee. The creditors would not generally have the deep industry expertise to operate the company over the long term, although they could of course appoint interim management for the short term. Generally, the creditors would liquidate the company’s assets, selling aircraft and routes to third parties, although if part of the business was especially attractive, it could be sold to an appropriately financed leveraged buyout team and thereby continue its operations. By this means, a reformed law would tilt the bankruptcy playing field away from continuing operation and towards liquidation
In a market such as the present, in which the economy remains strong, used aircraft remain saleable and route rights remain valuable, liquidation would be by far the most likely outcome of a bankruptcy, thereby reducing pressure on the bankrupt’s competitors. Only in a deep downturn such as 1981-82, in which there was no market for used aircraft and route rights were of little value, would continued operation while waiting for an upturn be a preferable alternative for the creditors controlling the situation.
As a further reform, one could always adapt some provisions of the 1785 Pennsylvania bankruptcy law. Seeing Delta and Northwest’s top management nailed by the ear to a pillory and whipped would at least relieve the feelings of those companies’ long suffering junior employees, and might produce some useful re-thinking in the airline industry as a whole!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.