Airlines - Bankruptcy, Bailouts, and Moral Hazard

Also available here. Written with Mutable Matter.

There’s a lot to like about the CARE Act.

By Washington’s standards, it was passed with unprecedented speed. It places due emphasis on household balance sheets, as well as those of corporations, unlike federal backstops in the past (an issue we’ve previously written about). Most importantly, it foregrounds the public health dimension of this crisis by boosting funding for health care and preparing the nation for an extended lockdown. All of these are laudable.

It is nonetheless imperfect.

The bailout for the airline industry inside this legislation is perhaps a paradigmatic case of moral hazard. Chapter 11 bankruptcy - the likely alternative to bailouts in this instance - reorganizes the capital structure of firms and allows them to continue their operations (especially firms of this size). Given that, we don’t see why the government has subsidized equity holders at the taxpayers’ expense in this case. (Put more directly: we see why, we just don’t think it’s appropriate.)

The basic economic intuition for why bailouts might be efficient in some cases goes something like this: bankruptcy has direct costs (legal fees etc.) and indirect costs (destroying relationships with employees and customers and foregone value-creating investment opportunities). So, in some cases, it might be efficient for the government to step in and backstop an otherwise viable/solvent business in times of distress to avoid these costs.

Part of the case against bailouts in these settings is that they incentivize managers not to take precautions in good times but instead bank on the ‘government put’ should bad times arise.‘Capitalism on the way up and socialism on the way down’, as it were.

One dimension of this discussion that has animated the popular press in the preceding weeks is share buybacks. Detractors of bailouts on the left and right have argued that these corporations are undeserving of support from the State because they spent income surpluses ‘artificially’ bolstering their share prices by buying back their equity to increase EPS figures and thereby boost executive compensation.

This discussion tends to be overly simplistic. If it is indeed the case that a large corporation has no investment opportunities with the return profile of equity holders’ outside options, it is not clear why they should not return those earnings to the corporation’s owners. As far as we can tell it is an open empirical question whether or not this was, in fact, the case for key actors in the airline industry the past couple of years.

Despite this concession, we still think these bailouts are unjustified for a variety of reasons and we’ll highlight three in particular:

First, airlines, unlike many service sector small businesses (eg a local accounting firm), have large valuable assets whose value does not depend on the capital structure of the organization that owns them. The value of a new A380 does not depend on whether it is owned by the old equity holders for Airline X or the previous creditors of Airline X whose debt has been turned into more junior equity claims – it is still an A380!

Second, American Airlines, Delta and United have, at separate times, all been in Chapter 11 bankruptcy for over 2 years in the past 20-year window. Their operations continued, equity took a hit, creditors took a haircut and taxpayers were largely uninvolved. Besides the fact that we have hedge fund managers prophesying on CNBC that the end of the world is imminent if the particular stock they own trades at 12% less than its current price, we candidly do not see what about this crisis makes bankruptcy such an unconscionable outcome for firms of this size, with these kinds of assets in this environment.

Finally, they can raise a substantial portion of the required liquidity in private credit markets. They already have! See here, here and here. The courts would likely put a stay on creditors’ claims until the worst parts of the crisis had dissipated allowing them to continue operations and limit worker layoffs.

To be sure, it isn’t all bad news. We are thrilled, for instance, that the proposed structure of the relief promises to give the taxpayer some equity in the airlines that take CARE Act funds. How exactly we will exercise our shareholder rights is a separate question, and perhaps this new era of society-first corporate governance will enable new types of digital shareholder participation platforms.

In times like these though, the increased proliferation of our most basic technology - common sense - would be a welcome silver lining.