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Haircuts for Airlines
Why debt-to-equity conversions should be part of the coronavirus bailouts
By Garett Jones
I’ve flown on many bankrupt airlines. There’s a good chance you have too: TWA, United, American, Delta, Northwest, US Airways—all have gone bankrupt within the last two decades, and all of them kept flying planes, uninterrupted by the bankruptcy process. While our nation’s leaders and pundits debate how to use COVID-19 emergency relief funds, good policy should target those funds to industries where loans, grants, and government guarantees are likely to have the largest payoffs for society. The airline industry isn’t likely to be anywhere near the top of that list.
First, a reminder: an airline shutdown isn’t the same as an airline bankruptcy. A shutdown means they really do stop flying planes, and the money you’ve spent for unused tickets is probably lost for months, maybe forever.
But an airline bankruptcy means—as a general rule—the airline, the airline’s investors, or the courts have decided that the airline is unlikely to repay the company’s bondholders and other creditors dollar for dollar. Bankruptcy is loan default on a mass scale. And a loan default doesn’t mean an airline stops providing airline service any more than a mortgage default means a house stops providing shelter.
Bankruptcy, by itself, isn’t enough to shut down an airline, and in the last two decades, both after 9/11 and after the Great Recession, bankruptcy wasn’t nearly enough to shut down America’s largest airlines.
Corporate bankruptcy is a process for sorting out which creditors are going to get repaid—and how much they’ll be repaid—when there isn’t enough money to repay exactly what was promised. In simple cases—and airlines are ultimately a pretty simple case, by modern standards—the end result is that bondholders and others who have lent money to the airline are told by the bankruptcy court that they’ll get paid, for example, 50 cents for every dollar they were promised. Shareholders are then given a diluted stake in the company, and their effective share prices fall quite a bit. Warren Buffett noted long ago that the return from investing in airlines is risky:
"[The airline industry] has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You've got huge fixed costs, you've got strong labor unions and you've got commodity pricing. That is not a great recipe for success. I have an 800 number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: 'My name is Warren and I'm an aeroholic.' And then they talk me down."
Unionized firms—which US airlines largely are—also tend to revisit their union-negotiated wage deals in the bankruptcy process, often reducing hourly pay, pension contributions, or (as in the case of the GM and Chrysler bankruptcies) creating a new, lower-wage tier for newly hired workers.
In the end, a bankrupt airline continues running with debt contracts of the past adjusted downward, and debt (and wage) contracts of the future better reflecting the new, grimmer financial reality. This ordinary bankruptcy process, which takes months or even years to fully resolve, works well enough for large, non-financial corporations to go on about their business with little disruption.
But sometimes, there’s demand for faster resolution—for more short-run certainty. Sometimes this demand is reasonable, sometimes not, but either way, governments sometimes turn to bailouts rather than bankruptcy because they’re convinced that we need to act now to save industries and save jobs.
Well, there’s another way to act now to save industries and save jobs, and it doesn’t require government bailouts or bridge loans or loan guarantees. This alternative goes by many names: speed bankruptcy, bondholder bail-ins, shared sacrifice, and debt-to-equity conversions, just to name a few. A few months ago, a Financial Times headline showed that this approach is now mainstream:
“European banks issue record 100 billion euros of ‘bail-in’ debt in 2019: Bonds are designed to bolster balance sheets in event of future financial crisis.”
The way bail-ins work is simple: when times get sufficiently tough for a bank—where “sufficiently tough” is determined by the pre-existing bond contract—people who have invested in those “bail-in” bank bonds will be told, in essence:
“Sorry that your bank investment turned sour. Instead of a guaranteed return of interest coupons and principal, you’re now getting shares in the bank, which may or may not pay dividends in the future. Now that the bank has fewer debt payments to make, it can spend more of its money on repaying depositors, paying employees, and maybe even paying off other debt.”
Over the last decade, Europe did a better job than the United States of taking long strides toward speed bankruptcy—getting ready, in a crisis, to knock debt off the balance sheet on a Friday so that the company’s net worth would be far stronger on the following Monday. Europe shows that this is a possible approach.
And this approach could be used in the United States. During today’s Great Coronavirus Cessation, if US bankruptcy courts truly believed that time was of the essence, they could create ad hoc bail-ins for US airlines.
This has strong parallels with what the Federal Deposit Insurance Corporation (FDIC) did repeatedly during and after the Great Recession. On a Friday, they told a troubled bank’s investors (and some uninsured depositors with big account balances) that they were getting repaid, say, 40 cents on the dollar, with perhaps more to be found later after a more lengthy financial investigation. By that Monday, the once-troubled bank was free to operate again, freed from much of its debt burden, and now with a larger amount of free cash flow in the future.
In the wake of the Great Recession, time really was of the essence in the banking sector, as it is today during the COVID-19 crisis in different, more deadly ways. And while 100 percent bailouts were the order of the day for the biggest banks in 2008 and 2009, a noisy minority of academic critics pointed out the possibility of using bail-ins to save big banks without government money. I was among these voices, but I was far from alone. Three examples:
“Since we do not have time for a Chapter 11 [traditional bankruptcy] and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes. They force a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move.” —Luigi Zingales, University of Chicago
“The debt holders are told, ‘Congratulations, you are the new equity holders.’” —N. Gregory Mankiw, Harvard University
“[T]he alternative ... I’ve been thinking of is to … convert Citibank’s long-term debt into equity.” —Robert Hall, Stanford University
If economists were recommending this approach to the nation’s biggest banks in the middle of the global financial crisis, and if European governments have broadly applied a similar approach to their own banks in the last decade, it’s very easy, and extremely conventional, to recommend the same approach now for America’s troubled airlines.
Take just one example: United Airlines. At the end of 2019, its balance sheet had $53 billion in assets and $13 billion in long-term debt. The global pandemic has obviously weakened United’s balance sheet massively since then, but before any bailout is discussed, the federal government should take a good long look at that $13 billion in long-term debt .Those debts reflect money owed to United’s investors, with regular coupon payments and a return of principal that mean cash out the door every quarter.
Even a 20 percent haircut on that debt—telling United’s bondholders they’ll get paid 80 cents on the dollar—would free up billions of dollars that the US government could then loan to another firm in financial trouble. And those debtholders could, as a consolation prize, be given shares in United—diluting United’s share price but giving United’s bondholders a chance to recover some or even all of their lost wealth. In my past work, I fleshed out in more detail the math of such a debt-to-equity conversion.
There’s more debt on United’s balance sheet that could take a haircut and be partly converted into United shares, but that simple example of United’s long-term debt is sufficient. It makes the point that the big airlines have made lots of financial promises that could be cut back a bit, converted partly from guaranteed debt payments into flexible dividend payments. Debt-to-equity conversions for the big airlines would be far simpler and far more practical than the debt-to-equity conversions economists, including me, proposed for big banks in 2008 and 2009. And those debt-to-equity conversions were already practical.
This time, as we face the unprecedented COVID-19 crisis, let’s devote our nation’s limited fiscal capacity to organizations that are in the greatest need of relief. The airlines will be able to fly with or without a bailout. If politicians end up granting some degree of bailout funds to America’s airlines, those same politicians should make a debt-to-equity conversion a condition of the bailout. We’re all in this together, we’re all making sacrifices, and airline bondholders should be part of “we.”