In defense of everyone’s least favorite measure of last resort
With COVID-19 spreading through the U.S., businesses have faced mounting struggles as consumers stay home and cut back on spending. The airline industry has been the hardest hit, with Delta CEO Scott Bastian saying in an internal memo that “the speed of the demand fall-off is unlike anything we’ve seen.” An industry trade group estimated revenue loss from the virus at between $63 billion and $113 billion globally. Thus far, airlines have tapped existing credit facilities to smooth the shock, but as debt payments come due and losses mount, they are at risk of defaulting on their debt. President Trump said on Friday that “we will be helping the airline industry if we have to,” and airline executives have reportedly reached out to the White House to discuss the terms of such a deal.
The public tends to balk at bailouts, which “socialize” losses for companies that enjoy profits during good times. Politicians on both sides of the aisle have ruled out assistance to corporations amid the current crisis. But despite the perennial unpopularity of bailouts, the federal government has seen fit to rescue ten firms and three entire industries — including the airline industry after 9/11 — since 1970.
Milton Friedman used to stress that capitalism is a system of profit and loss. When the government cushions firms’ losses, it’s both unfair and distortive because it obstructs the efficient allocation of resources. In the case of firm failures, bankruptcy courts ensure efficient allocation by enforcing the property rights of a company’s debt and equity holders. But while the logic of efficient allocation seems to apply equally to booms and busts, during times of acute economic stress, the normal bankruptcy process sometimes fails to produce the optimal outcome.
Typically, struggling businesses enter bankruptcy under Chapter 11 of the U.S Bankruptcy Code, which allows them to restructure their debt and continue operating as a “going concern” while the terms of their reorganization are negotiated in court. This kind of bankruptcy takes at least several months, and in order to continue operating through the process, a firm needs access to credit. Usually, those funds come in the form of “debtor-in-possession” (DIP) financing, by which a creditor extends loans in order to keep the bankrupt firm alive. These loans are typically in the best interest of creditors, since keeping a bankrupt firm’s assets in operation increases the expected payout to lenders following bankruptcy.
However, during a credit crunch, firms face difficulty obtaining such financing, as lenders contend with massive systemic risks not present during typical bankruptcies. Holdings across balance sheets become distressed, so banks are not in an especially good position to extend a lifeline to any one debtor. Much like bank runs, the absence of DIP financing is a collective-action problem. A sufficient capital injection is likely to reduce the harm to all of a firm’s stakeholders — shareholders, creditors, and employees — but no creditor wants to shoulder that burden.
The alternative is Chapter 7 bankruptcy, which requires a wholesale liquidation of the struggling firm. In this case, a bankruptcy trustee sells off the business’s assets to the highest bidder and uses the proceeds to cover the firm’s liabilities. The company immediately folds and lays off all of its workers.
While it is often used in individual bankruptcy, corporations rarely go bankrupt under Chapter 7, because immediate liquidation imposes greater costs on both a firm’s stakeholders and the economy. Thus, when they do take place, Chapter 7 liquidations arguably constitute a “market failure,” or “a situation in which the allocation of goods and services by a free market is not efficient, often leading to a net social welfare loss.” Only in the rare case of market failure does government intervention improve economic outcomes.
In 2008, the prospect of Chapter 7 bankruptcies led policymakers to bailout American automakers. As three economic officials explain in a recent book on that crisis, “the financial system was so weak that there was simply not enough money in the private sector for the normal bankruptcy process” to unfold. A disorderly liquidation of Detroit would have had massive ripple effects through the supply chain — from parts-makers, to dealers, to consumers with car warranties, to municipalities that relied on tax revenue from automakers. The Bush administration predicted it would lead to a “more than one-percent reduction in real GDP growth and about 1.1 million workers losing their jobs.”
The government stepped in not to prevent a bankruptcy but to facilitate it under Chapter 11 as the market had failed to do. Detroit’s lenders still took large “haircuts” on their debt, the value of the companies’ shares plummeted, and union employees lost out on expected pensions and benefits. But the bailouts eliminated the deadweight loss that would have occurred otherwise, while also reducing uncertainty by completing the bankruptcies swiftly — 31 days for Chrysler and 40 days for GM.
To be clear, no businesses seem to face uncontrolled bankruptcies yet. Airlines still have large existing credit facilities and may be able to secure loans in the private market if the impact of the virus proves ephemeral. Steven Rattner, the Obama administration’s “auto czar,” argues that “if the airlines run out of cash, there is certainly debtor-in-possession financing” available.
But while Rattner’s assessment is encouraging, it may be overly optimistic. If the coronavirus shock spreads to the financial system, and banks face their own difficulties, a credit crunch could close the spigots of capital. Indeed, the White House has already suspended interest payments on federally held student loans until further notice. Mortgage payments may come next, if Italy’s experience with the virus is any guide.
We have entered uncharted economic territory. Questions abound as to the duration and depth of the coming recession, which may limit the private market’s ability to facilitate orderly bankruptcies in the near future. In that worst-case scenario, we should consider government assistance, if properly implemented, an attempt to bolster the market rather than to distort it.