Man Without Qualities

Tuesday, August 13, 2002

Flying Zombies

In a competitive market with few competitors but excess capacity, one might expect that the bankruptcy of one competitor would lift the prospects of the survivors. But when US Air filed for Chapter 11 protection, its competitors' stock prices were savaged. Why?

The Times says:

[US Airways] took another step yesterday toward trimming its labor costs by presenting a proposal for concessions to the International Association of Machinists, which represents US Airways' 5,500 fleet service workers. The union, which also represents 6,800 mechanics at the carrier, said both of those groups of workers would vote on concessions before the end of the month. US Airways has already reached agreements with its pilots and flight attendants for concessions that would save about $550 million a year. By bringing down its costs, US Airways will put competitive pressure on other carriers to do the same and give them more leverage in negotiations with their unions, analysts said. Cutting back its capacity is likely to mean more revenue for competitors, nudging them toward profitability. And US Airways could lower its costs enough to make room to experiment with a simplified fare structure.

But if US Airways unions are willing to grant it concessions, isn't it reasonable to think other airlines will be able to obtain the same concessions? And these developments that the Times' analysts say will give other airlines "more leverage in negotiations with their unions" and "more revenue ... nudging them toward profitability" hardly seems the stuff of stock price savaging. Is the market that out of touch?

No. In fact, there are very serious historical reasons to view the US Airways bankruptcy as a potential disaster for competing airlines. Consider the bankruptcy of the old Eastern Airlines. As with many airlines bankruptcies, the Eastern Airlines bankruptcy court viewed the airline as a "public service" - a characterization which the court used to justify Eastern's consumption of virtually all of its cash, equipment and other assets. In the end, even the secured creditors and administrative creditors of Eastern Airlines received just a few pennies for each dollar of debt. In the case of the secured creditors, the court allowed the airline to so run down and cannibalize the equipment securing the debt that when the creditors were finally able to foreclose, the equipment was often worthless. The so-called "administrative creditors" were unsecured creditors who advanced credit to the airline (sometimes involuntarily) after the bankruptcy. Such creditors did poorly, but they beat out the general, unsecured creditors, who received absolutely nothing.

But as far as competing airlines are concerned, the real importance of the bankruptcy court's treatment of airline cases does not lie solely in the outrageous treatment of the airline's creditors. Rather, the problem for the competing airlines is that they have to compete against an airline which is empowered to exploit its creditors for an operating subsidy which the non-bankrupt airlines don't have unless they, too, declare bankruptcy. Competing with a bankrupt, zombie airline is very expensive. Eastern Airlines converted several billion dollars of its creditors' funds into operating subsidies with the blessing of its bankruptcy court.

But it gets worse. If the bankruptcy courts continue to advance their "public service" approach to airline bankruptcies, creditors of existing airlines must take into account not only the increased likelihood that their debtor will seek bankruptcy protection resulting from the need to compete with a zombie, but also the likelihood that the creditors will be subject to Eastern Airlines style gutting of creditors rights if such a bankruptcy occurs. That means the cost of credit to competing, non-bankrupt airlines will rise substantially - further increasing the risk of bankruptcy. This vicious cycle could easily expand without limit. With the current structure of the airline industry and its weakened condition, it is no exaggeration to say that the US Airways bankruptcy has the potential to destroy the entire worldwide airline industry if US bankruptcy courts insist on following precedents such as Eastern Airlines. And the policies of insolvency courts of other jurisdictions are generally worse than those of the US courts, further exacerbating the potential problem.

The best possible thing the US Airways bankruptcy court can do for the nation and the national airline business is to take a very hard look at US Airways viability - and utterly reject the ill-conceived "public service" model. If the US Airways plan of reorganization is not quickly produced and clearly shown to be viable, US Airways should be promptly liquidated.

But historically, that has not been the way bankruptcy courts have treated airline bankruptcies.

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