In my last post in this forum a week ago I suggested that airlines would be one industry sector that would willingly enter into a shotgun marriage with the government by giving up equity and an ownership stake in exchange for a bailout:
Without policies that would enable them to survive, the consequences of a loss of passengers means no revenue, and a stock price that rapidly plummets toward zero. Since there is little revenue at the moment, the practice of spending free cash flow to buy back stock, as these companies did over the last few years, is probably over for now. Facing the grim reaper, they would now prefer that the government not only take an equity interest, but also mandate pricing and surcharges that would enable them to stay in business. In other words, these national air carriers become utilities run by the government.
Indeed, as of the second week of April, 230 applications for aid from passenger carriers has been received by the Treasury (Source: Bloomberg April 11, 2020).
Combined with the Fed’s recent decision to buy the bonds of issuers who have fallen from investment grade to junk under the new “Main Street New Loan Facility”, I expect increasing corporate actions from companies that were investment grade prior to March 22 to take action to get downgraded. At the moment, eligible borrowers from the new facility cannot have 2019 revenues higher than $2.5 billion or more than 10,000 employees (Source). The maximum loan size, for all practical purposes, is $25 million, which is a drop in the bucket for the major airlines. Since most big airlines will not be allowed to fail, I expect some of these limits to be relaxed if the economic crisis veers further out of control. Further, the limits on buybacks and compensation, and an interest rate of the overnight fed funds rate + 250 to 400 bps makes this loan very expensive, and makes it unlikely that large airlines will accept these terms. Thus I believe that we are only seeing the first inning of what will be a complete restructuring and perhaps consolidation of the airline industry.
Take for example, Delta Air Lines. Delta (2019 revenues $47 billion, 90,000 employees) is the first airline which has encouraged 35,000 employees to take voluntary leave. Fitch immediately downgraded Delta to BB+ from BBB-. At the time of this writing, Alaska, American, Delta, JetBlue and United are all junk. Southwest is rated BBB+ by Fitch, but very close to being downgraded to junk. As of this writing, the carriers, many of whom were buying back their stocks with free cash flow just a few months ago, are negotiating with the Treasury to get a bailout without having to pay the taxpayer back. .
A few days ago my pilot friends and I flew over an airport in Southern California. Mothballed – or “pickled” in airline lingo — aircraft as far as the eye could see.
Mothballed Or “Pickled” Aircraft Parked At Southern California Airport In March 2020
Financial economists, including those at the Fed, went to similar schools and learned the “Merton model” used for valuing the securities issued by a firm. This model relates different components of the capital structure, i.e. stocks and bonds of a firm, to each other, via an equation similar to the Black-Scholes equation used for option pricing. If we think of a company as issuing stocks and bonds to raise capital, the Merton model says that the bonds are a “put option” on the assets of the firm, and stocks are a “call option” on the assets of the firm. Thus holders of the company’s stocks can only lose the capital they put into the company, but can see unlimited benefits as the stock price rises. The holders of the bonds earn a “premium” in terms of the yield spread, but can in theory lose the full amount of what they have lent the company in exchange for senior rights to the assets of the company.
Thus, just as call options and put options are related to each other by the mathematical relationship called “put-call parity”, stocks and bonds are also related by an identical theoretical relationship in markets with no transactions costs. Their market price is linked by the common “asset volatility” which determines how far away from bankruptcy the firm is at any given time.
The simplest way to push the perception that the firm has moved further away from bankruptcy is then to (1) buy the stock to window-dress the company, which the Fed cannot do, yet, (2) suppress the asset volatility, which is also hard to do unless the Fed buys underlying assets and holds to them, or (3) buy the bonds and thus implicitly accomplish (1) and (2) by compressing the spread, which the Fed is beginning to do. The fly in the ointment, so to speak, is that like all other options, this relationship between stocks and bonds is a theoretical “arbitrage relationship”, which only holds true if there is essentially unlimited liquidity between the stocks and bonds. Like all arbitrage relationships, in misbehaving and illiquid markets it can fail to hold for extended periods of time.
As we just witnessed in the stock market debacle of mid-March, there simply isn’t ample liquidity in the markets. The absence of liquidity means that the ideal, academic relationship between stocks and bonds that people have become used to may eventually also break down, and even as corporate spreads of the bonds are driven tighter by Fed action, their stocks will tank and maybe even go to zero. The net result? The Fed, aka the taxpayer, will own the underlying assets of the firms!
Let us pause for a moment and think about this in the context of airlines. If (1) the government provides support for recently downgraded companies, (2) you can control the factors that result in a downgrade, then (3) strategically it makes sense to get downgraded. People, and yes companies, respond to incentives. A perverse consequence of the expanded and unlimited safety net that the Fed and Treasury are providing is that it becomes optimal for airlines, and other companies, to “zombify”. This “strategic default” is not novel; in the global financial crisis many homeowners and companies with underwater loans simply walked away from the assets in exchange for a reprieve from their debt obligations. And zombification has become the norm in both Japan and Europe, where BOJ and ECB policies of cheap money have managed to keep the companies afloat for now.
In a deeply inter-connected system one cannot, of course, let companies fail entirely. We are living in a period where the government is likely going to become the main owner of much of corporate America in a creeping form of nationalization. Traditionally this is not great for profits, and not so great for existing owners of stock who are going to be elbowed out for more preferential terms for the government. To avoid this outcome, and similar to the 2008 Global Financial Crisis (”GFC”), companies will be forced to merge and consolidate, not unlike the forced sale of Bear Stearns to JP Morgan at that time.
As an investor, I believe that the implications are a little more actionable. If we know that the government is going to print money to buy debt to keep companies from defaulting, for now we should consider doing the same, since the Fed’s printing presses are, in the short term, essentially capable of printing unlimited amounts of cash. For companies that won’t be allowed to fail, it is better to hold their senior debt, and wait to buy stocks until the current holders of stock have capitulated. Just as banks were bailed out in the GFC with taxpayer money, there is little hope for airlines to survive without a bailout. The terms and conditions, as they are unveiled, will determine when the timing is right to join the government in buying their equity.