Financial Lifelines: Bankruptcies, Bailouts, and What They Mean for Stock and Bond Investors

When the economy turns south, sometimes it exposes cracks in certain companies or industries. There are a few lifelines built into the system—bailouts and bankruptcies for instance—but they're not all alike. Here what investors should know. preserver: tossing a financial lifeline
5 min read
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Key Takeaways

  • The type of bankruptcy—a liquidation or a reorganization—affects stock- and bondholders differently
  • Banks and automakers participated in various forms of bailout and bankruptcy during the financial crisis of 2008-09
  • Bailout of a company doesn’t guarantee common shares will emerge intact

As COVID-19 tore through the U.S. economy—grinding several large sections of it to a halt—questions arose about whether certain companies and industries might get thrown a lifeline by the government. Transportation, travel, leisure, entertainment—and really the entire Consumer Discretionary sector—are among the segments hit hardest by the virus.

Depending on the length of the crisis, certain industries like airlines might be in line for bailouts. And if bankruptcy is in the future for some companies, authorities are looking at ways to minimize disruption to the economy.

Whether such assistance is right or wrong philosophically is well beyond the scope of this article. But bankruptcy is baked into the capitalist system, and economic stability is part of the Fed’s mandate.

The question, though, is what assistance and transition programs might mean for an investor. And that depends on a couple things:

  • The type of assistance provided: Direct aid or a low-cost loan might have little impact on investors in the long-term, but sometimes allow the government to take a stake in company management.
  • The type of investment: Stockholders and bondholders are generally treated differently in a bankruptcy, for example.

If you’re an investor in a company or sector that might be affected, understanding the basics can help you position yourself. Here are a few definitions, rules of the road, and lessons learned from past bankruptcies and bailouts. 

Bankruptcy Claim? Get in Line, Bro

In general, a company bankruptcy falls into two categories: Chapter 7 (a "liquidation") and Chapter 11 (a "reorganization"). A full explanation by the Securities and Exchange Commission (SEC) is available on its website, but here's the gist:

Chapter 7 Liquidation. Company operations stop, a trustee is appointed to liquidate the assets and settle all claims in order of so-called "seniority."

  1. Secured claims—backed by collateral—are paid first. This typically includes bank loans and mortgages.
  2. Unsecured claims—including non-collateralized bank loans, vendors, suppliers, as well as bondholders—are next in line. This is one reason bond investing is often viewed as less risky than stock investing. As a bondholder, you're more likely to get your initial investment back (or at least a portion of it) than you are if you're a stockholder.    
  3. Residual claims—including common stock—are at the bottom of the waterfall (hence the word "residual" as in "what's left over after everything else"). According to the SEC, "usually, the stock of a Chapter 7 company is worthless and you have lost the money you invested." 

Chapter 11 Reorganization. Most publicly-held companies would choose reorganization if given the choice, as it allows the company to continue day-to-day operations while it rejiggers its assets, operational practices, and credit arrangements—and perhaps its management structure. In the case of large companies with thousands of employees, or so-called "systemically important" industries such as banks and financial institutions, this type of bankruptcy can help keep the workforce intact and the existing infrastructure in place.

Chapter 11 is meant to give the company a bit of "breathing room" from creditors. During the bankruptcy, bondholders and other creditors stop receiving interest and principal payments. That money is tied up until the end of the process.

In most cases, the reorganization will cancel all existing common shares, even if the company re-emerges as a public company. Why? It's that "residual claim" again. Typically, since the creditors (including bondholders) didn't get their claims fulfilled—and had their payments suspended during the bankruptcy—they become the new owners, and are often granted common shares in the reorganized company. General Motors (GM) is a recent example. 

General Motors: A Hybrid Between Bailout and Bankruptcy

Sometimes the government will step in and offer assistance in conjunction with a bankruptcy, if they deem it to be in the best interest of the nation. General Motors (GM), for example, went through a Chapter 11 bankruptcy during the financial crisis of 2008-09, wiping out all the equity in common shares. A $65 billion bailout orchestrated by the Obama administration made the government the controlling shareholder of the restructured company and, in the process, saved many jobs. Still, there was plenty of pain along the way for workers, creditors, executives, and the company’s network of dealers.

Ultimately, new GM shares were issued and began trading again, though they never gained much traction over the roughly 10 years between bankruptcy and the COVID-19 epidemic. GM shares traded at $33.99 on Jan. 31, the last month before the virus sent everything spinning down. That was down from $36.86 a share at the end of 2010.

That slight loss over nearly a decade doesn’t tell the entire story, however, because it doesn’t include dividends. GM suspended its dividend program in late April as it dealt with the pandemic.

Before that, it had a quarterly payout of $0.38 for every share (or $1.52 per year). Someone who owned 1,000 shares over that period would have been down around $2,900 on the original investment, but would have received more than $1,500 per year in dividends. Not too shabby when you consider that more conservative fixed income investments paid far less in recent years, often below 1%. By the time GM suspended the dividend, its yield had risen to more than 6%.

Financial Sector, Bailouts, and Bankruptcy: All of the Above

During the financial crisis, banks and other financial firms experienced bailout, bankruptcy, government facilitation, and everything in between. Entire books have been written about the many forms of assistance, but here’s a sampling.

  • Facilitating  a Sale:  As the crisis unfolded, two areas hit hard were big lenders with huge exposure to subprime mortgages (such as Washington Mutual and Countrywide Financial), and a few investment banks that had become over-leveraged (such as Bear Stearns and Merrill Lynch). Some of these were acquired by larger and more capitalized institutions—JPMorgan Chase (JPM) took on Bear and WaMu, Bank of America (BAC) got Merrill and Countrywide, and Wells Fargo (WFC) acquired Wachovia, for example. 
  • Taking a Stake: Citigroup (C) was the largest recipient of bailout funds, according to the Treasury Department, receiving some $45 billion—much of it in the form of preferred stock—that gave the U.S. government a 34% stake in the company. But C eventually paid back the bailout funds and the government shed its stake, leaving the company—and all common shareholders—whole.  
  • Traditional Chapter 11 Liquidation: At the other end of the spectrum is the bankruptcy of investment bank Lehman Brothers. Though several attempts were made to negotiate an orderly exit, in September 2008, the company filed what would become the largest bankruptcy in U.S. history—over $600 billion—with no direct bailout to the company. The government’s chief strategy with Lehman was damage control—essentially backstopping the financial system through Treasury and Federal Reserve facilities.  

Positioning Yourself

Do you hold—or are you considering taking a stake in—companies that are in the crosshairs of bailout and/or bankruptcy? Proceed with caution.

Even if a company comes out of bankruptcy and new shares are issued, those shares are completely different from a legal standpoint than the previous shares.

Companies not going bankrupt but getting government help also require a very close look before going in (or staying in, as the case might be).

Referring to bailouts during the coronavirus crisis, a bailout provides liquidity to businesses that have become cash starved as a result of their businesses being shut down. But just because a company is bailed out or is on a list of companies getting bailed out doesn’t mean the common shareholders are going to benefit.

For example, airlines are getting bailouts both in the form of grants and loans. But since the announcement of these vehicles to finance their continuing operations, the shares of these companies have not participated in any rallies.

And remember the lessons from the financial crisis.

Some might look at GM’s experience and say the company got off relatively easily, considering what many economists now see as mismanagement heading into the 2008 financial crisis.

“The understandable objection to bailouts is that they foster moral hazard, the willingness to act recklessly without fear of consequences,” wrote the late Paul Ingrassia of The Wall Street Journal in an 2010 article examining the bailouts of GM and Chrysler. “Yet the bailouts of these two companies had painful consequences aplenty for the major actors.”

Ingrassia, who won a Pulitzer Prize for his coverage of the auto industry, suggested that those considering investment in bailed out companies look for two things before jumping in: Spending discipline and good corporate governance.

Naturally, no one can know right away how these things might shape up. That means anyone itching to take a flyer on a bailed out company might want to wait a few quarters and closely watch how the company makes its spending decision, what it decides to invest in, and who it appoints to its board of directors. Share buybacks, increased executive compensation, and higher dividends might be signs of profligacy in a company still emerging from a bailout, and might not even be allowed under many circumstances. Instead, you arguably want to see the company invest in improving its plants and supply chains, as well as in hiring an executive team that’s respected in the industry and by Wall Street.

Doug Ashburn is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

Key Takeaways

  • The type of bankruptcy—a liquidation or a reorganization—affects stock- and bondholders differently
  • Banks and automakers participated in various forms of bailout and bankruptcy during the financial crisis of 2008-09
  • Bailout of a company doesn’t guarantee common shares will emerge intact

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