Bankruptcy and the Collateral Channel

This post comes to us from Efraim Benmelech of the Department of Economics at Harvard University and Nittai Bergman of the Department of Finance at MIT.

In the paper, Bankruptcy and the Collateral Channel, which is forthcoming in the Journal of Finance, we investigate whether bankrupt firms affect their competitors in a causal manner or whether the observed adverse effects merely reflect changes in the economic environment faced by the industry at large. Using a novel dataset of secured debt tranches issued by U.S. airlines, we provide empirical support for the collateral channel.

Airlines in the U.S. issue tranches of secured debt known as Equipment Trust Certificates (ETCs), Enhanced Equipment Trust Securities (EETCs), and Pass Through Certificates (PTCs). We construct a sample of aircraft tranche issues and then obtain the serial number of all aircraft that were pledged as collateral. For each of the debt tranches in our sample we can identify precisely its underlying collateral. We then identify the ‘collateral channel’ off of both the time-series variation of bankruptcy filings by airlines, and the cross-sectional variation in the overlap between the aircraft types in the collateral of a specific debt tranche and the aircraft types operated by bankrupt airlines. The richness of our data – which includes detailed information on tranches’ underlying collateral and airlines’ fleets – combined with the fairly large number of airline bankruptcies in our sample period, allows us to identify strategic externalities that are likely driven by a collateral channel rather than by an industry shock to the economic environment.

At heart, our identification strategy relies on analyzing the differential impact of an airline’s bankruptcy on the credit spread of tranches which are secured by aircraft of different model types. According to the collateral channel hypothesis, tranches whose underlying collateral are of model types which have a large amount of overlap with the fleet of the bankrupt airline, should exhibit larger price declines than tranches whose collateral has only little overlap with the bankrupt airline’s fleet.

For each tranche in our sample we construct two measures of bankruptcy induced collateral shocks. The first measure tracks the evolution over time of the number of airlines in bankruptcy operating aircraft of the same model types as those serving as collateral for the tranche. Since airlines tend to acquire aircraft of the same model types which they already operate, an increase in the first measure is associated with a reduction in the number of potential buyers of the underlying tranche collateral. The second measure of collateral shocks tracks the number of aircraft operated by bankrupt airlines of the same model type as those serving as tranche collateral. An increase in this second measure is associated with a greater supply of aircraft on the market similar to those serving as tranche collateral. Increases in either of these two measures, therefore, tend to decrease the value of tranche collateral and hence increase credit spreads.

Using both measures, we find that bankruptcy-induced collateral shocks are indeed associated with lower tranche spreads. For example, our univariate tests show that the mean spread of tranches with no potential buyers in bankruptcy is 208 basis points, while the mean spread of tranches with at least one potential buyer in bankruptcy is 339 basis points. Moreover, our regression analysis shows that the results are robust to a battery of airline and tranche controls, as well as airline, tranche and year fixed-effects.

We continue by showing that the effect of bankruptcy-induced collateral shocks on credit spreads is higher for less-senior tranches and tranches with higher loan-to-value. Further, we find that credit spreads of less profitable airlines display higher sensitivity to collateral shocks. Finally, using a host of robustness tests and analysis we show that our results are not driven by underlying industry conditions, or by other forms of potential contagion unrelated to the collateral channel.

The full paper is available for download here.

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