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Welcome to the Bankruptcy Economy

Jim Jubak

While Delta Air Lines (DAL Quote) appears headed for a corporate nose dive, its pilots have opted to pull the financial ripcord.

Faced with a management that has decided to use the threat of bankruptcy as a negotiating weapon, senior pilots have been filing for early retirement by the hundreds and then taking their pension in a lump-sum payout.

Every retiring pilot takes a haircut: A senior pilot at Delta gets a one-time payment of about $300,000, only half of what he or she would receive in monthly pension checks over the lifetime of the pension. But the Delta pilots know that pilots at US Airways stand to receive only about 25 cents on each dollar of their promised retirement benefits as a result of that company's repeated bankruptcy filings.

Welcome to the bankruptcy economy, where companies and governments walk away from long-standing promises to workers, and where workers scramble to collect as much as they can now in fear that even less will be available tomorrow.

Sure, management incompetence and shortsightedness have contributed to the creation of the bankruptcy economy. But the underlying causes are demographics -- a rapidly aging population as the baby boom generation gets set to retire -- and global competition. U.S. companies are struggling to cut costs so they can compete with overseas companies with younger workforces that receive few benefits, such as pensions or health care, in retirement.

The bankruptcies of U.S. steel companies and among U.S. airlines are certainly the most visible signs of the bankruptcy economy. But the phenomenon isn't limited to those two industries. Bankruptcy, either formally declared in the case of troubled companies or informal in the case of cities or the U.S. government, will restructure the entire economy in coming decades.

This restructuring is part of a new economy just now emerging that radically shifts costs and risks in our financial system. Today's column is the first part of a series, to run occasionally for the rest of this fall, on what that new economy will look like.

Delta's Troubled Skies

Let's start with the problems at Delta. The situation is clearly dire: Delta has lost $5.6 billion since 2001 and is dragging around $21 billion in debt. The Wall Street consensus projects the company will lose $12.85 per share in 2004 and another $4.55 a share in 2005.

The company calculates it needs a total of $2.7 billion in cost savings to stay out of bankruptcy. Some of that will come, the company hopes, from restructuring its debt: Delta recently completed an exchange for some of its unsecured bonds that will save $63 million in interest. But the company is in hock up to its eyeballs and has relatively little room for balance-sheet savings. The bulk of cost cuts will have to come from its employees.

Pilots, for example, are being asked to kick in about $1 billion in savings. That's not necessarily unfair, either, because Delta's pilots earn about 50% more than their peers at AMR (AMR Quote) unit American Airlines.

With that number in mind, you can decide that the pilots' union has selfishly decided to sink the company rather than take a pay cut.

Or you can see the decision to resist the pay cuts and the flow of senior pilots toward early retirement as a vote of no confidence in management's recovery plan.

You don't have to look any further than US Airways to find a basis for that belief. Despite a loan guarantee of $1 billion from the U.S. government, dumping the pension plan for all its pilots on the federal Pension Benefit Guaranty Corp. last year, and pay cuts and job eliminations, the company filed for bankruptcy a second time on Sept. 12.

Now US Airways is asking employees for another $800 million in cost savings and has stopped contributing to any of its remaining pension funds. The new plan, apparently, is to shed even more capacity, abandon another hub or two and somehow emerge as a profitable airline again. I'd have to agree with any Delta pilot who looked at that plan and said, "In your dreams." Unless oil drops to $28 a barrel, the current US Airways plan won't save the airline.

Lessons From the Steel Industry

To see the more likely fix to the airline industry's problems -- one that would mean the end of US Airways, however -- look to the troubles in the steel industry that sent just about every U.S. steel company through one or more bankruptcy restructurings beginning in the mid-1970s. The end result was a smaller but relatively healthy industry.

The steel industry is now led by a new player, Nucor (NUE Quote), and it employs far fewer steel workers at far lower total wage and benefit costs than it paid in 1975. Restructuring steel companies scaled back or eliminated pension plans for current workers, dumped pension liabilities for retired workers and scaled back or ended health care plans for retired workers.

You can get a sense of the magnitude of this restructuring by looking at the pension claims that the PBGC picked up from the steel industry in 1975-2002: $9.4 billion. The former value of those pension benefits owed to workers was much higher, of course, because the PBGC doesn't pay the full value of the company pension to workers. For example, if the United Airlines unit of UAL Corp. dumps its pension plans, now underfunded by about $8.3 billion, on the PBGC, the agency will cover about 77% of the funding gap. Workers and retired workers would eat the remaining $1.9 billion.

I think the glaring differences between steel companies and airlines obscure the basic similarities in the plight of the two industries: Both were suffering from massive overcapacity, were facing new low-cost competitors and were saddled with huge bills for total compensation as a result of a mature workforce backed by an army of retirees. In the case of the steel industry, the competition was foreign. In the case of the airlines, it's domestic. But in each case, the competition didn't have to carry the same total compensation burden.

Problems Ahead for Auto Industry

The steel and airline industries don't have a lock on this kind of problem. It's clearly on the horizon in the U.S. auto industry.

At General Motors (GM Quote), for example, the average cost of providing health care and pension benefits is around $1,360 a car. That's more per car than General Motors spends for steel. At Honda's (HMC Quote) U.S. operations, the health care and pension-benefit cost is only $107 a car.

GM spends so much more because behind its workforce stands an army of retirees and their dependents, all collecting benefits that competitors like Honda and Toyota Motor (TM Quote) simply don't have to pay. Of the 1.1 million people GM's plan covers, for example, only 200,000 are active workers. About 450,000 are retirees and their spouses. (The rest are dependents of active workers.) Last year, when the company earned $1.2 billion, it paid $3.3 billion to its retiree health care trust fund to meet future obligations.

In comparison, Toyota's 31,000-employee operation in the U.S. pays out virtually nothing in pensions or retirement health care benefits to its much younger workforce. At home in Japan, taxpayer-supported nationalized health care systems pick up the costs.

It's no wonder that U.S. companies, buffeted by low-cost competitors at home and overseas, have been looking for ways to reduce the cost of paying retirement benefits. The easiest way to do this, of course, is to simply skip a payment, or two or three, to company pension plans. Barclays Global Investors estimates 150 company pension plans were each more than $50 million underfunded at the end of 2003. The total funding shortfall in all corporate pensions was close to $300 billion.

Government Coming Up Short, Too

Corporations aren't the only ones skimping. The city of San Diego just got caught with a $1.2 billion shortfall in its pension fund for city workers. The city had been using projected earnings from its pension funds -- something allowed under both government and corporate-accounting policies -- to balance its budget and to avoid putting more cash into its pension plans. The city has now been locked out of the bond market and could be forced to file for bankruptcy.

And the Social Security program faces a demographic problem that is very similar to the one at GM. Thanks to the pending retirement of the baby boom generation, there are fewer and fewer workers paying into the system and more and more retirees collecting. In 1960, there were 5.1 taxpaying workers per Social Security beneficiary. Today, the ratio is down to 3.3 to 1. And by 2030, there will be just 2.2 workers paying in for every retiree collecting.

All of this leads to what I call the bankruptcy economy, named after the most effective, if most drastic, way a private company can remove costs for retirement benefits from its books. Bankruptcy is likely to be the continuing threat in negotiations with workers in industries facing challenges from low-cost competitors. Management will say, just as Delta's management has, "Take the cuts or we go out of business." In some cases, where the competitive gap isn't too large, that kind of forced cost-cutting might work. In others, as the steel and airline industries show, the threat will yield to the reality of bankruptcy. Maybe even multiple bankruptcies.

That's because under current law, bankruptcy is the best available tool for shifting costs from the books of private companies to those of the federal government. A bankruptcy can force the PBGC to pick up a company's pension costs. Think I'm being too cynical and that no company would use bankruptcy this way? In its latest bankruptcy filing, US Airways said that it would be "irrational" to make pension contributions because "it provides no benefit to the estate."

That's because pension plans and the PBGC stand way down the line of creditors in a bankruptcy. For all practical purposes, they have no chance of receiving anything in a restructuring.

The federal government doesn't go bankrupt. It just borrows more money. Run the presses a little longer, or stick taxpayers with a higher bill.

The final costs of a bankruptcy economy aren't simply measured in cash, however. Workers who don't trust management at many private companies will believe even less in management promises. Workers in the public sectors who thought their pensions were guaranteed will experience a rude and bitter awakening. Social Security recipients will get less back just as current workers are asked to put more in. And taxpayers will get socked with the bill and be left with more anger and cynicism.