Henry Bullock Professor of Finance & Real Estate; Director of the Guthrie Center for Real Estate Research; Director of the Crown Family Israel Center for Innovation
In our hyperconnected modern marketplaces, economic distress can spread as quickly as the common cold—but with much graver consequences. The current financial crisis in Greece threatens the stability of the euro; just four years ago, overly leveraged real estate assets nearly sunk the entire U.S. economy. Economists and policy makers know that this financial spillover, or “contagion,” occurs between companies, institutions, and countries, but the specific mechanisms by which it spreads are hard to identify. “It’s very difficult to differentiate real contagion from a general deterioration in economic conditions,” says Efraim Benmelech, an associate professor of finance at the Kellogg School of Management.
Benmelech and his colleague Nittai Bergman of the MIT Sloan School of Management have identified one such mechanism of financial contagion in their paper “Bankruptcy and the Collateral Channel,” which received the Journal of Finance’s prestigious Brattle Award. The authors analyzed the debt contracts of bankrupt airlines to trace how depreciations in the value of the aircrafts backing those debts spread directly to other, non-bankrupt airlines, distressing their assets as well.
“Airlines have been going through bankruptcy cycles for more than twenty years,” Benmelech says, which makes the industry an ideal environment with which to study financial contagion. “But what happens within the industry when an airline files for bankruptcy? How does it affect its non-bankrupt competitors? This wasn’t clear to us, but with the aircraft data we realized that we had an opportunity to answer this question.”
A Laboratory for Studying the “Collateral Channel”
Airline companies finance their operations with a form of securitized debt similar to a mortgage. “Instead of a house, the airline industry uses these big, bulky, expensive assets called airplanes,” Benmelech explains. “And every airplane has a unique serial number, so for every debt contract we can identify the collateral behind it, aircraft by aircraft. This allowed us to use the industry as a laboratory for studying how this ‘collateral channel’ works to spread financial distress from company to company.”
After matching debt contracts to individual aircraft, the authors could compare how quickly the values of specific collateral assets fell. Benmelech uses a simplified example comparing Airline A, which is using Boeing aircraft to secure its debts, with Airline B, which is using Boeing and Airbus. If Airline A files for bankruptcy and liquidates its Boeing assets at fire-sale prices, the value of the Boeings owned by Airline B will also fall.
The key to establishing the existence of contagion is in comparing how fast the value of Airline B’s two assets falls in the wake of Airline A’s bankruptcy. If the financial shock to Airline B is due to an overall deterioration in economic conditions—“such as rising oil prices or declining demand,” offers Benmelech—both the Boeings and Airbuses owned by Airline B will lose their value at a similar rate.
“But if the concern is specifically about Airline A’s bankruptcy causing some difficulties for Airline B,” Benmelech continues, “then we should see a larger decline in the price of the bond that is backed by the same type of aircraft—Boeing—that are being operated by the failing airline. And this is exactly what we found.”
If the asset-backed bonds that a non-bankrupt airline uses to capitalize its operations suddenly drop in value, that airline may not be able to invest or hire as it had planned—or it may be driven to bankruptcy as well.
Of course, in the real-world data that Benmelech and Bergman studied, airlines use more than one or two kinds of aircraft to secure their debt. “Still, we know precisely what is in the collateral pool down to the level of Boeing 737s versus Boeing 757s,” Benmelech says. “The contagion comes from the fact that if a major airline goes bankrupt and has to sell off some 757s, then any other airline that is using its own 757s as collateral will suffer a decline in the value of their bonds as well.”
A Vicious Circle
This spillover can cause a vicious circle that drags other, non-bankrupt firms down as well. If the asset-backed bonds that a non-bankrupt airline uses to capitalize its operations suddenly drop in value, that airline may not be able to invest or hire as it had planned—or it may be driven to bankruptcy as well.
Benmelech uses an analogy to mortgage foreclosures to explain how contagion in the collateral channel can amplify normal downturns in the business cycle. “Let’s imagine two neighbors: one of them was fired from his job and can’t find another one, so his house is put for foreclosure,” Benmelech says. “Then the bank has to sell it in a fire sale, so its value goes down—and the value of the neighboring house goes down as well.
“Meanwhile, the neighboring homeowner would like to sell his house in order to take a lucrative job in another state,” Benmelech continues. “But if the value of his house went down because of the foreclosure next door, he may be less likely to sell off his property—and this may prevent him from moving and taking that lucrative job, which could put him in bad financial straits as well. This is what we mean by ‘amplification of the business cycle’: there is a negative shock to one entity, but the contagion makes it worse for everyone else.”
With the collateral channel empirically validated by Benmelech and Bergman’s research, how can company executives or economic policy makers use this information to guard against economic contagion? “The extent to which contagion spreads is based on how leveraged the other players’ assets in the system are,” Benmelech says. “To continue the disease analogy, a less-leveraged firm has a better immune system. On the other hand, leverage is the only way we can take advantage of opportunities when the economy is doing well. Some economists argue that we should limit leverage, but it’s not that simple.”
For Benmelech, whose interest in debt contracts and financial crisis goes back to his previous career in the Israeli Ministry of Finance, simply establishing the existence of the collateral channel is an important first step. “We offer no policy suggestions,” he says, “but hopefully this work will enable a second generation of research that can be more concerned with solutions.” As the global economy continues to reel from its ongoing encounters with financial contagion, that research cannot come a moment too soon.
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Benmelech, Efraim, and Nittai K. Bergman. 2011. “Bankruptcy and the Collateral Channel.” Journal of Finance 66(2): 337–378.