June 14, 2020

The Federal Resurrection Board

[The Wall Street Journal]

Why investors are betting on the shares of bankrupt companies like Hertz.

We thought we’d seen everything, but last week’s speculation in the shares of the bankrupt Hertz rental-car company is one for the financial books. The Federal Reserve now apparently has the power to raise the common stock of companies from the dead.

A bankruptcy judge in Delaware on Friday approved the request of Hertz Global Holdings Inc. to sell shares to the public to finance itself through bankruptcy. Hertz said the equity offering could raise as much as $1 billion in new capital, and Judge Mary Walrath said it was a cheaper alternative to typical debtor-in-possession bankruptcy financing.

Hertz came up with the stock-sale idea after watching its shares surge from pennies to more than $5 for a time last week despite its May bankruptcy filing. Typically shareholders are wiped out in bankruptcy, as bondholders, suppliers and other creditors line up to get repaid as the company restructures. Hertz says it has nearly $19 billion in debt outstanding.

But investors, many of them day traders with apparently not enough to do while sports gambling is on hold, are betting that the rental-car company could make a comeback as the economy reopens. Hertz calls this, with hilarious understatement, a “unique opportunity.”

The new shares could easily become worthless depending on how fast the economy reopens and how much cash is available to repay creditors. The New York Stock Exchange is moving to delist Hertz shares. Meantime, the run-up in the price of Hertz stock has let some former shareholders cash out for something above zero.

The bigger picture here is that investors are taking advantage of the Fed’s extraordinary intervention in credit markets. Shares of other debt-burdened firms, such as J.C. Penney, have also had rallies from the dead. The Fed has clearly made a decision to underwrite corporate debt to prevent a cascade of bankruptcies.

And with interest rates again near zero, and likely to stay that way for as far as the eye can see, investors are looking to get yield wherever they can. Junk bonds have seen a surge of pandemic cash, so why not gamble on the shares of bankrupt, or near-bankrupt, companies?

It’s hard to fault investors for making these choices given the financial incentives that the central bank is providing. Hertz investors in particular have been duly warned that their new shares are the equivalent of a bet at the racetrack.

But this anomaly of zombie stock rising is cause for concern about how the Fed is distorting price signals and the longer-term economic risks this creates. Capitalism is supposed to be a profit and loss system, but the Fed’s interventions have too often reduced or eliminated the possibility of loss. This may be warranted for now given that government ordered an economic shutdown that has cost companies their revenue. But we’ve learned since the Fed began on this course in 2009 that this can create a financial cycle of Fed intervention and debt that is hard to escape.

The Fed kept rates near zero for years after the financial panic of 2008-2009, giving corporations the incentive to pile on debt at low cost. Hertz is a classic example. But that same corporate debt load makes the economy more vulnerable than it should be to a slowdown or some political (or in this case pandemic) shock. The Fed then feels obliged to rush in again with even more guarantees.

The current Fed has already gone well past what the Ben Bernanke Fed did in underwriting prices, including some of the riskiest plays on Wall Street. Chairman Jerome Powell said last week that the Fed is even considering a yield-curve cap on long-term debt. This would further distort price signals, and it may lead to further weird allocations of capital like buying zombie shares in bankrupt companies like Hertz.

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