Hertz is offering bankrupt shares and people seem to want to buy, why?
I want to discuss finance this week as there have been some interesting developments in American finance in the case of Hertz. As the pandemic has caused tragedy and wreaked economic havoc across the rich world financial markets have recovered from their lows rather quickly. Not only have governments tried to help workers with fiscal stimuluses but central banks have once again expanded balance sheets. I’ve long argued that low interest rates and Quantitative Easing (QE) have distorting effects on financial markets; and this week we’ve had a prime example of how low interest rates on bonds and an expectation of implicit government guarantees create an incredible appetite for risk. In this post I will discuss the potential Hertz stock offering through Jefferies; I will begin to explain some relevant terms like QE, equity issue, implicit guarantees, and then explain what makes the proposed Hertz offering so extraordinary. Finally, I will wrap up by speculating on what such a rights issue would mean for financial markets as well as briefly discussing if we should expect to see more issues in bankrupt firms.
Let’s begin with some background, Hertz is a car rental firm which declared bankruptcy late in March as the travel industry is having a tough time with the pandemic. Bankruptcy is a process a firm enters when it can’t pay its debts, and the firm continues operations through a bankruptcy as it in some cases can reach an agreement with its creditors; and if it can’t the firm is liquidated to pay the creditors back as best it can. What makes the Hertz bankruptcy unique is that its shares are trading at prices over zero even though the firm is unable pay its debts which should make the shares worthless. This has led to Hertz asking, and being granted the option to, create and sell new shares in the company (a process known as an equity offering) in what some have called an initial bankruptcy offering.
Why would investors want to buy a share in a bankrupt firm? Well, to make money of course. Buying a share which should be worthless could be very lucrative if Hertz survives its bankruptcy. A related and more interesting question is why investors would take on such a tremendous risk? In finance theory one speaks of the risk-adjusted rate of return, or in plain English: a payoff commensurate to the risk the investor takes. Compared to other shares though, Hertz seems to be a very poor choice, the risk is immense and unlike most shares there’s a real risk that Hertz’ share will go to zero so the potential payoff will have to be extravagant for it to make sense to take the risk. This is where monetary policy and implicit guarantees come in.
By lowering interest rates central banks make low risk investments like government bonds less interesting investments compared to other asset classes. Central banks have for about a decade or so kept interest rates low through so-called Quantitative Easing programmes where the central banks creates new money to buy back government bonds from investors to raise prices and make people spend more by raising the values of their assets to get the inflation to pick up. This then makes bond returns lower and as mentioned investors want a high risk-adjusted rate of return, and the risk-adjusted rate of return decreases when risk increases and when the rate of return decreases. Bonds thus make for less exciting investments which forces investors to pursue riskier assets to reach the same rate of return. As former bond holders migrate to more risky investments in say stocks the prices of stocks increase which changes the risk-adjusted rates of return for stocks which can drive some former equity holders to riskier assets to get a higher rate of return; in short QE changes the equation for more investors than just bond investors. This effect is in my view an important element to why investors seem so glad to take on risk but on its own it might not drive small investors to high-risk equities like Hertz en masse which brings us on to implicit guarantees.
An implicit guarantee is an expectation from a firm or investor that a government will help a firm should it be in danger of failing, usually due to the firm being important to the economy or a powerful interest group. Of course implicit guarantees are tricky, by their nature they’re implicit and you never know whether a government will come to the rescue or not until there’s a risk that the firm will fail. Classical economic theory would suggest that government should always let all companies fail as the market is a jungle where only the strongest survive, and where every failed business frees up resources for new more innovative companies to replace it. The reality is more complex though, especially if you’re an elected politician and governments do bail out important firms when they feel they need to. How does implicit guarantees tie into our discussion about Hertz? Well, implicit guarantees radically change risk judgements, if one expects the government to bail out Hertz should it need a help then there’s almost no risk with a huge upside potential. I personally doubt that the federal government deems Hertz important enough to save, but in my view the investors who are buying Hertz must count on an implicit guarantee as it’s the only way that trade makes sense. Over the past couple of months one haven’t been able to make it through a single day without hearing that we’re living in “unprecedented times” which has been used to justify expansive measures to save jobs and businesses so if there was ever an implicit guarantee of Hertz I suppose it’d be now.
In the end I think Hertz will most likely fail, and all the newly minted shareholders will be left with worthless share as creditors get more than expected back. As mentioned, the best chance Hertz has is being bailed out but Hertz simply doesn’t have the political pull or economic heft to be saved. As for if we should expect more bankrupt equity offerings, I think there might be a few in America before there’s a high-profile case of a bankrupt firms closing up shop after offering new shares. I doubt this sort of manoeuvre would fly in Europe though, and if it did happen it’d would almost certainly be in the UK before it happens in the EU.
If you liked this post you can read last week's post here, and read everything I've written on QE here. I'd be grateful if you shared this post with a friend or coworker who might find it interesting, and consider coming back next week for a new post!
Written by Karl Johansson
Cover Photo by Kelly Lacy from Pexels
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