Mark Hulberg

A GM advertisement runs on a billboard in Times Square. (Photo: AFP)

Investors Roll Dice On Bankrupt GM

Since General Motors declared bankruptcy early this month, its common stock has traded for as much as $1.59 a share; it closed on Friday at $1.16. Those aren’t great prices, unless you consider that the company has warned investors that “even under the most optimistic of scenarios,” those shares are likely to be worthless.

Why would anyone buy shares of a bankrupt company? It would be easy to conclude that investors are simply being irrational — undoubtedly, some of them are. But studies of past bankruptcies raise the possibility that the market is being less irrational than it looks.

Every company, of course, has a predetermined pecking order — known technically as “absolute priority” — that specifies which creditors will be paid before others in a bankruptcy proceeding.

Senior creditors, like banks, are typically at the top of the list; bondholders are lower on the ranking, and holders of preferred stock lower still. Owners of common stock are at the bottom; they are to be paid only after everyone else.

That’s the theory. And, presumably, if it were followed in the case of GM, shareholders would almost certainly get nothing. GM bonds, which are higher in absolute priority than the common stock, have been trading for about $0.10 on the dollar. If holders of such bonds aren’t betting that they will be made whole, what makes owners of GM’s stock think they’ll get anything?

One answer is that bankruptcy courts don’t always follow the absolute priority ranking, said Adam Reed, a finance professor at the University of North Carolina at Chapel Hill.

In fact, some studies have found that such departures were common in the past, Reed said, concluding that it’s not out of the question that holders of GM common stock would receive some consideration from the bankruptcy court. Of course, it’s hard to gauge the probability of this in GM’s case.

Even trickier is measuring what any possible consideration would be worth. But every day, the markets face the equally daunting task of discounting uncertain outcomes — and are famously efficient at putting price tags on them. Why would markets suddenly become inefficient in the case of bankruptcies?

One study from a decade ago analyzed bankrupt companies’ stocks as though they were long-term call options, deeply out of the money. Its authors were three finance professors: Ben Branch of the University of Massachusetts; Philip Russel, now of Philadelphia University; and Violet M Torbey of Bond University in Australia.

Using the Black-Scholes options pricing model, one of the most widely employed on Wall Street for valuing derivatives, they found that the market might be realistically pricing the stocks of bankrupt companies.

Their conclusion had to be somewhat tentative, however, because precise values were not available for all these variables.

Branch said the odds are extremely low that GM’s stock will be higher when the company emerges from Chapter 11 than the $0.75 it fetched the day it filed for bankruptcy. He likened the stock of a bankrupt company to a lottery ticket that has only a small chance of paying off — and large odds of being worthless.


The New York Times

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