Indirect Costs of Bankruptcy

One of the big ideas to disabuse students of in finance is that the direct costs of bankruptcy are important.

The direct costs are the legal and liquidation costs of dissolving or reorganizing a business. These are obvious, but vastly overblown, largely because they are obvious.

The indirect costs are another matter entirely. This is the moose in the room of bankrutpcy.

Take GM for example. As recently as 1999 it had a market capitalization just below $50 billion, before peaking out somewhere in the fifties the next year. But, this morning its market capitalization was about $10 billion, and there is a reasonable argument to be made that the value of its production divisions is actually negative.

Here's the short story of what would happen if GM declared bankruptcy: some smallish percentage of that remaining $10 billion would be spent trying to figure out how to best preserve the rest of it. That cost fraction, which will run into the hundreds of millions of dollars isn't chump change, but it is only the direct cost of bankruptcy.

Notice that this completely misses the $40 billion or so that have already disappeared. Those are the indirect costs, and they are magnitudes larger than the direct costs. Where did that money go? In large measure it was lost in the unwillingness of people to invest their immediate driving future in a new GM car. This is a common problem in dying manufacturers of durable goods.

The management of a dying business works like this. Right now, GM is gambling that they can spend and save enough to recoup some of that lost $40 billion. It's not a bad gamble - sometimes this works out (as it did for GM in the late 90s). Later, if their valiant efforts fail, GM will declare bankruptcy: this is an admission that the $40 billion in indirect costs are gone for good, and that they are better of paying the direct costs of bankruptcy rather than the additional operating costs involved in recouping the indirect costs.