Now that Kmart has joined Enron in filing for bankruptcy, I have been deluged with questions about what all this means for the economy.  How does bankruptcy differ from downsizing, and are there more shoes to fall before the dawn of recovery can be seen?

Actually, Kmart is a more traditional bankruptcy that might actually allow that company to survive.  Enron certainly was caused by economic conditions - if oil prices remained high or rose further, would Enron have declared bankruptcy - but management decisions and information failures were the shocking aspects of that debacle. 

As in downsizing, the most obvious people hurt are company employees who lose their jobs.  However, bankruptcies differ from downsizing by putting substantial costs upon the owners of capital in the companies filing for bankruptcy protection.  Shareholders almost always lose most or all of their holdings.  Lenders, including bond holders, could lose most of the value of their loans depending upon whether the loans are secured by assets.

The latest recession has been notable, not in the number of bankruptcies, but in the relatively small recovery that lenders are receiving from the companies.  Typically, unsecured loans lose about half their value in a restructuring.  In the past twelve to eighteen months, the recovery from bankruptcy has been as small as 10-15 percent in some industries. 

Even the shareholders of companies that are downsizing lose considerable wealth, but those shareholders  can regain their value after the recovery.  After a bankruptcy filing, most or all of the value of those owning capital in the bankrupt companies are lost forever.  Also, downsized companies do not harm lenders while bankruptcies do. 

Bankruptcies also create surprise lenders.  Those who sold goods to Kmart but have not yet been paid will discover that they made a loan to Kmart that must be settled by the courts.  Yet, those vendors thought they were merely shipping goods and would receive payment in a timely fashion.  This conversion to a lender occurs even if the shipped goods already have been sold by Kmart. 

Indeed, one of the reasons why Kmart chose bankruptcy was because merchandisers were becoming worried that Kmart would go bankrupt.  The manufacturers may have been making only a few cents on every dollar of goods shipped and could not afford to be exposed to a potential loss of 50 or more percent in a bankruptcy settlement. 

Some furniture manufacturers actually were forced to close their doors because so much of their capital was tied up in bankruptcy proceedings from furniture store bankruptcies that they did not have enough capital left to operate their own businesses.  This cascading weakness caused by bankruptcies is one of the reasons why economists worry about rising defaults. 

The other major problem is that lending capacity can be compromised if enough bankruptcies tie up the capital of lending institutions or bond investors.  This is a problem confronting Japan throughout the past decade.

Fortunately, lending capacity in the United States is ample.  Therefore, few banks will reduce lending to regular customers because banks have exhausted too many funds in defaulted companies.

The other losers are the holders of real estate.  Bankruptcy allows defaulted companies to walk away from leases or negotiate better terms from landlords because of that threat.  In extreme cases, property values could be sufficiently depressed by these abrogated leases to undermine the financing capacity of real estate lenders.  This is not a concern for the overall economy at this time.

One might wonder how bankruptcy can get the merchandise back on the shelves that was not being delivered when bankruptcy was threatened.  Once the courts supervise the restructuring of bankrupt companies, funds are set aside to pay vendors for their wares.  Thus, Kmart is a better customer under court protection than it was before filing. 

Frankly, I believe the commentators are correct in stating that Kmart's bankruptcy is a natural evolution caused by better performance of competitors.  Perhaps they can right the ship after shedding their bad locations and lowering their interest burden through restructuring.  Remember, even after restructuring, Target and Wal-Mart will be fierce competitors. 

I also believe that the Enron bankruptcy has longer term implications.  At some point, investors must trust the information they are given.  Yet Enron tried, with some success, to alter regulations, hide contingent liabilities, and overstate its economic importance. 

Their accountants approved statements that were misleading or even incomplete or incorrect.  The Wall Street analysts signed off on the information provided by the company filings and by the company itself without asking questions about how so few employees could create so much value.  (Some lists reported it as the 5^th largest company but its payroll was not even in the top 1000 companies). 

In short, Kmart was a company failure during an economic downturn caused at least partially by fierce competitors.  Except for the size of the failure, there is no surprise here. 

Enron's failure probably was at least partially the result of deception and misinformation.  Until investors can be sure that the misinformation is not widespread, they will have doubts about the value of any information they receive.  That is an additional economic cost that may continue to create problems well after all the creditor issues have been settled.