Since 2000, legacy airlines have faced unprecedented internal and external challenges. Internally, the impact of the Internet on how tickets are sold and consumers search for fares and the growth of low cost airlines as a market force accessible to almost every consumer has hurt legacy airline revenues by placing downward pressure on airfares. More recently, airlines’ costs have been hurt by rising fuel prices (see figure 1). This is especially true of airlines that did not have fuel hedging in place. Externally, a series of largely unforeseen events—among them the September 11th terrorist attacks in 2001 and associated security concerns; war in Iraq; the SARS crisis; economic recession beginning in 2001; and a steep decline in business travel—seriously disrupted the demand for air travel during 2001 and 2002. Low fares have constrained revenues for both legacy and low cost airlines. Yields, the amount of revenue airlines collect for every mile a passenger travels, fell for both low cost and legacy airlines from 2000 through 2004 (see figure 2). However, the decline has been greater for legacy airlines than for low cost airlines. Legacy airlines, as a group, have been unsuccessful in reducing their costs to become more competitive with low cost airlines. Unit cost competitiveness is key to profitability for airlines because of declining yields. While legacy airlines have been able to reduce their overall costs since 2001, these were largely achieved through capacity reductions and without an improvement in their unit costs. Meanwhile, low cost airlines have been able to maintain low unit costs, primarily by continuing to grow. As a result, low cost airlines have been able to sustain a unit cost advantage as compared to their legacy rivals (see figure 3). In 2004, low cost airlines maintained a 2.7 cent per available seat mile advantage over legacy airlines. This advantage is attributable to lower overall costs and greater labor and asset productivity. Weak revenues and the inability to realize greater unit cost-savings have combined to produce unprecedented losses for legacy airlines. At the same time, low cost airlines have been able to continue producing modest profits as a result of lower unit costs (see figure 4). Legacy airlines have lost a cumulative $28 billion since 2001 and are predicted to lose another $5 billion in 2005, according to industry analysts. Since 2000, as the financial condition of legacy airlines deteriorated, they built cash balances not through operations but by borrowing. Legacy airlines have lost cash from operations and compensated for operating losses by taking on additional debt, relying on creditors for more of their capital needs than in the past. In the process of doing so, several legacy airlines have used all, or nearly all, of their assets as collateral, potentially limiting their future access to capital markets. In sum, airlines are capital and labor intensive firms subject to highly cyclical demand and intense competition. Aircraft are very expensive and require large amounts of debt financing to acquire, resulting in high fixed costs for the industry. Labor is largely unionized and highly specialized, making it expensive and hard to reduce during downturns. Competition in the industry is frequently intense owing to periods of excess capacity, relatively open entry, and the willingness of lenders to provide financing. Finally, demand for air travel is highly cyclical, closely tied to the business cycle. Over the past decade, these structural problems have been exacerbated by the growth in low cost airlines and increasing consumer sensitivity to differences in airfares based on their use of the Internet to purchase tickets. More recently airlines have had to deal with persistently high fuel prices—operating profitability, excluding fuel costs, is as high as it has ever been for the industry. Airlines seek bankruptcy protection for such reasons as severe liquidity pressures, an inability to obtain relief from employees and creditors, and an inability to obtain new financing, according to airline officials and bankruptcy experts. As a result of the structural problems and external shocks previously discussed, there have been 160 total airline bankruptcy filings since deregulation in 1978, including 20 since 2000, according to the Air Transport Association. Some airlines have failed more than once but most filings were by smaller carriers. However, the size of airlines that have been declaring bankruptcy has been increasing. Of the 20 bankruptcy filings since 2000, half of these have been for airlines with more than $100 million in assets, about the same number of filings as in the previous 22 years. Compared to the average failure rate for all types of businesses, airlines have failed more often than other businesses. As figure 5 shows, in some years, airline failures were several times more common than for businesses overall. With very few exceptions, airlines that enter bankruptcy do not emerge from it. Of the 146 airline Chapter 11 reorganization filings since 1979, in only 16 cases are the airlines still in business. Many of the advantages of bankruptcy stem from legal protection afforded the debtor airline from its creditors, but this protection comes at a high cost in loss of control over airline operations and damaged relations with employees, investors, and suppliers, according to airline officials and bankruptcy experts. Contrary to some assertions that bankruptcy protection has led to overcapacity and under pricing that have harmed healthy airlines, we found no evidence that this has occurred either in individual markets or to the industry overall. Such claims have been made for more than a decade. In 1993, for example, a national commission to study airline industry problems cited bankruptcy protection as a cause for the industry’s overcapacity and weakened revenues. More recently, airline executives have cited bankruptcy protection as a reason for industry over capacity and low fares. However, we found no evidence that this had occurred and some evidence to the contrary. First, as illustrated by Figure 6, airline liquidations do not appear to affect the continued growth in total industry capacity. If bankruptcy protection leads to overcapacity as some contend, then liquidation should take capacity out of the market. However, the historical growth of airline industry capacity (as measured by available seat miles, or ASMs) has continued unaffected by major liquidations. Only recessions, which curtail demand for air travel, and the September 11th attack, appear to have caused the airline industry to trim capacity. This trend indicates that other airlines quickly replenish capacity to meet demand. In part, this can be attributed to the fungibility of aircraft and the availability of capital to finance airlines. Similarly, our research does not indicate that the departure or liquidation of a carrier from an individual market necessarily leads to a permanent decline in traffic for that market. We contracted with Intervistas/GA2, an aviation consultant, to examine the cases of six hub cities that experienced the departure or significant withdrawal of service of an airline over the last decade (see table 1). In four of the cases, both local origin-and-destination (i.e., passenger traffic to or from, but not connecting through, the local hub) and total passenger traffic (i.e., local and connecting) increased or changed little because the other airlines expanded their traffic in response. In all but one case, fares either decreased or rose less than 6 percent. We also reviewed numerous other bankruptcy and airline industry studies and spoke to industry analysts to determine what evidence existed with regard to the impact of bankruptcy on the industry. We found two major academic studies that provided empirical data on this issue. Both studies found that airlines under bankruptcy protection did not lower their fares or hurt competitor airlines, as some have contended. A 1995 study found that an airline typically reduced its fares somewhat before entering bankruptcy. However, the study found that other airlines did not lower their fares in response and, more importantly, did not lose passenger traffic to their bankrupt rival and therefore were not harmed by the bankrupt airline. Another study came to a similar conclusion in 2000, this time examining the operating performance of 51 bankrupt firms, including 5 airlines, and their competitors. Rather than examine fares as did the 1995 study, this study examined the operating performance of bankrupt firms and their rivals. This study found that bankrupt firms’ performance deteriorated prior to filing for bankruptcy and that their rivals’ profits also declined during this period. However, once a firm entered bankruptcy, its rivals’ profits recovered. Under current law, legacy airlines’ pension funding requirements are estimated to be a minimum of $10.4 billion from 2005 through 2008. These estimates assume the expiration of the Pension Funding Equity Act (PFEA) at the end of this year. The PFEA permitted airlines to delay the majority of their deficit reduction contributions in 2004 and 2005; if this legislation is allowed to expire it would mean that payments due from legacy airlines will significantly increase in 2006. According to PBGC data, legacy airlines are estimated to owe a minimum of $1.5 billion this year, rising to nearly $2.9 billion in 2006, $3.5 billion in 2007, and $2.6 billion in 2008. In contrast, low cost airlines have eschewed defined benefit pension plans and instead use defined contribution (401k-type) plans. However, pension funding obligations are only part of the sizeable amount of debt that carriers face over the near term. The size of legacy airlines’ future fixed obligations, including pensions, relative to their financial position suggests they will have trouble meeting their various financial obligations. Fixed airline obligations (including pensions, long term debt, and capital and operating leases) in each year from 2005 through 2008 exceed total cash balances of these same legacy airlines by a substantial amount. Legacy airlines carried cash balances of just under $10 billion going into 2005 (see figure 7). These airlines fixed obligations are estimated to be over $15 billion in both 2005 and 2006, over $17 billion in 2007, and about $13 billion in 2008. Fixed obligations in 2008 and beyond will likely increase as payments due in 2006 and 2007 may be pushed out and new obligations are assumed. If these airlines continue to lose money this year as analysts predict, this picture becomes even more tenuous. The enormity of legacy airlines’ future pension funding requirements is attributable to the size of the pension shortfall that has developed since 2000.