According to the Absolute Priority Rule in Bankruptcy (roughly -- the details are daunting), secured creditors must be paid in full before senior unsecured creditors can receive anything, and they in turn must be paid in full before the junior creditors can receive anything, etc.
Eliot Spitzer, along with many members of the current US administration, appears to argue that the rules of bankruptcy should instead be "share-and-share alike". From Slate, Spitzer writes the following in his criticism of Geithner's role in the AIG bailout:
Geithner suggested he could not use the threat of AIG's default in the absence of a federal bailout to get concessions from AIG's creditors.
Why not? That is exactly what the government did with the auto industry, and rightly so. The entity providing financing to a near-bankrupt institution must always seek contributions from everyone else at risk.
Everyone?? and why not just those at the bottom of the priority list? Perhaps, it can be argued, that is what Spitzer meant by saying "everyone else at risk". And I could be persuaded that is what he meant if he hadn't referred to the auto industry, where the absolute priority rule seemed to be honoured more in exceptions than in law.
If senior creditors cannot be assured of being senior to junior creditors (or pension funds that essentially are common-stock holders), then they must anticipate that in the future their loans will become riskier, which will raise the borrowing costs for firms.
If that is what the politicians want, I would say, "Okay, go for it," except it isn't certain. The continuing fluidity of the "rule" reduces its value as a rule and creates uncertainty about the risks that lenders face with their loans. And the increased uncertainty unnecessarily raises the cost of capital.
Just rereading "Security Analysis" (Benjamin Graham, David Dodd -1934) and they discuss the same issue as being quite common at the time. They express it as " Impracticable to enforce basic legal rights of lien holder" (P 68 in the Classic edition). It is not exactly the same but it does indicate that the stated legal rights do not always indicate what actually occurs in a bankruptcy court. I would not describe this as anything new or surprising.
Posted by: Jim Sanders | December 04, 2009 at 11:18 AM
Most credit card companies will hike your interest rate to 29.99% if your monthly payment is late. If you find yourself short of cash when your payment is due, it is cheaper to take a cheap payday loan than to have your entire balance hiked to 30%.
Posted by: Dave | December 07, 2009 at 03:12 PM