Secret Liens and the Financial Crisis of 2008
University of North Carolina at Chapel Hill School of Law; Seton Hall Law School; Harvard Law School - John M. Olin Center for Law and Economics
January 4, 2009
American Bankruptcy Law Journal, Vol. 83, p. 253, 2009
This article explains the roots of financial crises in one of the oldest and most fundamental problems of commercial law: hidden leverage. Common law courts wrestled with this problem for centuries and developed a time - tested solution: the doctrine of secret liens. If the debtor becomes insolvent, the doctrine of secret liens punishes secret lien holders by subordinating their claims to those of other creditors. In other words, by overriding privately negotiated payment priorities, the doctrine of secret liens creates incentives for transparency. This article argues that legal changes over the last 80 years eroded the doctrine of secret liens, and thereby led to the financial crisis. Due to these legal changes, complex and opaque financial products received the highest priority in bankruptcy, and creditors' incentives were therefore to structure transactions using these favored financial products. The opaque credit environment that resulted permitted debtors - particularly investment banks - to hide the extent of their leverage, to the detriment of all creditors. This article argues that Congress can prevent future financial crises by restoring the doctrine of secret liens, or by adopting a modernized regulatory regime built on the doctrine of secret liens' fundamental insight - that creditors should be compelled to disclose their claims in exchange for payment priority.
Number of Pages in PDF File: 44
Keywords: systemic risk, bankruptcy, secret liens, common law, disclosure, leverage, derivatives, asset securitization, credit default swap, cds, collateralized debt obligation, cdo, mortgage backed security, priority, security interest, securitization, transparency, financial crisis, bailout
JEL Classification: C7, D23, D8, E22, E4, E6, G2, G21, G22, G24, G28, G33, G38, K12, K2, K4, N2, N21, N22Accepted Paper Series
Date posted: January 5, 2009 ; Last revised: October 16, 2009
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