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Secret Liens and the Financial Crisis of 2008

American Bankruptcy Law Journal, Vol. 83, p. 253, 2009

44 Pages Posted: 5 Jan 2009 Last revised: 16 Oct 2009

Michael Simkovic

USC Gould School of Law; Harvard Law School - John M. Olin Center for Law and Economics

Date Written: January 4, 2009

Abstract

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.

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, N22

Suggested Citation

Simkovic, Michael, Secret Liens and the Financial Crisis of 2008 (January 4, 2009). American Bankruptcy Law Journal, Vol. 83, p. 253, 2009. Available at SSRN: https://ssrn.com/abstract=1323190

Michael Simkovic (Contact Author)

USC Gould School of Law ( email )

699 Exposition Boulevard
Los Angeles, CA 90089
United States

Harvard Law School - John M. Olin Center for Law and Economics ( email )

Cambridge, MA 02138
United States

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