THE EASY CASE FOR THE PRIORITY OF SECURED CLAIMS IN BANKRUPTCY

For years, scholars have questioned the efficiency of secured debt, ma ny suggesting that it transfers uncompensated risk to unsecured credit ors. However, prior writing on the value of secured debt ignores the d istinction between the use and the availability of secured credit. As a result, previous models of secured debt erroneously assume that a de btor that can borrow on an unsecured basis will nevertheless borrow on a secured basis to reduce interest cost. This Article combines theory , experience, and empirical tests to show that earlier models do not r eflect the expected behavior of an economically rational debtor. These models fail to recognize that the most important form of secured debt , new money credit secured by collateral, tends to create value for un secured creditors as well as for the debtor. A debtor that can borrow unsecured has an economic incentive not to prematurely encumber its as sets because doing so gives away value in an amount-which the Article calls Theta-that exceeds any interest cost saving. Perhaps the most si gnificant component of this value is the increased liquidity that secu red credit affords. The Article also shows that this increased liquidi ty does riot generally keep alive debtors that should be allowed to fa il, because lenders will be reluctant to extend credit, even on a secu red basis, to debtors that are likely to go bankrupt Furthermore, trou bled debtors will themselves be reluctant to incur secured debt unless they can thereby avoid bankruptcy. Secured credit is therefore usuall y extended in these circumstances only where the liquidity would help the debtor regain viability. Accordingly, unsecured creditors themselv es should want debtors to have access to secured credit.