Yesterday's Wall Street Journal tells how the Obama administration forced J.P. Morgan Chase and other senior lenders to accept $2.25 billion on Chrysler's $6.9 billion in debt. "Senior secured lenders usually get paid in full before lower-priority lenders get anything," fretted the Journal. "Not this time."
"In its rush to save Detroit," argues our sister publication, The Economist, "the American government is trashing creditors’ rights."
Yes, bankruptcy law is the crown jewel of American capitalism and secured lending should be inviolate. It's also unfortunate that this "gerrymandering the rules," as Big Sis calls it, benefits Detroit and its unions, an easy target for critics.
But let's get real. This is an extraordinary move by the government, not an ongoing campaign to subvert bankruptcy.
For that, you'd have to look to the banking industry itself, which has waged a tireless effort to gerrymander its way around bankruptcy.
In fact, that's a good definition of securitization: it is a method of gerrymandering a loan such that the assets by which it is collateralized are removed from any future bankruptcy estate.
That's why banks were able to pass off subprime mortgages — not to mention trade receivables from BBB companies — as AAA credits. Because the (toxic) assets had been "sold" to an imaginary company, they were no longer affected by the risk that their originator might go bankrupt. (No one bothered to wonder if the assets themselves carried underlying insolvency risk.)
Even so, banks for many years sought a safe-harbor provision for securitization in bankruptcy, particularly after the bankruptcy of LTV Steel threw a scare into the industry. When the current bankruptcy law was being debated in 2005, banks felt more secure about securitization, and dropped the provision to avoid attracting opposition to an otherwise bank-friendly bill.
Still, the final law gave banks many end-runs around bankruptcy's "automatic stay," which prevents creditors from seizing collateral or terminating contracts from once a company files for bankruptcy. The law removed every conceivable type of financial instrument from the waterfall, and allowed banks to immediately net out their positions with an insolvent debtor — without court approval — and without consulting secured lenders.
"The bankruptcy code grant[s] those who have entered into financial derivative contracts with parties that subsequently become insolvent greater rights than these statutes grant those who enter into most contracts," then-FDIC general counsel William F. Kroener III told Congress in 1999.
The 2005 law expanded those 'rights,' a move that a University of Chicago law professor warned Congress, "would take us farther down the path of allowing sophisticated parties to opt out of bankruptcy."
Those same sophisticated parties, of course, are now complaining they've lost the very protections they've long sought to circumvent.
Here's an idea for the government. Offer to pay the banks the $4.65 billion they stand to lose, but only if they agree to a simple revision of the bankruptcy code: All contracts, regardless of type, are subject to the bankruptcy waterfall.
I bet there won't be any takers.
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