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SECURED CLAIMS IN BANKRUPTCY: Some Preliminary Points 3

To begin, let us assume that partial priority has no direct effect on borrowers other than on the distribution of the borrower’s assets in bankruptcy, which, in turn, affects the cost of both secured and unsecured credit. To the extent that a partial priority rule reduces the expected value of secured creditors’ share of bankruptcy value, secured creditors will charge more under such a rule than under a rule of lull priority. However, voluntary unsecured creditors, in aggregate, should be willing to charge less interest under a partial priority rule than under full priority. In a world where (1) the priority rule’s only effect is to change the distribution of assets in bankruptcy and (2) all of the unsecured creditors are voluntary and set their interest rates to reflect their risk of loss, the total cost of credit should remain unchanged. further


Now, let us assume (as we have argued is likely to be the case) that partial priority not only affects the distribution of value in bankruptcy, but also causes borrowers and their secured creditors to enter into more efficient arrangements than under full priority. In a world where partial priority has these two effects and all unsecured creditors set their interest rates to reflect their expected risk of loss, the total cost of credit will actually be lower than under full priority, because the risk of loss that unsecured and partially secured creditors face will be lower in a world where borrowers and their lenders act more efficiently.
Finally, let us make the assumptions more realistic by assuming that there are many unsecured creditors that are not voluntary and therefore cannot set the interest rate to reflect their expected risk of loss. These creditors will not charge less interest under partial priority than under full priority. Thus, the reduction in interest that unsecured creditors charge will not be as great as in a world where all of the unsecured creditors are voluntary. But the reduction in interest charged by voluntary unsecured creditors might still be greater than the increase in interest charged by secured creditors, in which case the total cost of credit will be lower under partial priority than under full priority. Otherwise, the total cost of credit will be higher under partial priority.

This post was written by , posted on February 18, 2015 Wednesday at 4:42 pm