Steven L. Schwarcz
Duke University, Durham, NC 27708
ABSTRACT
For years, scholars have questioned the efficiency of secured debt, many suggesting that it transfers uncompensated risk to unsecured creditors. The controversy recently intensified when Professor Bebchuk and Olin Fellow Fried of Harvard Law School advocated a set- aside of a portion of a debtor's collateral for unsecured creditors.
This Article argues that Bebchuk and Fried and other commentators have failed to recognize that the most important form of secured debt, new money credit secured by collateral, tends to create value for unsecured creditors as well as for the debtor. These commentators ignored the distinction between the use and the availability (and subsequent use only if needed) of secured credit. As a result, previous models of secured debt erroneously assumed that a debtor that can borrow on an unsecured basis may well prefer to borrow on a secured basis to reduce interest cost.
The Article combines theory and experience to show that those models do not reflect an economically rational debtor. A rational debtor that can borrow unsecured has an economic incentive not to prematurely encumber its assets because doing so gives away value in an amount, which the Article calls Theta, that exceeds any interest cost saving. Perhaps the most significant component of this value is the increased liquidity in times of financial trouble that secured credit affords.
The Article also shows that this increased liquidity does not generally keep debtors alive that should be allowed to fail. Bankruptcy creates market imperfections that tend to make lenders reluctant to extend credit, even on a secured basis, to debtors that are likely to go bankrupt. Furthermore, these market imperfections discourage troubled debtors from incurring secured debt unless they can thereby avoid bankruptcy. Secured credit is therefore usually extended in these circumstances only where the liquidity would help the debtor regain viability. Because this self-policing tendency of secured credit minimizes the likelihood of abuse, unsecured creditors themselves should be expected to want to debtor to have access to secured credit.