nervous secured creditors, facing demotion, sell out to speculators who are better able to handle that newly created sovereign risk

TO BE NOTED: From Forbes:

The Libertarian
The Deadly Sins Of The Chrysler Bankruptcy Richard A. Epstein, 05.12.09, 12:00 AM EDT

Why mortgage priorities matter.

The proposed bankruptcy reorganization of the now defunct Chrysler Corp. is the culmination of serious policy missteps by the Bush and Obama administrations. To be sure, the long overdue Chrysler bankruptcy is a welcomed turn of events. But the heavy-handed meddling of the Obama administration that forced secured creditors to the brink is not.

A sound bankruptcy proceeding should do two things: productively redeploy the assets of the bankrupt firm and correctly prioritize various claims against the bankrupt entity. The Chrysler bankruptcy fails on both counts.

On asset deployment, the bankruptcy court may approve a plan either to reorganize or liquidate the firm. The former is desirable when the "going-concern" value of a firm exceeds the fair market value that its pieces can fetch when sold off in liquidation. But when the firm is not viable, the bankruptcy trustee should sell off its assets in sensible units to maximize total revenue. For both reorganization and liquidation, the trustee in bankruptcy may disaffirm those executory (i.e. still unperformed) contracts that hurt the firm, thereby reducing them to the status of unsecured creditors.

On claim priority, unsecured creditors come at the bottom of the bankruptcy totem pole. The basic rule of credit transactions distributes the net assets first to secured creditors in the order of their priority. First mortgages are normally paid in full before second, and lower mortgagees receive anything, in order, on their loans. Unsecured creditors of all types have an equal claim regardless of the time they perfected their claims. But they receive their first dime only after secured creditors have been paid in full.

It is absolutely critical to follow these priority rules inside bankruptcy in order to allow creditors to price risk outside of bankruptcy. Upsetting this fixed hierarchy among creditors is just an illegal taking of property from one group of creditors for the benefit of another, which should be struck down on both statutory and constitutional grounds.

In a just world, that ignominious fate would await the flawed Chrysler reorganization, which violates these well-established norms, given the nonstop political interference of the Obama administration, which put its muscle behind the beleaguered United Auto Workers. Its onerous collective bargaining agreements are off-limits to the reorganization provisions, thereby preserving the current labor rigidities in a down market.

Equally bad, the established priorities of creditor claims outside bankruptcy have been cast aside in this bankruptcy case as the unsecured claims of the union health pension plan have received a better deal than the secured claims of various bond holders, some of which may represent pension plans of their own.

President Obama--no bankruptcy lawyer--twisted the arms of the banks that have received TARP money to waive their priority, which is yet another reason why a government ownership position in banks is incompatible with its regulatory role. Yet the president brands the non-TARP lenders that have banded together to fight this bogus reorganization as "holdouts" and "speculators."

Both charges are misinformed at best. A holdout situation arises when one party seeks to get a disproportionate return on the sale of an asset for which it has little value in use. Thus the owner of a small plot of land could hold out for a fortune if his land is the last piece needed to assemble a large parcel of land. But the entire structure of bankruptcy eliminates the holdout position of all creditors, secured and unsecured alike, by allowing the court to "cram" the reorganization down their throats so long as it preserves the appropriate priorities among creditors and offers the secured creditors a stake in the reorganized business equal to the value of their claims. Ironically, Obama's Orwellian interventions have allowed unsecured union creditors to hold out for more than they are entitled to.

His charge of "speculation" is every bit as fatuous. Speculators (who often perform a useful economic function) buy high-risk assets at low prices in the hope that the market will turn in their favor. By injecting unneeded uncertainty into the picture, Obama has created the need for a secondary market in which nervous secured creditors, facing demotion, sell out to speculators who are better able to handle that newly created sovereign risk. He calls on citizens to buy Chrysler products, but patriotic Americans will choose to go to Ford, whose own self-help efforts have been hurt by the Chrysler and GM bailouts.

Sadly, long ago Chrysler and GM should have been allowed to bleed to death under ordinary bankruptcy rules, without government subsidy or penalty. Libertarians have often remarked on these twin dangers in isolation. The Chrysler fiasco confirms their deadly synergistic effect.

Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law, The University of Chicago, the Peter and Kirsten Bedford Senior Fellow, The Hoover Institution, and a visiting law professor at New York University Law School."