Opinion

Felix Salmon

Hitting secured creditors

By Felix Salmon
November 20, 2009

Ira Stoll notes that the Miller-Moore amendment has passed. He calls it the “Bair-Miller-Moore Haircut”, and he doesn’t like it; I, on the other hand, think it’s a spectacularly good idea. This is the meat of it:

Payments to Fully Secured Creditors: Notwithstanding any other provision of law, in any receivership of a covered financial company in which amounts realized from the resolution are insufficient to satisfy completely any amounts owed to the United States or to the Fund, as determined in the receiver’s sole discretion, an allowed claim under a legally enforceable or perfected security interest (that became a legally enforceable or perfected security interest after the date of the enactment of this clause), other than a legally enforceable or perfected security interest of the Federal Government, in any of the assets of the covered financial company in receivership may be treated as an unsecured claim in the amount of up to 20 percent as necessary to satisfy any amounts owed to the United States or to the Fund. Any balance of such claim that is treated as an unsecured claim under this subparagraph shall be paid as a general liability of the covered financial company.

In English, this means that if you’re a secured creditor of a bank which has failed and which the federal government has to pay money to rescue, you are only guaranteed to receive 80% of your money back. Beyond that, you’re treated as an unsecured creditor.

This achieves three important goals.

Firstly, it means that lenders to dodgy banks will actually have to start doing underwriting, rather than simply relying on their security interest. That keeps everybody honest, and will give the system a heads-up when banks start getting into trouble.

Secondly, it means that wholesale lenders no longer have the ability to jump the queue when it comes to seniority. Banks should repay their depositors first, and then their senior unsecured creditors, and then their subordinated creditors, and then their preferred shareholders; whatever’s left over goes to common shareholders. But increasingly the pecking order has been upended by allowing banks to issue secured debt, which in practice ends up being senior even to depositors. In some countries, banks aren’t allowed to issue secured debt at all; this amendment doesn’t go that far, but at least it makes the debt a little bit riskier for the lender.

Thirdly, it means that banks will be forced to look at the big picture when it comes to their assets, rather than simply using them as collateral for cheap and dangerous short-term funding. Writes Stoll:

The provision make it harder and more expensive for banks to raise capital, and therefore, harder to get credit flowing again into the economy.

This is not entirely true. The provision makes it harder and more expensive for banks to raise secured capital — but as we’ve seen, there are lots of other funding sources available to banks. The more unpledged assets that a bank has, the easier it is for that bank to raise both unsecured debt and various forms of equity.

Conceptually, this is entirely what we want. If I have an asset worth $1 million, I can either borrow $900,000 against that asset and pay interest on the loan, or else I can sell off equity stakes in that asset for $1 million. I’m not sure why the former is a better idea than the latter, when we’re trying to deleverage the banks and move to a more equity-based (and less debt-based) world.

Does the Miller-Moore amendment make banks more liable to liquidity runs? Yes, but on the understanding that (a) they only become more vulnerable insofar as they’re reliant on the short-term repo markets, which is something we want to discourage; and (b) they have access to the Fed’s discount window anyway, so it’s not as though all secured funding sources can disappear overnight.

Why does Stoll love secured creditors so much? He says that “the rights of secured creditors took a beating in the Chrysler bankruptcy” — but that’s not true. They still had the right to provide DIP financing themselves (the role played by the government) or even to push Chrysler into liquidation. They sensibly didn’t exercise those rights, because doing so would have cost them an enormous amount of money compared to what they ended up getting. But the rights themselves were untouched.

The Miller-Moore amendment, by contrast, really does hit secured creditors. That’s a very good idea. Next up, let’s allow bankruptcy judges to modify mortgages, too.

Update: One more thought on this subject. Most secured funding for banks comes from the repo market, where banks borrow against securities they own. But what are banks doing holding so many securities in the first place? Shouldn’t their assets mainly be loans, which can’t be repoed?

Comments
7 comments so far | RSS Comments RSS

Perhaps I am getting more cynical as I age, but I suspect the actual reason for the objection is that this will require the people involved in a deal to do some actual due diligence, instead of just having a computer program write a standard contract.

Posted by Ken | Report as abusive
 

Just to make sure I get on the same page as you lot: am I right that the bill being amended is The Consumer Financial Protection Agency Act? AKA HR 3126? and can you link me to the amendment and/or a draft of the full bill as amended?

 

So banks should not own treasuries and mortgage passthroughs?

Posted by MacroJO | Report as abusive
 

residential whole loans can most certainly be repo’ed. Just not as easily done as in securitized form. methinks it is a chief reason for the FHLB system to exist.

Posted by Griff | Report as abusive
 

I love it that the anti-spam word is “toast.” A tribute to Tannin and Cioffi, free men, and their famous e-mail exchange, I suppose.

Anyway, with regard to my previous message, I have now discovered my mistake. The bill being amended here is the Financial Stability Improvement Act, or HR 3996.

 

Whole loans can definitely be repo’d. You’ll get a bigger haircut than on a Treasury, obviously. It would be so, so nice if Reuters hired people who had the faintest idea what they were talking about.

Posted by y81 | Report as abusive
 

It’s not even that bad. Secured creditors would lose nothing until shareholders and unsecured creditors had lost everything. So the haircut provision wouldn’t apply when a systemically significant financial firm teeters over into insolvency, it will only apply in spectacular, catastrophic collapses. Think of the Hindenberg.

It wouldn’t take a lot of underwriting to see something like that coming. The most likely candidates for the haircut would be existing creditors who demanded more and more collateral as the firm collapsed, jumping queue and exacerbating the liquidity crisis at the collapsing firm.

Also, the haircut would be discretionary. The FDIC could allow secured creditors who had taken collateral when the firm was solvent their full security interest, and just impose the haircut on creditors who had grabbed collateral from a firm that should already have been in receivorship.

I liked your calling the amendment a “spectaculary good idea” more than “not that bad,” but I’ll take it.

Posted by brad miller | Report as abusive
 

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