The Rhetoric of Bearing Risk

Theoretically, a bondholder is a lender, not an owner. But in practice, corporate bonds are priced depending on the estimated degree of risk – risky bonds have higher returns – and secured by the assets of the corporation, which the bondholders can examine before buying bonds issued by that corporation. So it still makes no sense to shield the bondholders from the risk, even when it turns out they misunderestimated it.

“Poor unadorned stockholders” should indeed take the first losses precisely because they get to keep *all* the profits above fixed salaries and bond interest when things are going well. And bondholders should take the second losses because their bonds already priced in a risk premium. Employees and vendors (such as parts companies and utilities) should reasonably expect to have the most senior claims because they’re not receiving any risk premium – *any* hit they take is uncompensated and therefore unjust.

Secured lenders made (and make) loans based, in part, on the priority they have in bankruptcy. A secured lender is capital, but is not equity capital. Equity capital doesn’t get the first bite–they come last, after everyone else, including trade creditors. Secured creditors go first, because the bankruptcy code says they go first (presumbably because we want to encourage secured lending). That’s the background principle, and that’s how the risk was priced. Secured lending is less lucrative and less risky than equity investing. The risk that a secured lender will be demoted in favor of junior creditors is not a risk that is priced into the loan, and not one that the lender has been compensated for.

First bite at the cherry??

Ambinder doesn’t know what he’s talking about. The tip-off being “every academic economist you happen to run across.” God forbid I’m ever subject to listening to those offhand conversations about the rules of capitalism.

The whole thing ought to be a reminder that the “rules of capitalism” is just a way of saying “I’m uneasy thinking about the way things really work.”

Whatever is in the terms of the contract. Capitalism. It works, bitches.

Henry, I just don’t see where you get that. Compensated by the government? Where is that in what Ambinder wrote? No, Ambinder is focused on exactly what he should be, relative priority to the assets of the company. That’s why he’s talking about “unsecured” creditors, and “secured” creditors, and “stockholders” Those are relevant technical categories for priority in bankruptcy. And that’s what the dispute has been about: will bondholders, whose claims are secured by all of the assets of the company (the plants, the inventory, the raw materials, the business itself) get paid the full value of their claims, or will some of that value be allocated to others whose claims have lower priority in bankruptcy? No one is asking the government to supply some new pool of funds to bail out the bondholders, only to allow them to have their legal remedy.

That’s why he’s talking about “unsecured” creditors, and “secured” creditors, and “stockholders” Those are relevant technical categories for priority in bankruptcy.

No, Ambinder’s “inviolate principle of rewarding risk-takers” specifically says that equity holders ought to have positive value in a bankrupt company. Which is obviously wrong, and the fact that I can’t say with certainty that he might not have found one or two “academic economists” to say the same thing is a sad indictment of the status of the profession in the era in which Nobel Laureates can’t get simple Ricardian Equivalence sums right.

once inviolate principle of rewarding risk-takers.

There is no such inviolate principle. Risk-takers get bigger returns than others when the risks in question pay off, not regardless of what happens. Ambinder seems to think that risk-taking is sufficient to earn large returns, rather than just necessary.

Or, what Lemuel Pitkin said.

The risk argument is a straw mand and a red herring. As Henry implies, there should be no distinction between the claims of the bondholders and the UAW. If Henry will look at the Administration’s perfered plan, he will see that it does not follow this principal. The UAW is owed ~$20B and is supposed to get ~$10B in cash and ~40% of the reorganized company. The bondholders are owed ~$30B and are supposed to get no cash and ~10% of the reorganized company. Here’s hoping that a bankruptcy judge teaches the Obama administration a lesson about fairness and the primacy of contract and bankruptcy law over politcal goals.

This is not, by the way, about unpaid wages, which U.S. bankruptcy already privleges above other unsercured claims. It’s about funds owed to the pension and retiree healthcare trust. Someone want to explain why the law should favor the UAW retirees over the bondholder retirees?

If the secured creditors claimed all their collateral, to whom would they sell it?

“The risk argument is a straw mand and a red herring. As Henry implies, there should be no distinction between the claims of the bondholders and the UAW. If Henry will look at the Administration’s perfered plan, he will see that it does not follow this principal. The UAW is owed ~$20B and is supposed to get ~$10B in cash and ~40% of the reorganized company. ”

This is technically correct as a matter of current law, but

a) Bear in mind that the UAW has already agreed to massively reduce what it is owed to try to save the company, whereas bondholders haven’t. If the UAW had acted like bondholders, they could have held out for what they were fully owed before the renegotiation of the retiree healthcare obligations, and would have been much bigger unsecured creditors than the bondholders, and consequently ended up with a bigger share of the pie post-bankruptcy. As a matter of justice, if arguably not law, the UAW shouldn’t be taking an equal haircut this time round.

b) Separate from that, I personally think all obligations to employees should take precedence over other unsecured creditors.

Also there’s been a lot of talk about secured creditors taking priority. I may be wrong, but nothing I’ve read suggest they aren’t in this instance. There are no GM secured bonds – only secured bank loans and asset backed securities. It’s the unsecured bondholders who are being asked to take a bath.

Bankruptcy class was a long time ago, so I’ll welcome being corrected by someone who actually knows the law, but here are a few thoughts:

1. secured creditors have priority, but only to the extent of their security. The liquidation value of many secured assets is probably close to zero, or even negative. An aging manufacturing plant in a city with really bad weather on land with likely environmental contamination — who wants that asset? Once you waive your right to take the asset in lieu of the debt, you’re just another creditor.

2. Unpaid pension obligations are a lot like debt, except the employee didn’t even want that risk. I’m not sure if pension obligations are superior to bond debt as a matter of law, but they certainly should be.

3. If the position of the government in the Chrysler and (likely) GM bankruptcy proceedings is wrong as a matter of law but the power of the government has overwhelmed the bankruptcy court, then the wronged parties have a remedy — appeal.

Wait. Maybe I’m really stupid, but I’m not getting something here.

You can’t reward a risk taking investor by ameliorating the harm he suffers when his investment goes belly up. If you do, he’s no longer a risk taker. The risk that his investment would crap out was the risk that made him a risk taking investor in the first place. If you ameliorate that risk you aren’t compensating a risk taker, you’re eliminating the original risk.

Is there something more to this or is it really that stupid?

Secured creditors go first, because the bankruptcy code says they go first (presumbably because we want to encourage secured lending).

Or because bondholders have *already* been rewriting the bankruptcy code. We have lots of secured lending (indeed, arguably too much), why would “we” want to encourage it? Neither the employee nor the vendor asked to take on risk and neither the employee nor the vendor is being paid to take on risk; if bondholders, who voluntarily agree to be paid for the risk of insolvency, are senior to that kind of involuntary creditor, that’s just obscene.

Corporate bonds should be secured only by the corporation’s net worth if it has any, and therefore, senior only to equity (unless, perhaps, it’s secured *by a specific asset*, like a mortgage, but I don’t think that’s what we’re talking about here).

It sounds to me like the bloke has misunderstood the argument about the relative priorities of *secured creditors* versus workers. It’s based on faulty logic, but more of a problem with the learning process than anything more fundamental.

” You could perhaps make a case on normative grounds that people who took a higher risk should get a bigger share of whatever is left. ”

No, you can’t. The sentence doesn’t even make any sense. The meaning of “took a higher risk” is that they agreed to get a smaller share, or no share, of “whatever is left” if things went badly. If they get a “bigger share” then they didn’t take a “higher risk.”

Not to mention the dividends they continued to extract while the company was making multi-billion dollar losses.

First I agree completely with henry’s thrust. The rewards for risk-taking come when the company does well and most of the benefit accrues to stockholders. When the company declares bankruptcy is the risk part of the risk taking, where if you don’t lose more than others, where exactly was the additional risk?

One thing not yet mentioned in this discussion is that stockholders *do* get risk mitigation from the government in the form of… wait for it… bankruptcy.

Before modern bankruptcy laws, an equity holder could be saddled with debt over and above the value of his assets. A failed entrepreneur might spend the rest of his life in debtor’s prison, rather than merely liquidating and giving creditors what’s left, or turning over ownership to said creditors in a reorg and afterwords being free of the debt.

But today, under normal corporate conditions, your stock value can never drop below zero.

I don’t always agree with the economics of this blog (and that’s when I can understand it) but this post certainly sounds right to me.

Yes, the ‘reward’ is actually an incentive built into the system. Not a discretionary tribute to virtue. It may be desirable to have systems which set up incentives for certain kinds of risk-taking (though actually the size of the risk – both of the probabilities and of the benefits/losses – is very relevant, as is background wealth thus marginal disutility of loss). More accurately a system may be set up so as to affect the cost-benefit analysis of economic actors. Risk is always a probability distribution over more than one possible outcome. (there’s also risk-aversion to be considered, which is VERY sensitive to the size of what is risked relative to wealth .

Yes, there’s nothing inherently good – or rewardable – about taking risks. Otherwise I’d be a professional coin-tosser (UK readers: rather than just a…yes, yes). So yes the point is stoopid – and should be framed, if it must be at all, in terms of whether the administration is interfering illegitimately in the (ahem) smooth running of the system, or frustrating legtimate expectations either unfairly or in a way that jeopardises the ‘incentives that make capitalism work’.

Spelling could also do with more government support as always.