Secured Lending as a Zero-Sum Game

This Article claims that law and economics literature made a profound mistake when it tried to adapt the Modigliani-Miller irrelevance hypothesis-famous in corporate finance theory-to the question of why it pays a debtor to issue secured debt as well as unsecured debt. The literature that is criticized claims that lending is a zero-sum game. If the debtor saves money from the secured loan, the debtor simply pays more later to an unsecured claim. Some "disturbing cause" must exist to disrupt the zero-sum game and render security interests rational for the debtor.

The author rigorously shows, however, that the zero-sum quality of secured lending is true only in a Ponzi scheme. The zero-sum game can exist only when the debtor is required (by assumption) to borrow beyond the amount of collateral. Thus, the law and economics literature purports to model credit markets, but it succeeds only in modeling perpetual Ponzi schemes.