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From Wikipedia, the free encyclopedia
Debt is that which is owed; usually
referencing assets
owed, but the term can cover other obligations. In the case of assets, debt is
a means of using future purchasing power in the present before a summation has been earned.
Some companies
and corporations
use debt as a part of their overall corporate
finance strategy.
A debt is
created when a creditor
agrees to lend
a sum of assets to a debtor. In modern society, debt is usually granted with
expected repayment; in many cases, plus interest.
Historically, debt was responsible for the creation of indentured servants.
Payment
Before a
debt can be made, both the debtor and the creditor must agree on the manner in which the debt will be
repaid, known as the standard of deferred payment. This payment
is usually denominated as a sum of money in units of currency,
but can sometimes be denominated in terms of goods. Payment can be made
in increments over a period of time, or all at once at the end of the loan
agreement.
A company
uses various kinds of debt to finance its operations. The various types of debt can generally be
categorized into: 1) secured and unsecured debt, 2) private and public debt, 3)
syndicated and bilateral debt, and 4) other types of debt that display one or
more of the characteristics noted above.[1]
A debt
obligation is considered secured if creditors have recourse to the assets of
the company on a proprietary basis or otherwise ahead of general
claims against the company. Unsecured debt comprises financial obligations,
where creditors do not have recourse to the assets of the
borrower to satisfy their claims.
Private
debt comprises bank-loan type obligations, whether senior or mezzanine.
Public debt is a general definition covering all financial instruments that are
freely tradeable on a public exchange or over the counter, with few if any
restrictions.
Loan
syndication is a risk management tool that allows the lead banks underwriting
the debt to reduce their risk and free up lending capacity.
A basic loan is the simplest form
of debt. It consists of an agreement to lend a principal sum for a fixed period
of time,
to be repaid by a certain date. In commercial loans interest,
calculated as a percentage of the principal sum per year, will also have to be
paid by that date.
In some
loans, the amount actually loaned to the debtor is less than the principal sum
to be repaid; the additional principal has the same economic effect as a higher
interest rate (see point (mortgage)).
A syndicated
loan is a loan that is granted to companies that wish to borrow more
money than any single lender is prepared to risk in a single loan, usually many
millions of dollars. In such a case, a syndicate of banks can each agree to put
forward a portion of the principal sum.
A bond
is a debt security issued by certain institutions such as
companies
and governments.
A bond entitles the holder to repayment of the principal sum, plus interest.
Bonds are issued to investors in a marketplace
when an institution wishes to borrow money. Bonds have a fixed lifetime,
usually a number of years;
with long-term bonds, lasting over 30 years, being less common. At the end of
the bond's life the money should be repaid in full. Interest may be added to
the end payment, or can be paid in regular installments (known as coupons)
during the life of the bond. Bonds may be traded in the bond markets,
and are widely used as relatively safe investments in comparison to equity.
In
national accounting, debts are added according to those who are indebted.
Household debt is the debt held by households. "National" or Public
debt is the debt held by the various governmental institutions (federal
government, states, cities ...). Business debt is the debt held by businesses.
Financial debt is the debt held by the financial sector (from one financial
institution to another). Total debt is the sum of all those debts, excluding
financial debt to prevent double accounting. These various types of debt can be
computed in debt/GDP ratios. Those ratios help to assess the speed of
variations in the indebtness and the size of the debt due. For example the USA
have a high consumer debt and a low public debt, while in eastern European
countries, for example, the opposite tends to be true.
There are
differences in the accounting of debt for private and public agents. If a
private agent promises to pay something later, it has a debt, and this debt is
enforceable by public agents. If a public body passes a law stating that it'll
pay something later (a kind of promise), it keeps the right to change the law
later (and not to pay). This is why, for instance, the money governments
promised to pay for retirements does not show up in the public debt assessment,
whereas the money private companies promised to pay for retirements do.
Main article: Securitization
Securitization
occurs when a company groups together assets or receivables and sells them in
units to the market through a trust. Any asset with a cashflow can be
securitized. The cash flows from these receivables are used to pay the holders
of these units. Companies often do this in order to remove these assets from
their balance sheets and monetize an asset. Although these assets are
"removed" from the balance sheet and are supposed to be the
responsibility of the trust, that does not end the company's involvement. Often
the company maintains a special interest in the trust which is called an
"interest only strip" or "first loss piece". Any payments
from the trust must be made to regular investors in precedence to this
interest. This protects investors from a degree of risk, making the
securitization more attractive. The aforementioned brings into question whether
the assets are truly off-balance-sheet given the company's exposure
to losses on this interest.
Debt, inflation and the exchange rate
As noted
above, debt is normally denominated in a particular monetary currency,
and so changes in the valuation of that currency
can change the effective size of the debt. This can happen due to inflation
or deflation, so it can happen even though
the borrower and the lender are using the same currency.
Thus it is important to agree on standards of deferred payment in advance, so
that a degree of fluctuation will also be agreed as acceptable. It is for
instance common[citation needed] to agree to
"US dollar denominated" debt.
The form
of debt involved in banking accounts for a large proportion of the money in most
industrialised nations (see money and credit money for a discussion of this). There
is therefore a relationship between inflation,
deflation, the money supply,
and debt. The store of value represented by the entire
economy of the industrialized nation, and the state's ability to levy tax on
it, acts to the foreign holder of debt as a guarantee of repayment, since
industrial goods are in high demand in many places worldwide.
Borrowing
and repayment arrangements linked to inflation-indexed units of account are
possible and are used in some countries. For example, the US government issues
two types of inflation-indexed bonds, Treasury
Inflation-Protected Securities (TIPS) and I-bonds. These are one of the safest
forms of investment available, since the only major source of risk — that of inflation
— is eliminated. A number of other governments issue similar bonds, and some
did so for many years before the US government.
In
countries with consistently high inflation, ordinary borrowings at banks may
also be inflation indexed.
Debt ratings, risk and cancellation
Lendings
to stable financial entities such as large companies or governments are often
termed "risk free" or "low risk" and made at a so-called
"risk-free interest rate". This is
because the debt and interest are highly unlikely to be defaulted. A good
example of such risk-free interest is a US Treasury
security - it yields the minimum return available in economics, but
investors have the comfort of the (almost) certain expectation that the US
Treasury will not default on its debt instruments. A risk-free rate is also
commonly used in setting floating interest rates, which are usually calculated
as the risk-free interest rate plus a bonus to the creditor based on the
creditworthiness of the debtor (in other words, the risk of him defaulting and
the creditor losing the debt). In reality, no lending is truly risk free, but
borrowers at the "risk free" rate are considered the least likely to
default.
However,
if the real value of a currency changes during the term of the debt, the
purchasing power of the money repaid may vary considerably from that which was
expected at the commencement of the loan. So from a practical investment point
of view, there is still considerable risk attached to "risk free" or
"low risk" lendings. The real value of the money may have changed due
to inflation, or, in the case of a foreign investment, due to exchange rate
fluctuations.
The Bank for International Settlements
is an organisation
of central banks
that sets rules to define how much capital banks have to hold against the loans
they give out.
Specific
bond debts owed by both governments and private corporations is rated by rating
agencies, such as Moody's, Fitch Ratings Inc., A. M. Best
and Standard & Poor's. The government or
company itself will also be given its own separate rating. These agencies
assess the ability of the debtor to honor his obligations and accordingly give
him a credit rating.
Moody's uses the letters Aaa Aa A Baa Ba B Caa Ca C, where ratings Aa-Caa
are qualified by numbers 1-3. Munich Re, for example, currently is rated Aa3
(as of 2004).
S&P and other rating agencies have slightly different systems using capital
letters and +/- qualifiers.
A change
in ratings can strongly affect a company, since its cost of refinancing
depends on its creditworthiness. Bonds below Baa/BBB
(Moody's/S&P) are considered junk-
or high risk bonds. Their high risk of default (approximately 1.6% for Ba) is
compensated by higher interest payments. Bad Debt is a loan that can not
(partially or fully) be repaid by the debtor. The debtor is said to default on his debt. These types of debt are
frequently repackaged and sold below face value. Buying junk bonds is seen as a
risky but potentially profitable form of investment.
Short of
bankruptcy, it is rare that debts are wholly or partially forgiven. Traditions
in some cultures demand that this be done on a regular (often annual) basis, in
order to prevent systemic inequities between groups in society, or anyone
becoming a specialist in holding debt and coercing repayment. Under English law,
when the creditor is deceived into forgoing payment, this is a crime: see Theft Act
1978.
International
Third World
debt has reached the scale that many economists are convinced that debt cancellation is the
only way to restore global equity in relations with the developing
nations.
Debt
allows people and organizations to do things that they would otherwise not be
able, or allowed, to do. Commonly, people in industrialised nations use it to
purchase houses, cars and many other things too expensive to buy with cash on
hand. Companies also use debt in many ways to leverage the investment
made in their assets,
"leveraging" the return on their equity. This leverage, the proportion of debt to equity, is
considered important in determining the riskiness of an investment; the more
debt per equity, the riskier. For both companies and individuals, this
increased risk can lead to poor results, as the cost of servicing the debt can
grow beyond the ability to pay due to either external events (income loss) or
internal difficulties (poor management of resources).
Excesses
in debt accumulation have been blamed for exacerbating economic problems.[2]
For example, prior to the beginning of the Great
Depression debt/GDP ratio was very high. Economic agents were
heavily indebted. This excess of debt, equivalent to excessive expectations on
future returns, accompanied asset bubbles on the stock markets. When
expectations corrected, deflation and a credit crunch
followed. Deflation effectively made debt more
expensive and, as Fisher explained, this reinforced deflation again, because,
in order to reduce their debt level, economic agents reduced their consumption and investment. The reduction
in demand reduced business activity and caused further unemployment. In a more
direct sense, more bankruptcies also occurred due both to increased debt cost
caused by deflation and the reduced demand.
It is
possible for some organizations to enter into alternative types of borrowing
and repayment arrangements which will not result in bankruptcy. For example,
companies can sometimes convert debt that they owe into equity in themselves. In
this case, the creditor hopes to regain something equivalent to the debt and
interest in the form of dividends and capital gains of the borrower. The
"repayments" are therefore proportional to what the borrower earns
and so can not in themselves cause bankruptcy. Once debt is converted in this
way, it is no longer known as debt.
Main article: Criticism of
debt
Some
argue against debt as an instrument and institution, on a personal, family,
social, corporate and governmental level. Islam forbids
lending with interest even today, while the Catholic
church allowed it from 1822 onwards, and the Torah states that all
debts should be erased every 7 years and every 50 years.
Debt will
increase through time if it is not repaid faster than it grows through
interest. This effect may be termed usury, while the term "usury" in other contexts
refers only to an excessive rate of interest, in excess of a reasonable profit
for the risk
accepted.
In
international legal thought, Odious debt is debt that is incurred by a
regime for purposes that do not serve the interest of the state. Such debts are
thus considered by this doctrine to be personal debts of the regime that
incurred them and not debts of the state.
In an
economy with high interest rates, debt will be more costly to a business than
more flexible dividends on equity investment. It may be easier for a struggling
business to be financed through equity investment as it may be possible to
avoid paying a dividend if times are hard.
Main article: Debt levels and flows
Global
debt underwriting grew 4.3% year-over-year to $5.19 trillion during 2004. It is
expected to rise in the coming years if the spending habits of millions of
people worldwide continue the way they do.
- ^ Joseph Swanson and Peter
Marshall, Houlihan Lokey and Lyndon Norley, Kirkland
& Ellis International LLP (2008). A Practitioner's Guide to Corporate
Restructuring page 5. City & Financial Publishing, 1st edition ISBN:
9781905121311
- ^ 5 Ways
to Get Out of Debt Faster. Kiplinger.
