Debt

Debt is that which is owed. A person or company owing debt is called a debtor. An entity to whom debt is owed is called a creditor. Debt is used to borrow purchasing power from the future. Companies use debt as a part of their overall corporate finance strategy.

Debt

Debt is that which is owed. A person or company owing debt is called a debtor. An entity to whom debt is owed is called a creditor. Debt is used to borrow purchasing power from the future. Companies use debt as a part of their overall corporate finance strategy.

Contents:
1 Payment
2 Types of debt
2.1 Securitization
3 Debt, inflation and the exchange rate
3.1 Inflation indexed debt
4 Debt ratings, risk and cancellation
4.1 Risk free interest rate
4.2 Ratings and creditworthiness
4.3 Cancellation
5 Effects of debt
6 Arguments against debt
7 Levels and flows

Payment

People or organizations often enter into agreements to borrow something. Both parties must agree on some standard of deferred payment, usually a sum of money denominated as units of a currency, but sometimes goods. For instance, one may borrow shares, in which case, one may pay for them later with the shares, plus a premium for the borrowing privilege, or the sum of money required to buy them in the market at that time.

Types of debt

There are numerous types of debt obligations. They include loans, bonds, mortgages and promissory notes. It is common to borrow large sums for major purchases, such as a mortgage, and pay it back with an agreed premium interest rate over time, or all at once at a later date (balloon payment). The amount of money outstanding is usually called a debt. The debt will increase through time if it is not repaid faster than it grows. In some systems of economics this effect is termed usury, in others, the term "usury" refers only to an excessive rate of interest, in excess of a reasonable profit for the risk accepted.

Large organizations can issue debt in the form of securities, known as bonds. Each bond entitles the holder to interest and principal repayments. Bonds are traded in the bond markets, and are widely used as relatively safe investments.

Securitization

Main article: securitization

Securitization occurs when a company lumps together a group of assets or receivables usually in different tranches determined by the riskiness of the debtor and sells them to the market through a trust. The cash flows from these receivables are used to pay the holders of this paper. 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 because the company often maintains what is called an interest only strip or first lost piece in the securitization. The piece that the company maintains gets hit first with any losses the trust may incur before any of the other investors see a loss, meaning that the investor in a securitization would get paid in case there are massive defaults and the company who securitized the assets would not get paid on its portion. The aforementioned brings into question whether the assets are truly of balance sheet given the company's commitment to keeping losses to investor at a minimum. Many rating agencies consider securitization debt because of their commitment to keeping these trusts loss free. If it has a cash flow coming in it can be securitized.

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 to agree to "US dollar denominated" debt.

The form of debt involved in banking gives rise to a large proportion of the money in most industrialised nations (see money and credit money for a discussion of this). There is therefore a complex relationship between inflation, deflation, the money supply, and debt. The store of value represented by the entire economy of the industrialized nation itself, 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.

Inflation indexed debt

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 be inflation indexed also.

Debt ratings, risk and cancellation

Risk free interest rate Main article: risk-free interest rate

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 textbook example of such risk-free interest is a US Treasury security - it yields you the minimum return available in economics, but you get the security of the knowledge that the US has never defaulted on its debt instruments. A risk-free rate is commonly used in setting floating interest rates, floating interest rate is usually calculated as risk-free interest rate plus a bonus to the creditor based on the creditworthiness of the debtor.

However if the real value of a currency has changed in the meantime, 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.

Ratings and creditworthiness

Debt of countries as well as private corporations is rated by rating agencies, such as Moody's, A.M. Best and Standard & Poor's. These agencies assess the ability of the debtor to honor his obligations and accordingly give him a credit rating. Moody's for example 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 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.

Cancellation

Short of bankruptcy, very often 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.

Effects of debt

Debt allows people and organisations to do things that they otherwise wouldn't be able or allowed to. 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 private equity.

This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment; the higher more debt per equity, the riskier. Debt as a whole is a sign of optimism, a society believes in its future (earnings especially), and of lack of work ethic, a society postpones the solution to present problems (when it compensates a fall in revenues, perceived as short term, by an increase in debt for instance)

Excesses in debt accumulation have been blamed for exacerbating economic problems. For example, prior to the beginning of the Great Depression debt/GDP ratio was very high. Economic agents were heavily indebted. This excess in debt, equivalent to excessive expectations on future returns, accompanied asset bubbles (stock market). When expectations corrected, deflation and credit crunch followed. Deflation effectively made debt more expansive and as Fisher explained this reinforced deflation again. In order to reduce their debt level, economic agents reduced their consumption and investetment. The reduction in demand reduced business activity and caused further unemployment. Also in a direct sense, more bankruptcies occurred due to increased debt cost caused by deflation, and the reduced demand.

It is possible for some organisations 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 lender 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.

See: Perils of the debt-propelled economy by Henry C K Liu

Arguments against debt

Main article: criticism of debt

Some argue against debt as an instrument and institution, on a personal, family, social, corporate and governmental level. Economics criticism focuses on debt fostering inequality. Muslim religion forbids lending with interest, the catholic church long did, and the torah wrote that all debts had to be erased every 7 years and every 50 years. Debt from a religious view point is condemned because by tying past and future it cuts from the present where God is to be found. Feminism concentrates on the perceived coercive nature of debt contracts. Environmental critics point out the disparity between material use of resources from economic growth and the limited resources of natural production. Examples would be the low ecological yield of natural resources and the limited usable energy from the sun.

Levels and flows

Main article: debt levels and flows

Global debt underwriting grew 4.3% year-over-year to $5.19 trillion during 2004.

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