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.
In modern economies money is created out of nothing by the banking system and so the question arises as to whether there is
any justification for interest (as distinct from administration cost) certainly in the case of investment for capital projects.
Binary economics queries the need for interest in such circumstances particularly as it
leads to unnecessary increase in the levels of debt.
Payment
Before a debt can be 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.
Types of debt
There are numerous types of debt, including basic loans, syndicated loans, bonds, and promissory notes. Debt, especially large sums of debt, can also be secured through a mortgage or other security interest over some of the debtor's property, in which case
the creditor will have some rights over that property in the event that the debtor becomes unable
to repay the debt and defaults on the loan.
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
annum, 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.
Accounting debt
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 European countries
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.
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 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 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 also be inflation indexed.
Debt ratings, risk and cancellation
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 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.
Ratings and creditworthiness
Specific bond debts owed by both governments and private corporations is rated by rating agencies, such as Moody's, 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.
Cancellation
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.
Satisfaction by writeoff
A debt is repaid in full by the lender writing off as a bad debt (for tax purposes) the principal and interest owed(on a debt
that is not being paid), leaving no debt remaining on its (the lenders) books.
A simple analogy gives a better understanding-if a stranger comes in and pays off a debt you owe,you no longer owe it, it(your
debt)has been paid. And in the tax writeoff example, the lender in writingoff the principal and interest of your debt has been
paid 100% of both principal and interest by his tax deduction yielding a tax savings equal to 100% of your debt. And accounting
recognizes this by extinguishing your debt in full -no longer permitting that debt to be shown on the lender's books.
Further "transfer" of this already paid debt to a collection agency is simply fraud as no debt remains to be collected
upon
Effects of debt
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, "levering" 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. 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.
Arguments against 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.
Levels and flows
-
Global debt underwriting grew 4.3% year-over-year to $5.19 trillion during 2004.
See also
External links
This entry is from Wikipedia, the leading user-contributed encyclopedia. It may not have been reviewed by professional editors (see full disclaimer)