Everything about Debt totally explained
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.
Types of debt
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's 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 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 doesn't 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 doesn't 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's 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 won't 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's 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, 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.
Cancellation
Short of bankruptcy, it's 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.
Effects of debt
Debt allows people and organizations to do things that they'd 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 won't 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's 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 isn't 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's incurred by a regime for purposes that don't 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. It is expected to rise in the coming years as the spending habits of millions of people worldwide continue the way they do.
Further Information
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