Debt

From Wikipedia, the free encyclopedia
Jump to: navigation, search
For other uses, see Debt (disambiguation).
Not to be confused with Debit.

A debt generally refers to money owed by one party, the debtor, to a second party, the creditor. Debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest.[1] The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.

Terms[edit]

Interest[edit]

Interest is the fee charged by the creditor to the debtor. Interest is generally calculated as a percentage of the principal sum per year, and is generally paid periodically at intervals, such as monthly or semi-annually.

Interest rates may be fixed or floating. In floating-rate structures, the rate of interest that the borrower pays during each time period is tied to a pre-established benchmark such as LIBOR or, in the case of inflation-indexed bonds, inflation.

Repayment[edit]

There are three main ways loans may be structured: so that the entire principal balance is due at the maturity of the loan; so that the entire principal balance is paid slowly or amortized over the term of the loan; or so that the loan partially amortizes during the term of the loan and a larger "balloon payment" is due at maturity. Amortization structures are common in mortgages and credit cards.

Collateral and recourse[edit]

A debt obligation is considered secured if creditors have recourse to specific collateral. Collateral may include claims on tax receipts (in the case of a government), specific assets (in the case of a company) or a home (in the case of a consumer). Unsecured debt comprises financial obligations for which creditors do not have recourse to the assets of the borrower to satisfy their claims.

Issuers of debt[edit]

Governments[edit]

Governments issue debt to pay for ongoing expenses as well as major capital projects. Government debt may be issued by sovereign states as well as by local governments.

The overall level of indebtedness by a government is typically shown as a ratio of debt / GDP. This ratio helps to assess the speed of changes in government indebtedness and the size of the debt due.

Businesses[edit]

A company may use various kinds of debt to finance its operations as a part of its overall corporate finance strategy. 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.[2]

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.

A basic loan or "term loan" is the simplest form of debt. It consists of an agreement to lend a fixed amount of money, called the principal sum or principal, for a fixed period of time, with this amount 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, or may be paid periodically in the interval, such as annually or monthly. Such loans are also colloquially called bullet loans, particularly if there is only a single payment at the end – the "bullet" – without a "stream" of interest payments during the life of the loan. There are many conventions on how interest is calculated – see day count convention for some – while a standard convention is the annual percentage rate (APR), widely used and required by regulation in the United States and United Kingdom, though there are different forms of APR.

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), and is sometimes referred to as a banker's dozen, a play on "baker's dozen" – owe twelve (a dozen), receive a loan of eleven (a banker's dozen). Note that the effective interest rate is not equal to the discount: if one borrows $10 and must repay $11, then this is ($11–$10)/$10 = 10% interest; however, if one borrows $9 and must repay $10, then this is ($10–$9)/$9 = 11 1/9% interest.[3]

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. A syndicated loan is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers. 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 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.

A letter of credit or LC can also be the source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, stormwater ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheques. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and a document proving the shipment was insured against loss or damage in transit. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin.

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.

Individuals[edit]

Common types of debt owed by individuals and households include mortgage loans, car loans, and credit card debt. For individuals, debt is a means of using anticipated income and future purchasing power in the present before it has actually been earned. Commonly, people in industrialised nations use consumer debt to purchase houses, cars and other things too expensive to buy with cash on hand.

Besides these more formal debts, private individuals also lend informally to other people, mostly relatives or friends. One reason for such informal debts is that many people, in particular those who are poor, have no access to affordable credit. Such debts can cause problems when they are not paid back according to expectations of the lending household. In 2011, 8% of people in the 28 European Union countries reported their households has been in arrears, that is, unable to pay as scheduled 'payments related to informal loans from friends or relatives not living in your household'. [4]

Asset-backed trusts[edit]

Main article: Securitization

Securitization occurs when a company pools loans, which serve as assets for a trust, and finances those loans by selling securities to the market. For example, a trust may own a pool of home mortgages, which pay principal and interest to the trust, and be financed by residential mortgage-backed securities. In this case, the asset-backed trust is a debt issuer of residential mortgage-backed securities.

Debt markets[edit]

Market interest rates[edit]

Main article: Bond valuation

Role of central banks[edit]

Central banks, such as the US Federal Reserve System, play a key role in the debt markets. Debt is normally denominated in a particular 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.

Role of rating agencies[edit]

Specific bond debts owed by both governments and private corporations are rated by rating agencies, such as Moody's, Standard & Poor's, Fitch Ratings, and A. M. Best. 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 or her 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. 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.

Default[edit]

Main article: Debt relief

Short of bankruptcy, it is rare that debts are wholly or partially relinquished. 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. An example is the Biblical Jubilee year, described in the Book of Leviticus.

Under English law, when the creditor is deceived into relinquishing the debt, this is a crime under the 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.[citation needed]

History[edit]

The anthropologist David Graeber argues in Debt: The First 5000 Years that trade starts with some sort of credit namely the promise to pay later for already handed over goods. Therefore credit and debt existed even before coins.[5][6]

The word "debt" comes from the French dette and ultimately Latin debere (to owe), from de habere (to have).[7][8] The letter b in the word debt was reintroduced in the 18th century, possibly by Samuel Johnson in his Dictionary of 1755, as several other words that had existed without a b had them reinserted at around that time.

Criticisms[edit]

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. In hard times, the cost of servicing debt can grow beyond the debtor's ability to pay, due to either external events (income loss) or internal difficulties (poor management of resources).

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.

Excesses in debt accumulation have been blamed for exacerbating economic problems.[9] 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.

At the household level, debts can also have detrimental effects. In particular when households make spending decisions assuming income to increase, or remain stable, for the years to come. When households take on credit based on this assumption, life events can easily change indebtedness into over-indebtedness. Such life events include unexpected unemployment, relationship break-up, leaving the parental home, business failure, illness, or home repairs. Over-indebtedness has severe social consequences, such as financial hardship, poor physical and mental health,[10] family stress, stigma, difficulty obtaining employment, exclusion from basic financial services (European Commission, 2009), work accidents and industrial disease, a strain on social relations (Carpentier and Van den Bosch, 2008), absenteeism at work and lack of organisational commitment (Kim et al., 2003), feeling of insecurity, and relational tensions.[11]

Levels and flows[edit]

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.

References[edit]

  1. ^ "Debt Definition". Investopedia. Retrieved 16 May 2012. 
  2. ^ 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 978-1-905121-31-1
  3. ^ Formally, a discount of d% results in effective interest of d/(1-d)%.
  4. ^ Eurofound, (2013). Informal debts, http://www.eurofound.europa.eu/pubdocs/2013/73/en/2/EF1373EN.pdf
  5. ^ David Graeber: Debt: The First 5000 Years, Melville 2011. Cf. http://www.socialtextjournal.org/reviews/2011/10/review-of-david-graebers-debt.php
  6. ^ "What is Debt? – An Interview with Economic Anthropologist David Graeber". Naked Capitalism. 
  7. ^ http://dictionary.reference.com/browse/debt
  8. ^ http://www.merriam-webster.com/dictionary/debt
  9. ^ 5 Ways to Get Out of Debt Faster (internet video). Kiplinger. 2007. 
  10. ^ Fitch et al (2011) The relationship between debt and mental health: a systematic review. Mental Health Review Journal; 16,4: 153-166. http://dx.doi.org/10.1108/13619321111202313
  11. ^ Dubois & Anderson (2010) Managing household debts: Social service provision in the EU. Working paper. Dublin: European Foundation for the Improvement of Living and Working Conditions. http://www.eurofound.europa.eu/areas/socialprotection/householdebts.htm