Enterprise Finance: Reading: Debt

Linked from https://en.wikipedia.org/wiki/Debt

Debt refers to something that is owed or due either physically or metaphorically. In the physical sense, the parties to debt are lenders (those who give) and borrowers (those who receive). In the metaphorical sense, debt refers to a moral obligation not based on physical value (e.g.: debt of gratitude).

Debt was the first form of commerce (barter system) documented in human history and existed about 2,900 years prior to the invention of coinage. Today there are many examples of lenders of monetary debt that include sovereign nations, banks, credit card companies, payday loan providers, individuals, etc., who in many instances subject their borrowers to contractual terms that designate the amount and timing of repayments of the debt and that frequently include the payment of principal and interest.^[1]

History

Main article: History of money

Anthropologist David Graeber in his award winning book ^[2][3] Debt: The First 5000 Years writes that trade started with debt (the promise to pay later for already handed over goods) around 3500 BC with coinage not being invented until about 2,900 years later around 600 BC.

Etymology[edit]

The word debt is based on the Latin word debitum (meaning: something owed/thing owed) whose past participle debere means owe/to owe. In Old French this Latin word was changed to dete and in Middle English to dette with its modern-day French and English spelling being debt.

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, which percentage is known as an interest rate, and is generally paid periodically at intervals, such as monthly or semi-annually.

Many conventions on how interest is calculated exist - 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.

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 benchmark such as LIBOR or, in the case of inflation-indexed bonds, inflation.

For some loans, the amount actually loaned to the debtor is less than the principal sum to be repaid. This may be because upfront fees or points are charged, or because the loan has been structured to be sharia-compliant. The additional principal due at the end of the term has the same economic effect as a higher interest rate. This 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 percent interest; however, if one borrows $9 and must repay $10, then this is ($10-$9)/$9 = 11-1/9 percent interest.^[7]

Repayment[edit]

There are three main ways repayment may be structured: the entire principal balance may be due at the maturity of the loan; the entire principal balance may be amortized over the term of the loan; or the loan may partially amortize during its term, with the remaining principal due as a "balloon payment" 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.

Types of borrowers

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 industrialized nations use consumer debt to purchase houses, cars and other things too expensive to buy with cash on hand.

People are more likely to spend more and get into debt when they use credit cards vs. cash for buying products and services.^{[8][9][10][11][12]} This is primarily because of the transparency effect and consumer's "pain of paying.” ^[10][13] The transparency effect refers to the fact that the further you are from cash (as in a credit card or another form of payment), the less transparent it is and the less you remember how much you spent.^[13] The less transparent or further away from cash, the form of payment employed is, the less an individual feels the "pain of paying” and thus is likely to spend more.^[10] Furthermore, the differing physical appearance/form that credit cards have from cash may cause them to be viewed as "monopoly” money vs. real money, luring individuals to spend more money than they would if they only had cash available.^[11][14]

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 percent of people in the European Union 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".^[15]

Businesses[edit]

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

A term loan is the simplest form of corporate 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.

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 company may also issue bonds, which are debt securities. 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.

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 cheque. 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.

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, sometimes known as municipalities.

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

Default[edit]

Main article: Debt relief

Debtors of every type default on their debt from time to time, with various consequences depending on the terms of the debt and the law governing default in the relevant jurisdiction. Riskier borrowers must generally pay higher rates of interest to compensate lenders for taking on the additional risk of default. Debt investors assess the risk of default prior to making a loan, for example through credit scores and corporate and sovereign ratings.

Individuals and companies may go into bankruptcy if they are unable to satisfy their debts. 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}^]

Debt markets[edit]

Market interest rates[edit]

Main article: Bond valuation

Loans versus bonds[edit]

Bonds are debt securities, tradeable on a bond market. A country's regulatory structure determines what qualifies as a security. For example, in North America, each security is uniquely identified by a CUSIP for trading and settlement purposes. In contrast, loans are not securities and do not have CUSIPs (or the equivalent). Loans may be sold or acquired in certain circumstances, as when a bank syndicates a loan.

Loans can be turned into securities through the securitization process. In a securitization, a company sells a pool of assets to a securitization trust, and the securitization trust finances its purchase of the assets by selling securities to the market. For example, a trust may own a pool of home mortgages, and be financed by residential mortgage-backed securities. In this case, the asset-backed trust is a debt issuer of residential mortgage-backed securities.

Role of central banks[edit]

Central banks, such as the U.S. 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 percent 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 investment.

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.

Excessive debt accumulation has been blamed for exacerbating economic problems. For example, before the Great Depression, the debt-to-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,^[16] 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.^[17]

Levels and flows[edit]

Main article: Debt levels and flows

Global debt underwriting grew 4.3 percent year-over-year to US$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.

Reading: Debt

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