Debt
Encyclopedia
A debt is an obligation
owed by one party (the debtor
) to a second party, the creditor
; usually this refers to asset
s granted by the creditor to the debtor, but the term can also be used metaphor
ically to cover moral
obligations and other interactions not based on economic value.
A debt is created when a creditor agrees
to lend
a sum of assets to a debtor. Debt is usually granted with expected repayment; in modern society, in most cases, of the original sum plus interest
.
In finance
, debt is a means of using anticipated future purchasing power
in the present before it has actually been earned. Some companies
and corporation
s use debt as a part of their overall corporate finance
strategy.
in his Dictionary of 1755 – several other words that had existed without a b had them reinserted at around that time.
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
or services. Payment can be made in increments over a period of time
, or all at once at the end of the loan agreement
.
uses various kinds of debt to finance
its operations
. 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.
A debt obligation is considered secured, if creditors have recourse to the assets of the company on a proprietary
basis or otherwise ahead of general claims against the company.
Unsecured debt comprises financial obligations, where creditors do not have recourse to the assets of the borrower to satisfy their claims.
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 , 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 loan
s, 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.
Rather than the entire principal amount of the loan being due at the end of the loan, the principal may be slowly repaid or "amortized" over the course of the loan – see amortizing loan
. This is particularly common in mortgage
s and in the minimum payment on credit card
s.
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. 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 government
s. 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 year
s; 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 market
s, and are widely used as relatively safe investments in comparison to equity
.
The 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.
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 has a high consumer debt and a low public debt, while in eastern 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.
given the company's exposure to losses on this interest.
, 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
, broad money
, and demand deposit
s for a discussion of this). There is therefore a relationship between inflation
, deflation
, the money supply
, and debt. The store of value
represented by the entire economy of the industrialized nation, 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.
s, 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.
". 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 or her 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 bank
s that sets rules to define how much capital banks have to hold against the loans they give out.
, 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 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. Munich Re
, for example, currently is rated Aa3 . 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.
. 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
: 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.
made in their asset
s, "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. 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.
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 (in the Jubilee year
, as described in the Book of Leviticus).
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.
In an economy with high interest rates, debt will be more costly to a business than more flexible dividends on equity investment. It may be easier for a struggling business to be financed through equity investment as it may be possible to avoid paying a dividend if times are hard.
At the household level, debts can also have detrimental effects. In particular when households make spending decisions assuming income to remain the same -or increase- for the years to come. When households take-on credits 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 health (physical and mental), family stress, stigma, barriers to 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.
Obligation
An obligation is a requirement to take some course of action, whether legal or moral. There are also obligations in other normative contexts, such as obligations of etiquette, social obligations, and possibly...
owed by one party (the debtor
Debtor
A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...
) to a second party, the creditor
Creditor
A creditor is a party that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property or...
; usually this refers to asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s granted by the creditor to the debtor, but the term can also be used metaphor
Metaphor
A metaphor is a literary figure of speech that uses an image, story or tangible thing to represent a less tangible thing or some intangible quality or idea; e.g., "Her eyes were glistening jewels." Metaphor may also be used for any rhetorical figures of speech that achieve their effects via...
ically to cover moral
Morality
Morality is the differentiation among intentions, decisions, and actions between those that are good and bad . A moral code is a system of morality and a moral is any one practice or teaching within a moral code...
obligations and other interactions not based on economic value.
A debt is created when a creditor agrees
Loan agreement
A loan agreement is a contract entered into between which regulates the terms of a loan. Loan agreements usually relate to loans of cash, but market specific contracts are also used to regulate securities lending....
to lend
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
a sum of assets to a debtor. Debt is usually granted with expected repayment; in modern society, in most cases, of the original sum plus interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
.
In finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, debt is a means of using anticipated future purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...
in the present before it has actually been earned. Some companies
Company
A company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
and corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
s use debt as a part of their overall corporate finance
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
strategy.
Etymology
The word comes from the French dette and ultimately Latin debere (to owe), from de habere (to have). The letter b in the word debt was reintroduced in the 17th century, possibly by Samuel JohnsonSamuel Johnson
Samuel Johnson , often referred to as Dr. Johnson, was an English author who made lasting contributions to English literature as a poet, essayist, moralist, literary critic, biographer, editor and lexicographer...
in his Dictionary of 1755 – several other words that had existed without a b had them reinserted at around that time.
Payment
Before a debt can be made, both the debtorDebtor
A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...
and the creditor
Creditor
A creditor is a party that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property or...
must agree on the manner in which the debt will be repaid, known as the standard of deferred payment
Standard of deferred payment
A standard of deferred payment is the accepted way, in a given market, to settle a debt – a unit in which debts are denominated. It is one of the defining functions of money; for example, while the gold standard reigned, gold or any currency convertible to gold at a fixed rate constituted such a...
. This payment
Payment
A payment is the transfer of wealth from one party to another. A payment is usually made in exchange for the provision of goods, services or both, or to fulfill a legal obligation....
is usually denominated as a sum of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
in units
Units of measurement
A unit of measurement is a definite magnitude of a physical quantity, defined and adopted by convention and/or by law, that is used as a standard for measurement of the same physical quantity. Any other value of the physical quantity can be expressed as a simple multiple of the unit of...
of currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
, but can sometimes be denominated in terms of goods
Good (economics and accounting)
In economics, a good is something that is intended to satisfy some wants or needs of a consumer and thus has economic utility. It is normally used in the plural form—goods—to denote tangible commodities such as products and materials....
or services. Payment can be made in increments over a period of time
Time
Time is a part of the measuring system used to sequence events, to compare the durations of events and the intervals between them, and to quantify rates of change such as the motions of objects....
, or all at once at the end of the loan agreement
Loan agreement
A loan agreement is a contract entered into between which regulates the terms of a loan. Loan agreements usually relate to loans of cash, but market specific contracts are also used to regulate securities lending....
.
Types of debt
A companyCompany
A company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
uses various kinds of debt to finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
its operations
Business operations
Business operations are those ongoing recurring activities involved in the running of a business for the purpose of producing value for the stakeholders...
. 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.
A debt obligation is considered secured, if creditors have recourse to the assets of the company on a proprietary
Property
Property is any physical or intangible entity that is owned by a person or jointly by a group of people or a legal entity like a corporation...
basis or otherwise ahead of general claims against the company.
Unsecured debt comprises financial obligations, where creditors do not have recourse to the assets of the borrower to satisfy their claims.
Private debt comprises bank-loan type obligations, whether senior or mezzanine
Mezzanine capital
Mezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares...
. 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
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
or "term loan" is the simplest form of debt. It consists of an agreement to lend a fixed amount of money, called the , for a fixed period of time
Time
Time is a part of the measuring system used to sequence events, to compare the durations of events and the intervals between them, and to quantify rates of change such as the motions of objects....
, with this amount to be repaid by a certain date. In commercial loans interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
, 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 loan
Bullet loan
In banking and finance, a bullet loan is a loan where a payment of the entire principal of the loan, and sometimes the principal and interest, is due at the end of the loan term. Likewise for bullet bond...
s, 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
Day count convention
In finance, a day count convention determines how interest accrues over time for a variety of investments, including bonds, notes, loans, mortgages, medium-term notes, swaps, and forward rate agreements . This determines the amount transferred on interest payment dates, and also the calculation of...
for some – while a standard convention is the annual percentage rate
Annual percentage rate
The term annual percentage rate , also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year , rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual 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
Point (mortgage)
Points, sometimes also called a "discount point", are a form of pre-paid interest. One point equals one percent of the loan amount. By charging a borrower points, a lender effectively increases the yield on the loan above the amount of the stated interest rate...
), 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.
Rather than the entire principal amount of the loan being due at the end of the loan, the principal may be slowly repaid or "amortized" over the course of the loan – see amortizing loan
Amortizing loan
In banking and finance, an amortizing loan is a loan where the principal of the loan is paid down over the life of the loan, according to some amortization schedule, typically through equal payments....
. This is particularly common in mortgage
Mortgage
A mortgage is a security interest in real property held by a lender as a security for a debt, usually a loan of money. A mortgage in itself is not a debt, it is the lender's security for a debt...
s and in the minimum payment on credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
s.
A syndicated loan
Syndicated loan
A syndicated loan is one that 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....
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. Loan syndication is a risk management tool that allows the lead banks underwriting
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
the debt to reduce their risk and free up lending capacity.
A bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
is a debt security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
issued by certain institutions such as companies and government
Government
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
s. A bond entitles the holder to repayment of the principal sum, plus interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
. Bonds are issued to investors
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
in a marketplace
Marketplace
A marketplace is the space, actual, virtual or metaphorical, in which a market operates. The term is also used in a trademark law context to denote the actual consumer environment, ie. the 'real world' in which products and services are provided and consumed.-Marketplaces and street markets:A...
when an institution wishes to borrow money. Bonds have a fixed lifetime, usually a number of year
Year
A year is the orbital period of the Earth moving around the Sun. For an observer on Earth, this corresponds to the period it takes the Sun to complete one course throughout the zodiac along the ecliptic....
s; 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
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
) during the life of the bond. Bonds may be traded in the bond market
Bond market
The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and...
s, and are widely used as relatively safe investments in comparison to equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
.
Debt syndication
A syndicated loan is one that 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.Non Fund Base
Letter of Credit:The 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
Advising bank
An advising bank advises a beneficiary that a letter of credit opened by an issuing bank for an applicant is available. Advising Bank's responsibility is to authenticate the letter of credit issued by the issuer to avoid fraud...
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.
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 has a high consumer debt and a low public debt, while in eastern 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-sheetOff-balance-sheet
Off-balance sheet usually means an asset or debt or financing activity not on the company's balance sheet.Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients...
given the company's exposure to losses on this interest.
Debt, inflation and the exchange rate
As noted below, debt is normally denominated in a particular monetary currencyCurrency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
, and so changes in the valuation of that currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
can change the effective size of the debt. This can happen due to inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
or deflation
Deflation (economics)
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% . This should not be confused with disinflation, a slow-down in the inflation rate...
, so it can happen even though the borrower and the lender are using the same currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
. 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
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
denominated" debt.
The form of debt involved in banking accounts for a large proportion of the money in most industrialised nations (see money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
, broad money
Broad money
In economics, broad money is a measure of the money supply that includes more than just physical money such as currency and coins . It generally includes demand deposits at commercial banks, and any monies held in easily accessible accounts...
, and demand deposit
Demand deposit
Demand deposits, bank money or scriptural money are funds held in demand deposit accounts in commercial banks. These account balances are usually considered money and form the greater part of the money supply of a country.-History:...
s for a discussion of this). There is therefore a relationship between inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
, deflation
Deflation (economics)
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% . This should not be confused with disinflation, a slow-down in the inflation rate...
, the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
, and debt. The store of value
Store of value
A recognized form of exchange can be a form of money or currency, a commodity like gold, or financial capital. To act as a store of value, these forms must be able to be saved and retrieved at a later time, and be predictably useful when retrieved....
represented by the entire economy of the industrialized nation, 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 bondInflation-indexed bond
Inflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780...
s, 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
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
– 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.
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 rateRisk-free interest rate
Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time....
". 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
Treasury security
A United States Treasury security is government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States federal government, and they are often referred to simply as Treasuries...
- 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 or her 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
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
is an organisation of central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
s 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'sMoody's
Moody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...
, Fitch Ratings Inc., A. M. Best and Standard & Poor's
Standard & Poor's
Standard & Poor's is a United States-based financial services company. It is a division of The McGraw-Hill Companies that publishes financial research and analysis on stocks and bonds. It is well known for its stock-market indices, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian...
. 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
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
. 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
Munich Re
Munich Re Group is a reinsurance company based in Munich, Germany. It is one of the world’s leading reinsurers. ERGO, a Munich Re subsidiary, is the Group’s primary insurance arm....
, for example, currently is rated Aa3 . 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
Refinancing
Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic factors such as, inherent risk, projected risk, political...
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
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
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 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 – see debt reliefDebt relief
Debt relief is the partial or total forgiveness of debt, or the slowing or stopping of debt growth, owed by individuals, corporations, or nations. From antiquity through the 19th century, it refers to domestic debts, in particular agricultural debts and freeing of debt slaves...
. An example is the Biblical Jubilee year
Jubilee (Biblical)
The Jubilee year is the year at the end of seven cycles of Sabbatical years , and according to Biblical regulations had a special impact on the ownership and management of land in the territory of the kingdoms of Israel and of Judah; there is some debate whether it was the 49th year The Jubilee...
, described in the Book of Leviticus.
Under English law
English law
English law is the legal system of England and Wales, and is the basis of common law legal systems used in most Commonwealth countries and the United States except Louisiana...
, when the creditor is deceived into relinquishing the debt, this is a crime
Crime
Crime is the breach of rules or laws for which some governing authority can ultimately prescribe a conviction...
: see Theft Act 1978
Theft Act 1978
The Theft Act 1978 is an Act of the Parliament of the United Kingdom. It supplemented the earlier deception offences contained in sections 15 and 16 of the Theft Act 1968 by reforming some aspects of those offences and adding new provisions...
.
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 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 investmentInvestment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
made in their asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s, "leveraging" the return on their equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
. This leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
, 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
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
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
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
followed. Deflation
Deflation (economics)
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% . This should not be confused with disinflation, a slow-down in the inflation rate...
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
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
and investment. The reduction in demand reduced business activity and caused further unemployment. In a more direct sense, more bankruptcies
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
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
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
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. IslamIslam
Islam . The most common are and . : Arabic pronunciation varies regionally. The first vowel ranges from ~~. The second vowel ranges from ~~~...
forbids
Islamic banking
Islamic banking is banking or banking activity that is consistent with the principles of Islamic law and its practical application through the development of Islamic economics. Sharia prohibits the fixed or floating payment or acceptance of specific interest or fees for loans of money...
lending with interest even today, while the Catholic Church allowed it from 1822 onwards, and the Torah
Torah
Torah- A scroll containing the first five books of the BibleThe Torah , is name given by Jews to the first five books of the bible—Genesis , Exodus , Leviticus , Numbers and Deuteronomy Torah- A scroll containing the first five books of the BibleThe Torah , is name given by Jews to the first five...
states that all debts should be erased every 7 years and every 50 years (in the Jubilee year
Jubilee (Biblical)
The Jubilee year is the year at the end of seven cycles of Sabbatical years , and according to Biblical regulations had a special impact on the ownership and management of land in the territory of the kingdoms of Israel and of Judah; there is some debate whether it was the 49th year The Jubilee...
, as described in the Book of Leviticus).
Debt will increase through time if it is not repaid faster than it grows through interest. This effect may be termed usury
Usury
Usury Originally, when the charging of interest was still banned by Christian churches, usury simply meant the charging of interest at any rate . In countries where the charging of interest became acceptable, the term came to be used for interest above the rate allowed by law...
, while the term "usury" in other contexts refers only to an excessive rate of interest, in excess of a reasonable profit for the risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
accepted.
In international legal thought, Odious debt
Odious debt
In international law, odious debt is a legal theory that holds that the national debt incurred by a regime for purposes that do not serve the best interests of the nation, should not be enforceable. Such debts are, thus, considered by this doctrine to be personal debts of the regime that incurred...
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.
In an economy with high interest rates, debt will be more costly to a business than more flexible dividends on equity investment. It may be easier for a struggling business to be financed through equity investment as it may be possible to avoid paying a dividend if times are hard.
At the household level, debts can also have detrimental effects. In particular when households make spending decisions assuming income to remain the same -or increase- for the years to come. When households take-on credits 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 health (physical and mental), family stress, stigma, barriers to 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.
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.See also
- Derivative (finance)Derivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
- Debt bondageDebt bondageDebt bondage is when a person pledges him or herself against a loan. In debt bondage, the services required to repay the debt may be undefined, and the services' duration may be undefined...
- Debtors' prison
- DissavingDissavingDissaving is negative saving. If spending is greater than income, dissaving is taking place. This spending is financed by already accumulated savings, such as money in a savings account, or it can be borrowed....
- Financial marketFinancial marketIn economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
s - List of finance topics
- Odious debtOdious debtIn international law, odious debt is a legal theory that holds that the national debt incurred by a regime for purposes that do not serve the best interests of the nation, should not be enforceable. Such debts are, thus, considered by this doctrine to be personal debts of the regime that incurred...
- Revolving accountRevolving accountA revolving account is an account created by a lender to represent debts where the outstanding balance does not have to be paid in full every month by the borrower to the lender. The borrower may be required to make a minimum payment, based on the balance amount. The most common example of a...
- Saving
- EquityStockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
- Time value of moneyTime value of moneyThe time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....
- Thomson Financial League Tables