Discussion Area Discussion Area

What is debt hangover?What is debt hangover? Concepts with Explanation Concepts with Explanation

( Examples)( Examples) The debt hangover and its impact The debt hangover and its impact

on debt marketon debt market How to avoid/strategies to avoid How to avoid/strategies to avoid

debt hangover problemsdebt hangover problems ConclusionConclusion

What is debt hangover?What is debt hangover? A situation where agents (firms, governments, A situation where agents (firms, governments,

individuals) hold too much debt holding back individuals) hold too much debt holding back normal economic activity.normal economic activity.

Debt overhang occurs when the interest burden Debt overhang occurs when the interest burden of existing debt is greater than the profit the of existing debt is greater than the profit the firm can generate from its core business. Debt firm can generate from its core business. Debt overhang was a situation faced by many banks overhang was a situation faced by many banks during credit crisis.during credit crisis.

the condition of an organization (for example, a the condition of an organization (for example, a business, government, or family) that has business, government, or family) that has existing debt so great that it cannot easily existing debt so great that it cannot easily borrow more money, even when that new borrow more money, even when that new borrowing is actually a good investment that borrowing is actually a good investment that would more than pay for itself.would more than pay for itself.

Explanation Explanation A debt burden that is so large that an A debt burden that is so large that an entity cannot take on additional debt to entity cannot take on additional debt to finance future projects, even those that finance future projects, even those that are profitable enough to enable it to are profitable enough to enable it to reduce its indebtedness over time. reduce its indebtedness over time.

Debt overhang serves to avoid current Debt overhang serves to avoid current investment, since all earnings from new investment, since all earnings from new projects would only go to existing debt projects would only go to existing debt holders, leaving little incentive for the holders, leaving little incentive for the entity to attempt to dig itself out of the entity to attempt to dig itself out of the hole. In the context of sovereign hole. In the context of sovereign governments, the term refers to a governments, the term refers to a situation where the debt stock of a situation where the debt stock of a nation exceeds its future capacity to nation exceeds its future capacity to repay it. repay it. 

Problems with debt Problems with debt hangoverhangover

Debt imposes the cost of debt Debt imposes the cost of debt interest repayments. A high level of interest repayments. A high level of debt increases the cost of servicing debt increases the cost of servicing debt. If this cost of paying debt debt. If this cost of paying debt interest payments is too high then interest payments is too high then firms may be unwilling to invest and firms may be unwilling to invest and individuals reluctant to spend - individuals reluctant to spend - governments may have to increase governments may have to increase tax. Thus debt can be a restriction to tax. Thus debt can be a restriction to economic recovery.economic recovery.

A further problem is when debt A further problem is when debt interest payments are so high, firms interest payments are so high, firms or individuals lose hope of ever or individuals lose hope of ever getting on top of their debts so are getting on top of their debts so are encouraged to default on debt.encouraged to default on debt.

ExamplesExamples

MF Global (john corzine CEO)MF Global (john corzine CEO) MF Global made a $6.3 billion investment on its MF Global made a $6.3 billion investment on its

own behalf in bonds of some of Europe’s most own behalf in bonds of some of Europe’s most indebted nations. Failure of those, and other, indebted nations. Failure of those, and other, repo positions contributed to the massive repo positions contributed to the massive liquidity crisis at the firm.  MF could not repay  at the firm.  MF could not repay these monies with its own funds. According the these monies with its own funds. According the New York Times, "MF Global dipped again and New York Times, "MF Global dipped again and again into customer funds to meet the demands", again into customer funds to meet the demands", perhaps beginning as early as August 2011.perhaps beginning as early as August 2011. MF MF Global declared bankruptcy on October 31, 2011, Global declared bankruptcy on October 31, 2011, and faced liquidation beginning in November and faced liquidation beginning in November 2011.2011.

Lehman BrothersLehman Brothers

CDO’s overcast, didn't pay CDO’s overcast, didn't pay interest on debt,interest on debt,

Due to over burden of liabilities Due to over burden of liabilities debt hangoverdebt hangover

Its bank volume of $600 billion Its bank volume of $600 billion was greater than the countries was greater than the countries budget volumebudget volume

That’s y , they couldn't borrow That’s y , they couldn't borrow further money to save its further money to save its position.position.

Debt overhangs & debt Debt overhangs & debt HangoverHangover

Economists have a special word for this type of Economists have a special word for this type of problem – a debt overhang. Its economic effects are problem – a debt overhang. Its economic effects are fairly well understood. Debt operates rather like a fairly well understood. Debt operates rather like a tax. Debt servicing costs, like a tax, reduce the tax. Debt servicing costs, like a tax, reduce the disposable income of the borrower. Too much debt disposable income of the borrower. Too much debt means a higher debt “tax” and a greater drag on means a higher debt “tax” and a greater drag on activity – lower lending by banks and spending by activity – lower lending by banks and spending by households and companies. Debt and taxes also affect households and companies. Debt and taxes also affect incentives. incentives.

These effects are often captured in a relationship These effects are often captured in a relationship called the Laffer curve. Higher tax rates may boost called the Laffer curve. Higher tax rates may boost tax revenues, but only up to a point.tax revenues, but only up to a point.

In that event, both the taxpayer and the tax collector In that event, both the taxpayer and the tax collector are worse off. The same applies to debt.are worse off. The same applies to debt.

Debt Laffer CurveDebt Laffer Curvethis curve shows the relationship between tax rates and tax this curve shows the relationship between tax rates and tax revenue collected by governments.revenue collected by governments.

The curve suggests that, as taxes increase from low levels, tax The curve suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows revenue collected by the government also increases. It also shows that tax rates increasing after a certain point (T*) would cause that tax rates increasing after a certain point (T*) would cause people not to work as hard or not at all, thereby reducing tax people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates reached 100% (the far right of the revenue. Eventually, if tax rates reached 100% (the far right of the curve), then all people would choose not to work because curve), then all people would choose not to work because everything they earned would go to the government.everything they earned would go to the government.

Impacts on EconomyImpacts on Economy

The government and cities would be The government and cities would be forced into bankruptcy.forced into bankruptcy.

Ultimately, a deflationary period would Ultimately, a deflationary period would begin.begin.

Falling consumer confidence would slow Falling consumer confidence would slow down the economydown the economy

An unpleasant rise in interest won't An unpleasant rise in interest won't make its paymentsmake its payments

Countries towns rates and decreasing Countries towns rates and decreasing government servicesgovernment services

Higher taxes in the countriesHigher taxes in the countries A loss of entrepreneurship and A loss of entrepreneurship and

countries brain draincountries brain drain Longer-term high unemployment in the Longer-term high unemployment in the

countrycountry

Nature of the debt hangover crisis

The central problem of capitalist economic system is:

The problem of overproduction/under-consumption

Increasing unemployment and underemployment

Decline in real wages and rise in super-profits

The mortgage and credit card debt Speculative corporate financial activities Increased of wealth and income

How Did All This Happen?According to Prof. Richard D. Wolff Department of Economics, University of Massachusetts at Amherst Richard D. Wolff, “Capitalism Hits the Fan,” in Gerald Friedman et al. (eds.), The Economic Crisis Reader (Boston:

Dollars & Sense, 2009).

workers experience a rising level of wages This came to an end; real wages stopped

rising and they have never resumed since Workers became more productive, but got

paid the same; wages began to decline The gap between labor and capital grew

bigger

The large corporations made huge profits and had much money at their disposal

They bought other corporations (mergers and acquisitions) and they put their money into banks

The banks loaned that money (with interest) to workers who didn’t have money to consume

This was done to raise their purchasing power because their wages weren’t enough to buy things

Then What? No longer raised workers’ wages, the

workers had to go into debt to survive Debt went up and up and things got

out of control The banks continued to loan money

through new loans (secondary mortgages) at high interest rates, and this would be a profit bonanza for the banks As corporations increasingly began to

invest abroad (outsourcing production and services), workers lost their jobs, and this led to greater unemployment and underemployment

Unemployed workers with a lot of debt would unable to make their mortgage and credit card payments, and this led to foreclosures and bankruptcies

This, in turn, led to the collapse of the banking system, necessitating a government bailout of the banks.

Debts Hangover

Which Way Out of the Debt Hangover Crisis? Economic must work remain within the

frameworks or budgets. Changes that are required to

redistribution of wealth and income to increase mass consumption

This would increase demand for consumer goods, hence increase production, and create jobs for the unemployed, as well as raising revenue for the state through corporate and individual income taxes

All these would require a restructuring of the economy

For corporations or For corporations or businessbusiness

Expert CounselingExpert Counseling Tax CoverTax Cover Restructuring debt Restructuring debt Reschedule debtReschedule debt Retrenchment / Resizing business Retrenchment / Resizing business Sale out business Sale out business

Preventing Tomorrow’s Preventing Tomorrow’s Debt HangoverDebt Hangover

Regulatory policyRegulatory policy Fluctuations in the credit cycle Fluctuations in the credit cycle

(increase liquidation)(increase liquidation) A better-designed debt contractA better-designed debt contract

But, who listens ?