Debt overhang
Debt overhang is the condition of an organization (for example, a business, government, or family) that has existing debt so great that it cannot easily borrow more money, even when that new borrowing is actually a good investment that would more than pay for itself.
This problem emerges, for example, if a company has a new investment project with positive net present value (NPV), but cannot capture the investment opportunity due to an existing debt position, i.e., the face value of the existing debt is bigger than the expected payoff. Hence, the equity holders will be reluctant to invest in such a project because most of the benefits will be reaped by the debt holders. In addition, debt holders will not finance the firm if the company cannot convince the debt holders that the project will not fail.
The situation emerges if existing debtholders of a company can be expected to lay claim to (part of) the profits of the new project, and this renders the NPV of the project (when undertaken by this company) negative.
Overview
The result of having excessive debt is that any earnings generated by new investment projects are partially appropriated by existing debt holders. A firm facing debt overhang cannot issue new junior debt because default is likely. Moreover, more debt will make the problems of debt overhang worse not better. In addition, the firm's shareholders do not want to issue new stock because this forces shareholders to bear some of the losses that would have been borne by junior creditors. Thus, the firm refuses to fund projects with a positive NPV. This problem was first discussed by Myers (1977).
Debt overhang can affect firms or banks that have excessive amounts of debt, but are
The concept of debt overhang has been applied to sovereign governments, predominantly in
Debt overhang and the financial crisis of 2007–2008
The problem of debt overhang was used as a justification by governments to inject capital into banks around the world after the collapse of
Structural macroeconomic debt overhang
This occurs if there is a latent output gap or underemployment in an economy, which is bridged repeatedly by
See also
- Capital structure
- Corporate finance
- Credit creation
- Debt-trap diplomacy
- Default logic
- Default trap
- Economic colonialism
- Poverty trap
- Terminal debt
- Balance sheet recession
References
- ^ "Debt Overhang". Investopedia ULC. August 2007. Retrieved 2007-08-10.
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- ^ McIntire, Mike (2009-01-17). "Bailout Is a Windfall to Banks, if Not to Borrowers". New York Times. Retrieved 2009-01-20.
- ^ Accountability for the Troubled Asset Relief Program: The Second Report of the Congressional Oversight Panel January 9, 2009. "Archived copy" (PDF). Archived from the original (PDF) on 2011-01-06. Retrieved 2013-11-04.
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: CS1 maint: archived copy as title (link) Downloaded January 20, 2009.
Further reading
- Krugman, Paul R. (1988). "Market-Based Debt-Reduction Schemes". NBER Working Paper No. W2587. SSRN 238157.
- Myers, S. (1977). "Determinants of Corporate Borrowing". .