Debt overhang
Encyclopedia
Debt overhang is when an organization (for example, a business, government, or family) 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
Net present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...

 (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 to debt holders. Thus, debt holders will not finance the firm.

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.

Likewise, a family refinancing on a house in negative equity
Negative equity
Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan. In the United States, assets with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".People...

 might have reduced payments to an affordable level, allowing them to eventually pay off the house, but would be rejected by banks because the collateral is less than the amount borrowed.

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 solvent
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...

, in the sense that the value of their assets exceeds the value of their liabilities. Debt overhang also prevents firms that are insolvent, with assets worth less than their liabilities from recovering from their troubles. Bankruptcy
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....

 which takes the form of Chapter 11 reorganization or receivership
Receivership
In law, receivership is the situation in which an institution or enterprise is being held by a receiver, a person "placed in the custodial responsibility for the property of others, including tangible and intangible assets and rights." The receivership remedy is an equitable remedy that emerged in...

, for banks, can cure the problems of debt overhang for insolvent institutions. Successful bankruptcy reorganizations allow organizations to reduce their debt levels and allow new private shareholders to bear enough of the gains from new investments that they will pursue new projects that have positive expected net present value
Net present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...

.

The concept of debt overhang has been applied to sovereign governments, predominantly in developing countries (Krugman, 1988). It describes a situation where the debt of a country exceeds its future capacity to pay it. Debt overhang in developing countries was the motivation for the successful Jubilee 2000
Jubilee 2000
Jubilee 2000 was an international coalition movement in over 40 countries that called for cancellation of third world debt by the year 2000. This movement coincided with the Great Jubilee, the celebration of the year 2000 in the Catholic Church...

 campaign.

Debt overhang and the financial crisis of 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 Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...

 in September 2008 and the subsequent falls in stock markets worldwide. Nevertheless, many governments in the financial crisis of 2008, including the United States, primarily bought newly issued preferred stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...

. Preferred stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...

 is similar to debt in that it gets paid before common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...

; it also pays regular dividends that are similar to interest. Thus, the capital infusions of Troubled Assets Relief Program
Troubled Assets Relief Program
The Troubled Asset Relief Program is a program of the United States government to purchase assets and equity from financial institutions to strengthen its financial sector that was signed into law by U.S. President George W. Bush on October 3, 2008...

's Capital Purchase Program
Capital Purchase Program
The Capital Purchase Program or CPP is a preferred stock and equity warrant purchase program conducted by the US Treasury's Office of Financial Stability as part of Troubled Assets Relief Program...

 (TARP CPP) in the United States may have done little to cure debt overhang problems in the United States largest banks. Academic research suggests that if the government bought common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...

 or toxic assets in troubled banks that the debt overhang problem would be better corrected. Nevertheless, if a bank is very insolvent, subsidies will have to be extremely large to correct the problems of debt overhang and unsecured debt
Unsecured debt
In finance, unsecured debt refers to any type of debt or general obligation that is not collateralised by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment....

 and preferred stock holders may have to bear some losses. Interviews with many bank executives found that many banks were not eager to increase lending after receiving TARP funds. The Congressional Review Panel, created to oversee the TARP, concluded on January 9, 2009 that, "Although half the money has not yet been received by the banks, hundreds of billions of dollars have been injected into the marketplace with no demonstrable effects on lending."

Structural macroeconomic debt overhang

This occurs if there is a latent output gap or underemployment in an economy, which is bridged repeatedly by credit creation, the build up of which results in a debt overhang. Conversely, you may deduce from a long term tendency to build up debt the existence of latent structural underemployment. Typically private lenders (banks) boldly venture forth: whether they lend to developing countries like in the 1970s, covered by the expected stream of high future coupons, or excessive consumption of their own folk covered by higher paper valuations of assets, it is the same basic story. In the eventual shakeout (due yet again, in the last instance, to latent underemployment), the debt overhang is preserved by substituting public debt for private debt (bailouts), and—keeps growing.

Further reading

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