ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel
  • »
  • Education and Science»
  • Economics

Understanding Financial Debt

Updated on September 7, 2009

Businesses, individuals, and governments raise funds from each other and at the same time they transfer surplus funds to each other. Individuals and governments can raise funds from others only by borrowing. Businesses may obtain funds by the sale of ownership (stocks or direct participation investments), but they prefer to borrow part of their additional requirements so as not to dilute their control or to share their profits. Many savers do not care to bear the risks involved in ownership, but by lending they obtain a preferred claim on the income and assets of a business.

In a complex society, borrowers rarely come into direct contact with lenders. Rather, the funds flow through financial middlemen, including commercial and mutual savings banks, savings and loan associations, insurance companies, and pension funds. These intermediaries find uses for the funds that enable them to pay an agreed return to the savers, return the principal as requested, and, except for government-operated trust funds, to yield some profit above the costs of the operations.

These objectives, along with certain legal restrictions, direct the nature of the types of loans and investments that may be made by institutional lenders. The types of loans and investments available are determined in turn by the needs of the borrowers as they offer their debts to obtain current funds. Thus the credit standards of lenders as well as the needs of borrowers determine through what instruments and channels credit is made available. Sometimes lenders speak of evaluating a borrower's position in terms of the "Cā€™s of credit": Does the borrower have character, capacity, and collateral (or capital)? In addition to ultimate repayment, the lenders are interested in the return on and the liquidity or saleability of debt holdings before maturity.

Varying Terms

The main characteristic of borrowing is "to owe money", but it must be emphasized that the terms of debt vary considerably. Interest, the charge for the use of funds, may be due on a monthly or semimonthly basis, or it may not be due until maturity. The repayment of principal (the original amount borrowed) may be due on demand by the lender (call loans) or as far in the future as 50 years or more (bonds) and may be made as a single sum or in periodic partial payments (installment or amortized loans). Depending on the credit standing and reputation of the borrower, the loan may be unsecured (debentures), secured by the assignment of specific assets as collateral (mortgages), or secured by specific collateral and also guaranteed by another party.

In some cases the loan must be held to maturity by the original lender (nonmarketable); in others it may be salable to other lenders (negotiable and transferable). In some cases the loan may be repaid before maturity at the discretion of the borrowers (callable); in others the loan may not be called for repayment before maturity.

Interest Rates

The rates charged the different borrowers likewise differ significantly from one another, but they tend to display a more or less stable pattern of differentials reflecting for the most part the different risks, the time period, and the service and collection expense of the loans. Since 1929 the rates for short issues have generally run below rates for long issues, reflecting the greater stability in the price of short issues. Rates on the "riskless" federal issues have run below rates on the highest-grade corporate issues.

High-grade state and local government issues generally have sold at rates below comparable taxable federal issues. The differential reflects the tax exemption advantage (since 1941, when tax exemption was prohibited on all future federal taxable issues) that the municipals provide to investors paying the high federal tax rates effective on income in the upper brackets.

Consumer loans usually pay the highest rate on borrowings (12% or more), reflecting the higher cost of servicing these loans and the relative "newness" of this type of borrowing. Differences in costs account for the fact that the average rate charged on smaller commercial loans is higher than that charged on large loans, although to some extent the difference reflects the better credit risk and bargaining strength of the borrower usually present in large loans.

Over a period of time, the level of the rates as well as the differentials tend to shift with changes not only in the condition of the money market and the relative supply and demand situation of the different types, but also with changes in the institutional framework of the national economy. When interest rates rise, the market price of existing issues falls and vice versa.

Gross versus Net Borrowing

Despite the repayment and retirement of debt as it matures or is amortized, the outstanding volume of debt need not decline. Rather, as has happened in most years, it will increase if, at the same time, some borrowers are obtaining new and larger loans. Generally as the old loans mature or are paid off, lenders are interested in making new loans to the original borrower or to some other borrower so they may keep their funds working.

Sociolegal Basis of Debt

The credit system is so well developed that the acceptance of debt as a suitable means of financing and investing generally is taken for granted. But it was not very long ago that the money supply consisted of metallic coins, which were accepted as a medium of exchange mainly because they had intrinsic value as commodities. Borrowing was undertaken usually to cover dire emergencies and to finance the growing needs of the ruling groups. The debtors' jail was a dreaded institution as recently as the early 19th century. In even earlier periods lending was frowned on, and "taking a return" was prohibited and held to be usury. Now debt is commonplace.

The widespread use of debt as an instrument of external financing and investing has been possible because three basic conditions have prevailed: (1) There is a disposition on the part of the members of the community to meet their obligations. (2) There is a well-developed legal system and enforcing machinery to protect property rights. (3) The standard of deferred payments (money) is reasonably stable in purchasing power. Without these three elements the credit system would be stifled. There must be confidence that the payment will be made and that it will be equitable. The basic essential for a credit system is a climate of faith in money and promises to pay.

Debt and Wealth

The importance of debt in the savings process is revealed by a study of its status in wealth at the start of the 1960's. In the U.S., for example, 55% of the financial assets held by individuals as personal savings (excluding homes and automobiles) normally consists of debt of others (obtained directly or indirectly through banks or financial intermediaries). Roughly half the physical investment assets (homes and automobiles) are purchased on a net basis with funds obtained by borrowing. Similarly, more than one quarter of die corporate assets consists of debt of others (as shown by corporate holdings of cash, U.S. government issues, and notes receivable), while about 40% of total corporate assets is obtained by borrowing.

Debt and Production

A fairly close relationship exists in the United States between the volume of borrowing and the value of the Gross National Product (GNP). As GNP has risen, savings also have risen and made more funds available for borrowing. As a result, the amount of debt has been maintained in most years at nearly double the level of GNP. The dollar change from year to year in debt has been equivalent, on the average, to about 10% of the value of GNP. The transfer of funds, however, has been much greater than indicated by this 10% figure, which reflects only the amount by which new loans exceed retirements.

In years of prosperity and inflation, the rate of debt growth has climbed above this long-term trend, and in years of recession or depression it has fallen below. Apparently, as the United States grows, it spends, saves, and borrows more, but in some years it borrows and spends too much in terms of capacity and in other years it borrows and spends too little. The net change in debt understates the importance of debt to specific areas of production that rely on the gross amount of new loans; on the other hand it overstates the importance of debt because it includes borrowings to buy existing assets.

Debt and the Money Supply

Debt performs its major role in its dual capacity as an instrument of financing to debtors and as an instrument of investing to creditors. But it also plays another role in its position as the base on which additional purchasing power is created. Over a period of time, debt has been substituted for gold and silver as the basis of the money supply. Now the money supply consists largely of bank liabilities in the form of notes and checking accounts. The money supply increases as banks substitute their debts for the debts of borrowers. In the process they provide a type of debt more acceptable in payment by others.

Understanding Business Debt

Business expenditures may be financed by using the original contributions of the owners, by saving part of current earnings, and by going to outsiders for more funds, or by a combination of these methods. Corporations, the dominant form of business organization in the economy, account for about three quarters of business borrowing, or about 36% of all borrowing. External sources provide somewhat more than two fifths of the funds obtained by corporations, and of this by far the largest sums are raised by borrowing.

Businesses borrow for different purposes and for different time periods. They borrow on short term (less than one year) generally to cover temporary increases in inventories and other working-capital needs, such as receivables from customers, for taxes, and sometimes in anticipation of more permanent financing. They borrow on long term to expand or to renovate their plant and equipment (factories, warehouses, stores, farms, machinery, and tools), and to cover a permanent rise in their working capital requirements. Business borrowing includes also long-term loans on multifamily residential buildings.

Business managers expect to be able to service their debts out of the higher income anticipated from an enlargement of their earning power as a result of the borrowing. The practice concerning repayment of debts among business borrowers in the United States varies, and even within an individual firm it may vary for the different types of debt. Some pay off their loans, in particular their long-term debt, while others obtain new loans. In many instances, especially sphere short-term trade credit from their suppliers and bank loans are concerned, business borrowers have a line of credit that provides for renewals of borrowings up to a certain maximum.

Understanding Consumer Debt

Consumers borrow mainly on long-term mortgage loans to finance the purchase of their homes. Home buyers in the United States outnumber renters by about 3 to 2. Consumers also need funds for periods of short or intermediate length to finance the purchase of "big ticket" consumer items such as automobiles, furniture, and appliances, and to a small extent for home repairs and modernization. By the use of credit, the high cost of homes and durable goods has been spread over time as the services they perform have been consumed. In a sense, consumer ownership of these assets has eliminated purchases from business suppliers of such services, and in turn consumer loans may be regarded partly as a substitute for the business loans that would have been incurred if business had continued to provide the services directly.

Some funds are needed also by consumers to cover other types of outlays ranging from delayed payments, allowed by charge accounts and by gas, electric, and telephone bills, through a relatively small amount of "financial" loans to make purchases of stock market securities. The severe losses experienced by margin holders of stocks in the crash of 1929, and the institution by Congress in 1934 of controls on this type of credit through the Federal Reserve Board, have limited the use of credit in the purchase of stock market securities.

Comments

    0 of 8192 characters used
    Post Comment

    No comments yet.