Debt - Wikipedia, the free encyclopedia http://en.wikipedia.

org/wiki/Debt

Debt
From Wikipedia, the free encyclopedia.

Debt is that which is owed. A person who owes debt is called a debtor. A person to whom it's owed is called a creditor.
Debt is used to borrow purchasing power from the future.

Contents
1 Payment
2 Types of debt
3 Debt, inflation and the exchange rate
3.1 Inflation indexed debt
4 Debt ratings, risk and cancellation
4.1 Risk free interest rate
4.2 Ratings and creditworthiness
4.3 Cancellation
5 Effects of debt
6 Arguments against debt
7 Levels and flows
8 See also
9 External links

Payment
People or organisations often enter into agreements to borrow something. Both parties must agree on some standard of
deferred payment, most usually a sum of money denominated as units of a currency, but sometimes a like good. For
instance, one may borrow shares, in which case, one may pay for them later with the shares, plus a premium for the
borrowing privilege, or the sum of money required to buy them in the market at that time.

Types of debt
There are numerous types of debt obligations. They include loans, bonds, mortgages, promissory notes, and debentures. It
is very common to borrow large sums for major purchases, such as a mortgage, and pay it back with an agreed premium
interest rate over time, or all at once at a later date. The amount of money outstanding is usually called a debt. The debt
will increase through time if it is not repaid faster than it grows. In some systems of economics this effect is termed usury,
in others, the term "usury" refers only to an excessive rate of interest, in excess of a reasonable profit for the risk accepted.

Large organizations can break their debt into many small units of debt, known as bonds. Each bond entitles the holder to
the remaining repayments on that unit of debt. Bonds can be traded during the repayment period, and so ownership of the
debt is seen as a form of investment.

Because bonds are traded on the bond market, they have a fluctuating price. This implies that the overall debt represented
by the total number of any particular type of bond also has a fluctuating price.

Debt, inflation and the exchange rate

As noted above, debt is normally denominated in a particular monetary currency, and so changes in the valuation of that

1 of 4 9/1/2005 7:02 PM
Debt - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Debt

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 gives rise to a large proportion of the money in most industrialised nations (see
money and credit money for a discussion of this). There is therefore a complex relationship between inflation, deflation,
the money supply, and debt. The store of value represented by the entire economy of the industrialized nation itself, 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 bonds, 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 be inflation indexed also.

Debt ratings, risk and cancellation

Risk free interest rate

Main article: 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 rate". This is because the debt and interest are highly unlikely to be defaulted. A
textbook example of such risk-free interest is a government bond of US government - it yields you the minimum return
available in economics, but you get the security of the knowledge that US has never defaulted on its debt instruments. A
risk-free rate is commonly used in setting floating interest rates, floating interest rate is usually calculated as risk-free
interest rate plus a bonus to the creditor based on the creditworthiness of the debtor.

However if the real value of a currency has changed in the meantime, 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 entity that sets rules to define what loans qualify as "risk free" or not. It is a
very powerful institution, formed by the Bretton Woods agreements, which has had a pivotal position in central banking
since 1947 when it opened.

Ratings and creditworthiness

Debt of countries as well as private corporations is rated by rating agencies, s.a. Moody's, A. M. Best and Standard and
Poors. These agencies assess the ability of the debtor to honor his obligations and accordingly give him a credit rating.
Moody's for example 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 (as of 2004). 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 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.

2 of 4 9/1/2005 7:02 PM
Debt - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Debt

Cancellation

Short of bankruptcy, very often debts are wholly or partially forgiven. 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.

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 organisations to do things that they otherwise wouldn't be able or allowed to. 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 investment made in their private equity. This leverage, the
proportion of debt to equity, is considered important in determining the riskiness of an investment; the higher more debt
per equity, the riskier.

The properties of debt have been blamed for exacerbating economic problems. For example, during the onset of the Great
Depression there was deflation, which effectively made debt throughout society grow. This resulted in a contraction of
consumption since the borrowers were on average people who had to consume less due to the increased proportion of their
earnings going towards repayments while the lenders were on average people who would invest their extra purchasing
power. The reduction in consumtion reduced business activity and caused further unemployment. Also in a direct sense,
more bankruptcies occurred due to increased effective debt than otherwise might have been the case.

It is possible for some organisations 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 lender 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.

See: Perils of the debt-propelled economy by Henry C K Liu

http://www.atimes.com/atimes/Global_Economy/DI14Dj01.html

Arguments against debt

Main article: Criticism of debt

There are many arguments against debt as an instrument and institution, on a personal, family, social, corporate and
governmental level. Economics criticism focuses on debt fostering inequality. Religious critics contend the ethical issues
connected with debt, especially the element of luck, while Feminism concentrates on the perceived coercive nature of debt
contracts. Environmental critics point out the disparity between material use of resources from economic growth and the
limited resources of natural production. Examples would be the low ecological yield of natural resources and the limited
usable energy from the sun.

Levels and flows

Main article: debt levels and flows

Global debt underwriting grew 4.3% year-over-year to $5.19 trillion during 2004.

See also
Bond (finance)

3 of 4 9/1/2005 7:02 PM
Debt - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Debt

Credit
Credit repair
Debt consolidation
Default (finance)
Derivative security
Domestic debt
External debt (foreign debt)
Financial market
Global debt
Government debt (public debt)
Interest
List of finance topics
Personal debt (household debt)
Sovereign debt
Triple deficit
Usury
Thomson Financial league tables
Time value of money

External links
OECD country debt (http://www.oecd.org/site/0,2865,en_21571361_31596493_1_1_1_1_1,00.html )

Retrieved from "http://en.wikipedia.org/wiki/Debt"

Categories: Credit | Core issues in ethics

This page was last modified 15:21, 30 August 2005.

All text is available under the terms of the GNU Free Documentation License (see Copyrights for
details).

4 of 4 9/1/2005 7:02 PM