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Debt: The Big Hangover Has Only Just Begun

Whatever the economic indicator—from manufacturing reports to home sales to consumer spending—the message is clear: The U.S. recovery is under way. It will likely be a tepid comeback, but it will still fit economists' definition of a recovery. While most post-World War II recessions have been followed by strong recoveries, economists and business leaders all caution that this time it will be different.

The Great Recession had many causes. Clearly the bursting of the bubble in asset values, particularly U.S. residential real estate, was the main cause of the subprime mortgage crisis and the resultant bust. Those asset valuations did not shoot higher on their own; they were sustained by ever-increasing debt levels that primed the pump and inflated the bubble.

While asset values can evaporate in an instant, the indebtedness assumed to acquire the asset does not. Significant debt can take years and even decades to eradicate. Unless, of course, the debtor goes bankrupt. While filing for Chapter 11 may appear to be a quick solution, it is by no means an easy one. Few debtors are willing to write off their equity unless there is no other alternative.

Whatever the ultimate resolution, the struggle to pay off, refinance, or renegotiate significant debt can be difficult and is always fertile ground for unintended consequences. The challenges for this recovery and indeed for efforts to increase economic growth in the decade ahead will ultimately be whether those consequences are manageable.

Debt Reliance

So how did we get here? For most of the last 25 years, individuals, businesses, and governments abandoned their Depression-era distaste for debt. With a view that only better times were ahead, we all began to rely on ever-increasing indebtedness to fund expenditures large and small. According to data from Morgan Stanley (MS), total U.S. debt—individual, corporate, and government—rose from approximately 150% of GDP in 1980 to more than 350% by the end of 2008. As financial institutions increased their leverage significantly above historic norms and the Federal Reserve opened the spigot to resuscitate the economy following the bursting of the dot-com bubble in the early 2000s, even the weakest borrowers were able to borrow at levels unheard of in prior decades.

As the financial crisis unfolded, central banks around the world used whatever tools available to them to save the economy from a true meltdown. Across the globe, central banks and governments cut interest rates and provided financing where needed. Even as the crisis eased, governments turned their attention to providing economic stimulus and restoring growth. So in no small part, the solution to too much debt has been even more debt.

To fully understand the problem ahead, it is important to recognize that more than $1 trillion of corporate high-yield debt, often called "junk bonds," will come due between now and 2015. High-yield debt is debt securities issued by companies that do not have investment-grade credit ratings—essentially, the riskiest and most highly leveraged businesses. You only get a sense of the true size of the corporate debt burden when you add another trillion dollars of bank and other debt that these companies have to repay or refinance in the next few years.

Financial Squeeze

All of this must take place during a period in which the federal, state, and local governments and international sovereign debtors will all be borrowing ever-increasing sums; prime corporate borrowers will be refinancing hundreds of billions of dollars of their debt in the ordinary course of business; and financial institutions will simply have less lending capacity than they had just a few years ago.

Highly leveraged borrowers often seek to raise equity to pay off debt. Converting debt to equity is a sound solution if you can achieve it. For some companies, those that are particularly highly leveraged or that operate in the hardest-hit sectors, equity infusions will neither be available nor sufficient to avert more drastic measures. Most highly leveraged companies will need to sell assets or business units to survive. Some will not survive and will have no choice but to be acquired or seek bankruptcy protection.

Strong, well-capitalized companies will no doubt take advantage as their more highly leveraged rivals struggle. In theory at least, this is the way market capitalism is supposed to work. However, given the sheer scale of this problem, it will not simply affect a handful of companies. Rather, it will have a pervasive, negative impact on the economy, job creation, and long­term economic growth. Massive equity injections or restructurings or asset sales will be required not to grow these businesses, but to simply keep them alive. The strongest companies will emerge stronger, but many companies will simply disappear, at least in their current form.

As we move beyond the initial stages of the recovery we are likely to see many changes in the way companies, even those that are relatively financially healthy, manage their capital structures. Returning capital to shareholders, whether through share buybacks or dividends, will likely decrease in importance for all but the strongest companies. Corporate treasurers will be studying the intricacies of balance-sheet-boosting actions such as debt-for-equity swaps, sale­leaseback transactions, and convertible debt and equity offerings.

Painful Deleveraging

Similarly, boards of directors will be seeking to understand their fiduciary duties when approaching the "zone of insolvency." Whether they ultimately file for Chapter 11 or not, they will certainly bone up on the finer points of the bankruptcy code.

Ironically, the sovereign debt worries that have surfaced in Dubai and Greece may lead some investors to conclude that the better-capitalized corporate debtors may actually be much safer long-term risks than certain sovereign borrowers. That is a discussion for another day.

Most optimistic economic forecasts indicate that the global economy will grow slowly during 2010, with pessimists predicting challenging economic conditions for years to come. However robust the rebound, the global economy will take several years to fully recover. The global debt burden is indeed heavy and will be a drag on near-term economic growth. Deleveraging will be a painful and difficult process.

While political leaders will likely press central banks and financial institutions to lend more to stimulate job creation and economic growth, it is easy to see that such actions would likely create yet another, even larger bubble. Having barely survived the bursting of the housing bubble, the bursting of an even larger bubble is one prospect we should avoid at all costs.

Aquila is a partner in the Mergers & Acquisitions Group of Sullivan & Cromwell LLP.

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