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Decoding the financial crisis: How does the overhang of debt affect the global economy?
Today's world financial system faces multiple challenges, among which the issue of debt overhang is of particular concern. This phenomenon occurs when an organization (such as a business, government, or household) faces so much debt that it cannot easily borrow more money, even if the new borrowing would be a desirable investment. In this case, even if the net present value (NPV) of the investment is positive, it will be difficult for the company to seize the opportunity because existing shareholders may not benefit and lenders will be unable to provide funds due to concerns about project failure.
Debt overhangs can affect the normal operations of companies or banks and prevent them from making ideal investments.
The operating mechanism of debt ceiling
The core problem with debt overhang is that existing creditors keep part of the earnings generated, which makes companies facing too much debt reluctant to make new investments. Typically, when a company faces this kind of debt problem, it cannot issue new subordinated debt because the risk of default is too high. In addition, shareholders are reluctant to issue new shares because it would mean they would have to bear a portion of the losses that would otherwise be borne by subordinated creditors.
Businesses refuse to fund projects with positive NPV, resulting in a vicious cycle of capital liquidity.
Debt overhang and bankruptcy restructuring
Bankruptcy reorganization (such as Chapter 11 bankruptcy law in the United States) can solve the debt overhang problem of some companies. This restructuring allows companies to reduce debt levels and new shareholders to share in the proceeds from new investments, thereby facilitating new projects. However, it also means acknowledging the previous financial situation, which is an extremely challenging process for institutions that are already unable to repay their debts.
The debt crisis facing the world
With the outbreak of the financial crisis in 2007-2008, the problem of overhanging debt became increasingly apparent. Many governments have chosen to inject capital into banks to ease liquidity constraints. Still, these capital infusions often consist of simply purchasing newly issued preferred stock, which does little to solve debt problems. Studies show that the debt overhang problem may be better improved if the government can purchase common stocks or distressed assets.
Many banks were not keen on increasing lending after receiving capital infusions, resulting in funds not flowing into the market as expected.
Conclusion
Overall, the debt overhang problem not only affects individual companies, but may also cause widespread knock-on effects on the national and global economies. This makes it imperative for policymakers to find effective solutions to prevent future financial crises. How will the future economic landscape change as the debt overhang is resolved or worsened?
