Blog
Debt: Betting the balance-sheet
6th July 2010
Why are we drowning in debt? Well, governments have to borrow because they are spending more money than they raise in taxes. Households borrowed to buy houses and splurge on consumer credit. But what about firms? Why did they take on such huge debts? The Economist has a special feature on debt, here’s a summary:
- By the 1980s riskier firms were able to borrow in a way that had been previously difficult. Investors were prepared to lend – at relatively high rates of interest. Put simply, lenders were prepared to take higher risks for higher potential rewards.
- A long period of low interest rates and shallow recessions created an atmosphere in which borrowing seemed far less expensive and risky.
- At the same time the desire for high credit ratings was going out of fashion. Managements that hoarded cash were told to return it to shareholders so it could be invested elsewhere rather than being spent. Spare cash, supported by more borrowing, helped finance what seemed like exciting takeover opportunities.
- A stronger motive for borrowing more may have been executive pay. Many managers are paid in share ‘options’ to some extent. If the share prices rise, executives can turn into multimillionaires. The quickest way to boost a company’s share price, in the short term, is the ability to meet quarterly targets for earnings per share. And borrowing cash to buy back a company’s shares tends to increase earnings per share. As the article points out, chief executives these days come and go almost as quickly as managers of football clubs. A high-risk strategy may pay off in the short term; higher debt levels may sink the company only in the longer term, after the executive has left.
We’re all probably going to have to get used to an era in which debt grows far less rapidly. As governments raise taxes, cut spending and households try to repair their balance sheets, many firms will be hurt – even if they avoided excess debt themselves.
