Debt Re Structuring

What Is Debt Restructuring?

Debt restructuring is a process used by companies to avoid the risk of default on existing debt or to take advantage of lower available interest rates. Debt restructuring can be carried out by individuals on the brink of insolvency as well, and by countries that are heading for default on sovereign debt.

Key Takeaways

The debt restructuring process can be carried out by reducing the interest rates on loans or by extending the dates when a company’s liabilities are due.

A debt restructure might include a debt-for-equity swap, when creditors agree to cancel a portion or all of the outstanding debt in exchange for equity in the company.

A nation seeking to restructure its debt might move its debt from the private sector to public sector institutions.

How Debt Restructuring Works

Some companies seek to restructure debts when they're facing bankruptcy. They might have several loans are structured in such a way that some are subordinate in priority to other loans. The senior debtholders would be paid before the lenders of subordinated debts if the company were to go into bankruptcy. Creditors are sometimes willing to alter these and other terms to avoid dealing with a potential bankruptcy or default.

The debt restructuring process is typically carried out by reducing the interest rates on loans, by extending the dates when the company’s liabilities are due to be paid, or both. These steps improve the firm’s chances of paying back the obligations. Creditors understand that they would receive even less should the company be forced into bankruptcy and/or liquidation.

Restructuring debt can be a win-win for both entities. The business avoids bankruptcy and the lenders typically receive more than what they would through a bankruptcy proceeding.

 Individuals can restructure their debts in various ways as well, but be sure to check the credentials and reputation of any debt relief service you're considering with your state's attorney general or consumer protection agency because not all are reputable.

Types of Debt Restructuring

A debt restructure might also include a debt-for-equity swap. This occurs when creditors agree to cancel a portion or all of their outstanding debts in exchange for equity in the company. The swap is usually a preferred option when the debt and assets in the company are very significant, so forcing it into bankruptcy would not be ideal. The creditors would rather take control of the distressed company as a going concern.

A company seeking to restructure its debt might also renegotiate with its bondholders to "take a haircut"—where a portion of the outstanding interest payments would be written off, or a portion of the principal will not be repaid.

A company will often issue callable bonds to protect itself from a situation in which interest payments cannot be made. A bond with a callable feature can be redeemed early by the issuer in times of decreasing interest rates. This allows the issuer to readily restructure debt in the future because the existing debt can be replaced with new debt at a lower interest rate.

Other Examples of Debt Restructuring

Individuals facing insolvency can renegotiate terms with creditors and tax authorities. For example, an individual who is unable to keep making payments on a $250,000 subprime mortgage might agree with the lending institution to reduce the mortgage to 75%, or $187,500 (75% x $250,000 = $187,500). In return, the lender might receive 40% of the proceeds of the house sale when it's sold by the mortgagor.

Methods

Debt-for-equity swap

In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company.

Debt for equity deals often occur when large companies run into serious financial trouble, and often result in these companies being taken over by their principal creditors. This is because both the debt and the remaining assets in these companies are so large that there is no advantage for the creditors to drive the company into bankruptcy. Instead the creditors prefer to take control of the business as a going concern. As a consequence, the original shareholders' stake in the company is generally significantly diluted in these deals and may be entirely eliminated, as is typical in a Chapter 11 bankruptcy.

Debt-for-equity swaps are one way of dealing with sub-prime mortgages. A householder unable to service his debt on a $180,000 mortgage for example, may by agreement with his bank have the value of the mortgage reduced (say to $135,000 or 75% of the house's current value), in return for which the bank will receive 50% of the amount by which any resale value, when the house is resold, exceeds $135,000.

Bondholder haircuts

A debt-for-equity swap may also be called a "bondholder haircut". Bondholder haircuts at large banks were advocated as a potential solution for the subprime mortgage crisis by prominent economists:

Economist Joseph Stiglitz testified that bank bailouts "are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this". He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.[3]

Economist Jeffrey Sachs has also argued in favor of such haircuts: "The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices."[4]

If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute dollars and the government may be able to just provide guarantees in the short term to buttress confidence in the recapitalized institution. For example, Wells Fargo owed its bondholders $267 billion, according to its 2008 annual report.[5] A 20% haircut would reduce this debt by about $54 billion, creating an equal amount of equity in the process, thereby recapitalizing the bank significantly.

Informal debt repayment agreements

Most defendants who cannot pay the enforcement officer in full at once enter into negotiations with the officer to pay by installments. This process is informal but cheaper and quicker than an application to the court.

Payment by this method relies on the cooperation of the creditor and the enforcement officer. It is therefore important not to offer more than you can afford or to fall behind with the payments you agree. If you do fall behind with the payments and the enforcement officer has seized goods, they may remove them to the sale room for auction.

Debt restructuring provides a less expensive alternative to bankruptcy when a company, individual, or country is in financial turmoil. It's a process through which an entity can receive debt forgiveness and debt rescheduling to avoid foreclosure or liquidation of assets.