Debt Overhang - Debt Overhang and The Financial Crisis of 2008

Debt Overhang and The Financial Crisis of 2008

The problem of debt overhang was used as a justification by governments to inject capital into banks around the world after the collapse of Lehman Brothers in September 2008 and the subsequent falls in stock markets worldwide. Nevertheless, many governments in the financial crisis of 2008, including the United States, primarily bought newly issued preferred stock. Preferred stock is similar to debt in that it gets paid before common stock; it also pays regular dividends that are similar to interest. Thus, the capital infusions of Troubled Assets Relief Program's Capital Purchase Program (TARP CPP) in the United States may have done little to cure debt overhang problems in the United States largest banks. Academic research suggests that if the government bought common stock or toxic assets in troubled banks that the debt overhang problem would be better corrected. Nevertheless, if a bank is very insolvent, subsidies will have to be extremely large to correct the problems of debt overhang and unsecured debt and preferred stock holders may have to bear some losses. Interviews with many bank executives found that many banks were not eager to increase lending after receiving TARP funds. The Congressional Review Panel, created to oversee the TARP, concluded on January 9, 2009 that, "Although half the money has not yet been received by the banks, hundreds of billions of dollars have been injected into the marketplace with no demonstrable effects on lending."