Debt Overhang - Overview

Overview

The result of having excessive debt is that any earnings generated by new investment projects are partially appropriated by existing debt holders. A firm facing debt overhang cannot issue new junior debt because default is likely. Moreover, more debt will make the problems of debt overhang worse not better. In addition, the firm's shareholders do not want to issue new stock because this forces shareholders to bear some of the losses that would have been borne by junior creditors. Thus, the firm refuses to fund projects with a positive NPV. This problem was first discussed by Myers (1977).

Debt overhang can affect firms or banks that have excessive amounts of debt, but are solvent, in the sense that the value of their assets exceeds the value of their liabilities. Debt overhang also prevents firms that are insolvent, with assets worth less than their liabilities from recovering from their troubles. Bankruptcy which takes the form of Chapter 11 reorganization or receivership, for banks, can cure the problems of debt overhang for insolvent institutions. Successful bankruptcy reorganizations allow organizations to reduce their debt levels and allow new private shareholders to bear enough of the gains from new investments that they will pursue new projects that have positive expected net present value.

The concept of debt overhang has been applied to sovereign governments, predominantly in developing countries (Krugman, 1988). It describes a situation where the debt of a country exceeds its future capacity to pay it. Debt overhang in developing countries was the motivation for the successful Jubilee 2000 campaign.