What is Debt Overhang?

Mary McMahon
Mary McMahon

Debt overhang is a term originally coined to describe a financial situation where a company is so deep in debt that it cannot embark on new projects because any earnings from those projects will promptly be taken by creditors. The company has no incentive to move forward on investments because they will generate no profits, but it also cannot repay its debt because it is not making enough money to do so. Economists have also applied this model to national governments and their economies, showing how debt overhang can become a significant barrier to economic development. Individuals can also experience a form of debt overhang.

The best way to escape debt overhang is by declaring bankruptcy.
The best way to escape debt overhang is by declaring bankruptcy.

The only realistic way to escape debt overhang is by declaring bankruptcy. By declaring that it is not possible to pay outstanding debts and requesting an ability to reorganize, debt responsibilities can be reduced, allowing repayment to occur. However, declaring bankruptcy has substantial costs, including a lowered credit rating in the future, and may not be possible in all cases. National governments, for example, cannot usually evade debts by filing for bankruptcy.

Debt overhang can occur for a variety of reasons. There are numerous legitimate reasons to take on new debt, ranging from investing in projects with future potential to funding current initiatives. As debt begins to accumulate, it can be difficult to get good terms on additional debts, and eventually the balance of debt can outweigh the profits being made. This makes it impossible to ever repay the debt, and sets up the situation of debt overhang.

When companies are in a state of debt overhang, they are powerless to invest in new initiatives, cannot take on more debt to pay off the existing debt, and can find themselves in a very uncomfortable position. It is sometimes possible to renegotiate terms with creditors to bring debt to a more manageable level. The other option is to liquidate, closing and selling off all assets to repay the debt, or to declare bankruptcy and attempt to cancel or shrink the debt.

For national governments with a large net debt, debt overhang is a serious problem. Many developing nations are in the position of repaying substantial loans while trying to build their economies. Investors are not attracted by the economic climate out of fear that profits will be heavily taxed to cover the national debt, and these nations cannot take on more debt to kickstart their economies. Some economists have promoted debt forgiveness and grant programs to get developing economies out from under the debt overhang.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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