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What is debt restructuring?
Debt restructuring is the debt relief that governments give to countries that are suffering debt crises. Countries suffering debt crises often need their debt restructured in order to be able to repay it.
Many times, debt restructurings merely reduce interest rates and extend loan repayment schedules by offering more time for repayment, rather than actually reducing how much money must be repaid overall. Countries seeking their debt to be restructured often have little hope of paying back their existing debts on time or at full value due to circumstances beyond their control.
Debt restructuring is different from debt relief, which is the act of relieving debt without changing its terms. Debt relief can come in many forms including forgiving taxes, providing less expensive loans, or even canceling some of the debt entirely.
When a country or company has taken on too much debt, they are seen to be at risk of defaulting. This is when the borrower cannot repay the full amount of what they owe back to the creditor. The international community can help by restructuring their debt which means that they agree on new terms with the borrower before repayment starts again.
The conditions for this are agreed between countries depending on how much money was lent and how risky it is based on factors including their ability to repay. They usually involve cutting the interest rates on the loan or postponing payment – in some cases, companies can even change who owns their debt.
Types of debt restructuring
There are various types of debt restructuring based on how they are classified. Each classification would be mentioned and each type would be discussed briefly.
Haircut debt restructuring
This involves either reducing interest rates paid by borrowers on the debt or cutting back some of it.
This type of restructuring of debt involves swapping a borrower’s debt for new longer-term debt with a lower interest rate.
In both of the cases above, the debtor repays only part of the money they owe.
Partial vs complete debt restructurings
Another classification of debt restructuring can be either partial or complete. The partial type refers to a situation where only certain parts of a borrower’s liability are affected by the refinancing while the complete debt restructuring refers to a process where all aspects of a borrower’s loans are changed simultaneously.
Voluntary vs involuntary restructuring of debt
In addition, there are distinctions between voluntary and involuntary restructurings
Pre-default and post-default types of debt restructuring
A pre-default process involves the financial institution discussing alternative payment schedules with the customer before they have missed any payments on their loans. Pre-default debt restructuring is preferred in a partial restructuring; because only a small part of a loan is modified. This usually makes it easier for the borrower to continue paying back all types of debts, but can also reduce their long-term wealth since they will not be able to renegotiate all types of loans at the same time.
On the other hand, in a post-default process, negotiations only take place after at least one creditor has forced the borrower to repay with default interest rates or fees that can be very high. Post-default processes are often more difficult than before since creditors do not want to lend additional money until there is some sort of repayment plan in place to address the outstanding debts. Post-default restructurings are preferred when interest rates and repayment periods are extended over complete types that change every aspect of the loan simultaneously. The main reason for this preference is that borrowers may not have enough money or assets to make regular payments if their total liabilities remain unchanged after a complete type of debt restructuring takes place.
Other types could also be domestic or international – depending on whether the creditors and debtors are all within the same country or across international borders.
Other debt restructuring types
- Troubled debt restructuring
- Corporate debt restructuring
- Personal debt restructuring
- Consumer debt restructuring
- Sovereign debt restructuring
- Out-of-court settlement
- Prepackaged bankruptcy plan
- Debt swaps or exchanges
- Credit default swap
- Securitized debt
- Capitalization of interest on arrears
- Cramdown legislation
- TARP bailout package
Troubled debt restructuring
This type of restructuring is aimed at an entity that has defaulted on its loan obligations because of financial difficulty and the creditor is interested in avoiding a full-scale bankruptcy. This restructuring of debt is similar to the type already present in standard bankruptcy proceedings, which aims to reduce the amount payable by the debtor over time.
Corporate debt restructuring
This type of debt restructuring can come about as a result of either distress or insolvency but most often they are done as part of an overall corporate reorganization plan and collateral is generally used to secure the loans for this type of debt restructuring.
Personal debt restructuring
With personal types of restructuring of debt, there only needs to be financial problems because of the economy. It is not necessary for there to also be insolvency or even default; this can include anything from having a creditor agree to lower rates to one where the creditor agrees to reduce the amount owed.
Consumer debt restructuring
This generally focuses on cases where individuals have borrowed money due to “distress”. However, this distress does not need to be long term and it could come about as a result of temporary unemployment, medical bills, or other types of personal hardship such as divorce or family death.
Sovereign debt restructuring
Sovereign debt restructuring is the process by which creditors and debtors renegotiate the terms of their government’s debts. It usually occurs in times of economic distress when a nation is unable to pay back its owed balance. Sovereign debt restructuring typically occurs at the point where lenders believe that the possibility of repayment has reached an end. The threat of default often generates difficult negotiations between indebted governments, global financial institutions like the International Monetary Fund (IMF), other governments, investors holding the distressed debt, and multinational organizations.
An out-of-court settlement is a type of debt restructuring that takes place outside of the judicial system which results in the settlement of debt with the creditor. It is generally done between the parties involved and does not need to involve bankruptcy proceedings or formal processes. It can be helpful when the debtor wants to avoid bankruptcy but wishes to erase his debt.
Prepackaged bankruptcy plan
A prepackaged bankruptcy plan is the type of restructuring where a plan has already been agreed upon by the creditors, so they are aware that there is no risk with regards to their types of debts. This tends to come about as a result of (or at least concurrently with) an insolvency proceeding, such as Chapter 11 bankruptcy.
Debt swap or exchanges
Debt swap or exchanges are a type of personal bankruptcy. Debtors can be released from their debts and creditors can get back assets they would possibly not be able to recover with a conventional liquidation bankruptcy.
It is done by having the creditor sell his claim to an investor called a ‘swap provider’ who then cancels most or all of the debt in return for interest, share warrants (which entitle him to buy shares at a fixed price) or some other form of equity in the debtor.
Credit default swap
A credit default swap is a swap agreement that provides protection against default on certain types of debt. The protection buyer makes periodic payments, known as the CDS “fee” to the protection seller until maturity or until an event of default occurs, and receives a payoff if the reference entity defaults. It is essentially an over-the-counter insurance contract for bond investors who believe they are taking too much risk – these investors pay a fee to reduce their exposure to credit risk without giving up interest or principal by selling the bond. CDS are not traded on exchanges like stocks are, but through dealers which charge fees.
Securitized loans are another form that can come about as part of a defaulted loan. In this case, the original creditor agrees with a third-party financial institution to transfer repayment responsibility of the debt through the use of a special type of security. The financial institution offers an investor or group of investors funds that they promise to pay back at regular intervals with interest. In return, the creditor agrees to transfer all rights in collecting on the loan. Securitized loans are frequently traded among institutions, just like other types of securities, and can be purchased by banks themselves in order to earn more money off the debt repayment that it has previously made to its own customers. They are extremely common in today’s society where lending institutions often purchase defaulted debts from one another so as not to take any loss
Capitalization of interest on arrears
Repayment terms can be restructured by including interest on overdue amounts. When this occurs, it is sometimes referred to as capitalization of interest or compounding interest.
Congress passed cramdown legislation that allows bankruptcy courts to modify mortgage loans through a process called cramdown. This comes about during a Chapter 11 bankruptcy case where the debtor requests that lenders receive less than what they are owed.
TARP or Troubled Asset Relief Program is a federal program that used $700,000,000,000 to purchase troubled assets and equity from financial institutions and banks. This is a form of debt restructuring and the money given to institutions was used as investments. In 2009, TARP money was used to purchase investments from banks and high-risk loans from financial institutions and the idea behind it was that they would start lending again and help with economic recovery.
The Greek debt restructuring
For example in Greece, creditors cut 100 billion euros from what they were owed by Greece and stretched out repayment over a much longer period with an average interest rate of only 2%. This helped Greece to get back on its feet and repay more of its debts instead of defaulting completely.
Debt restructuring pros and cons
There are advantages and disadvantages to the restructuring of debts to help people who are struggling financially. There are also benefits and drawbacks to creditors to grant debt relief to their customers. Restructuring of debts allows business owners to handle unexpected expenses, which can be helpful when there is a costly event or other unplanned situation occurs that could compromise the total amount of incoming revenue for the company; it helps companies work towards solving issues created by unforeseen financial problems so they can go back to normal operations as quickly as possible without any major disruptions.
The disadvantages of debt restructuring include various risks involved with changing one’s monthly payments, making it harder for consumers to budget their finances. In addition, it may not be possible for everyone who has been granted debt relief or restructured loans from creditors because they have to meet specific criteria in order to qualify. Another drawback is customer delinquency in paying debts, which can lead to bankruptcy filings in certain cases if people do not agree with debt relief offers given by creditors.
Debt restructuring pros
- Decreases risk of default
- Reduces immediate debt burden
Debt restructuring cons
- May decrease an organization’s creditworthiness, making the organization less likely to be able to borrow in the future
- Increase chances of delinquency if not handled correctly since creditors may still want their money back in due time
- Costs associated with legal fees, tighter budgets, etc. can make it costly for an organization to restructure its debts
Does debt restructuring hurt your credit?
No, debt restructuring does not hurt your credit rating. Debt restructurings are often a good way to manage debt and avoid bankruptcy. When a consumer has too much high-interest credit card loans or other unsecured loans, it might be time to consider a debt restructuring.