Debt vs Equity: or Bonds vs Stock
Given the current collapse of Bear Stearns, and the buyout by JP Morgan at just $2 a share, I thought today might be a good time to talk about Debt and Equity in a company. So, here are your basics:
A company's debt is often held in the form of bonds. These bonds are generally issued at an interest rate i, and can either be paid in full at a maturity date or over a period of time. Bonds are normally a sound investment with lower risk than their counterpart stock. Therefore, bonds are issued at lower interest rates. This is due to the fact that in the event of a collapse, such as Bear Stearns, the bond holders are paid first. Stock holders are compensated only with that remains, if anything remains at all!
Equity is usually equated with common stock. This is the value of share in the company that you often seen sliding across Bloomberg TV. Stock is generally more risky for the aforementioned reasons, and so you can expect to earn a higher rate of return on stocks. In the late 20th and early 21st century, companies have been finding stock to be quite cumbersome for the same reasons mentioned. Having to pay a higher interest rate to a bunch of unconnected shareholders can be fruistrating, and thus in the spirit of creative response, companies found a way around the issuing of stock or bonds.
Commerical Paper: is the creative response to the problem of common stock. Commerical paper is essentially the company using its good standing with a known bank to obtain loans. This cuts out the stockholders. This process, however, can also be risky. Banks that make these loans generally do so on good faith, so if a corporation does not make good on the faith, the banks can be left holding the bill. Enron was a case and point of this occurrence.
So there you have it! Debt vs Equity. It is, as always, a small and incomplete explanation of how the process functions. But I hope you have left informed!
A company's debt is often held in the form of bonds. These bonds are generally issued at an interest rate i, and can either be paid in full at a maturity date or over a period of time. Bonds are normally a sound investment with lower risk than their counterpart stock. Therefore, bonds are issued at lower interest rates. This is due to the fact that in the event of a collapse, such as Bear Stearns, the bond holders are paid first. Stock holders are compensated only with that remains, if anything remains at all!
Equity is usually equated with common stock. This is the value of share in the company that you often seen sliding across Bloomberg TV. Stock is generally more risky for the aforementioned reasons, and so you can expect to earn a higher rate of return on stocks. In the late 20th and early 21st century, companies have been finding stock to be quite cumbersome for the same reasons mentioned. Having to pay a higher interest rate to a bunch of unconnected shareholders can be fruistrating, and thus in the spirit of creative response, companies found a way around the issuing of stock or bonds.
Commerical Paper: is the creative response to the problem of common stock. Commerical paper is essentially the company using its good standing with a known bank to obtain loans. This cuts out the stockholders. This process, however, can also be risky. Banks that make these loans generally do so on good faith, so if a corporation does not make good on the faith, the banks can be left holding the bill. Enron was a case and point of this occurrence.
So there you have it! Debt vs Equity. It is, as always, a small and incomplete explanation of how the process functions. But I hope you have left informed!
11 comments:
The housing crumble found that there was very little equity in relation to the massive debt that these loans garnered.
That's definitely true. Many of these companies let clever financial analysts make them think they'd created securities were they couldn't lose. It's at that very moment, that they should realize, they are going to lose!
I think the clever analyst theory is a bit too narrow in the real economy. But while people made money it was a great ride for them.
Who picks up the remains?
In this case, it seems the answer is....the taxpayers!
Bernanke and Bush are covering the savings and loan entities at the expense of normal Americans savings accounts.
Bernanke is destroying the working class with his understated inflation.......the CPI is a total joke it uses a sham known as hedonics to VASTLY understate inflation the REAL rate of inflation if we used the pre hedonics calculation for the CPI would be more than double what the gov states, probably around 15%.
When you look at the REAL rate of inflation and subtract the 2 1/4 Fed Funds rate which is also a joke you see that REAL interest rates are strongly negative in fact they are double digit negative and that means gold will soar and inflation will rage while the working class will be destroyed to bail out the Bear Stearns, JMP Chases and the wealthy elite at the expense of the working class.
Larry said...
Bernanke and Bush are covering the savings and loan entities at the expense of normal Americans savings accounts."
They are covering the wall street firms at the expense of the working class larry and its dispicable.
Excellent summary of debt and equity Octavion..........you write such powerful brief and succinct articles i wish i could write brief articles that were so powerful and effective.
If your looking for another similar topic to summerize and clarify for the average person i would suggest you write about hedonics and real interest rates.................those are going to be extremely valuable concepts to understand during the next decade and with a good definition are fairly straitforward.
Octavian said...
In this case, it seems the answer is....the taxpayers!"
Like Warren Buffet said this is a case of a billionaire and a workingclass guy going out to lunch and the billionaire sticks the working stiff with the bill.
Thank you very much for your suggestions and comments thus far. I'll look into those concepts of hedonics and real interest rates.
I agree with you. I think the Fed's primary job is to control inflation. They are forsaking that job to bail out wall street, which will only cause more problems down the road. And they're using that calculation of CPI to cover their tracks. As a student living on fixed income, I know inflation has been horrendous by our nation's standards.
The Federal Reserve is nothing more than a political tool that Corporate America employs to generate more funds for their expanding portfolio.
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