What Is a Debt Bomb?
A debt bomb is a situation occurring when a major financial institution, such as a multinational bank, defaults on its obligations which, in turn, causes disruption not only in the financial system of the institution’s home country but also in the global financial system as a whole.
Key Takeaways
- A debt bomb is a situation where a default on a large accumulation of debt can produce major negative consequences not only for the borrower but for many other market participants.
- The term “debt bomb” is a metaphor meant to highlight both the catastrophic effects and the way they can spread through the economy like the shockwave of an explosion.
- Some examples of recent or potential debt bombs include the Greek national debt crisis and the accumulation of consumer debt in the U.S.A.
Understanding Debt Bombs
As the old saying goes, “If you owe the bank a million dollars, the bank owns you. If you owe the bank $100 million, you own the bank.” A debt bomb is the latter situation.
A default on a debt (or debts) that make up a major fraction of a lender’s portfolio (or many lenders’ portfolios) can have financial ramifications that go far beyond the borrower and their credit rating. When a debt bomb “goes off” the lenders will also face considerable financial stress as they write down the value of the asset that the debt represents on their books. This can negatively impact their bottom line, increase their liquidity needs, and even trigger reserve and regulatory requirements.
Smart lenders may be willing to go to great lengths to negotiate or assist borrowers in avoiding default in order to avoid these consequences. (Smarter lenders may avoid putting themselves in the situation, to begin with, by diversifying their holdings and hedging their risk). The larger the debt, the more severe these effects will be.
In turn, especially in today’s integrated global financial networks, this can lead the lenders to default on their debts or be forced to liquidate other assets, putting financial stress on the lenders’ own creditors or on other borrowers. The resulting debt deflation can even have serious consequences for the real economy as businesses curtail their activities to cover their financial positions or face a liquidity crisis that leaves them unable to finance ongoing operations.
The debt burden of a single entity isn’t the biggest concern; it’s the ripple effect that worries global policymakers. The effects of a debt bomb ripple outward through the financial system like the shockwave of overpressure created by a physical explosion. A larger debt bomb will not only have a more severe initial impact on lenders, but its impact will also be felt by a wider range of market participants, indirectly connected to the debt bomb by a complex network of counterparty relationships and economic interdependencies. This often results in a cascading effect of systemic risk, pulling industries, regions, or economies down with the debt bomb.
Examples of Debt Bombs
Whether an individual company, industry, or an entire nation piles debt on top of debt, it raises the threat of a debt bomb. With enough leverage, things eventually collapse under their own weight.
In many respects, as economic growth has become more integrated through globalizationthe negative effects of debt bombs can have new and unparalleled consequences for international partners. For instance, since the unwinding of international markets brought on by the housing crisis in the United States in 2009, the country of Greece’s overwhelming national debts have troubled its European Union counterparts. Even today, Greece struggles to get its fiscal house in order, which continues to weigh on other European Union member countries.
A debt bomb can also occur if consumer spending is based heavily on debt. For example, if consumers incurred huge credit card debt, individual debt holders could default en masse and create trouble for creditors. In the U.S., consumer debt outstanding as a percent of GDP has increased to record highs of nearly 20% in recent years. Widespread defaults on consumer debts are often connected to economic recessions. Defaults on mortgages by households were a major factor in the 2008 financial crisis.