Debt Crisis How the United

Debt Crisis

How the United States

Debt Crisis Affected United States Companies

This report is a two part report that focuses on the general topic of the United States of America's national debt crisis. The first part of the report attempts to provide insights into the causes and affects of the debt as well as identifying some large and small companies that are most affected. In many cases, the governmental budgeting crisis went as far as causing failures for some of these companies. The second part of the report aims to discuss the risks and valuations of companies and instruments as well as risk and valuation methodologies that have been developed with respect to the debt situation. The focus of these methodologies will be related to the debt market, investment banking and the secondary mortgage market, valuing the risks and returns of the companies and instruments involved. The research attempts to present an extensive discussion regarding methods of valuation.

Introduction

There have been many efforts by the governmental factions to try to control the problem of debt accumulation. For example, the Balanced Budget Act of 1997 was directed on our nation's healthcare delivery system and was designed to balance the overall federal budget. Because of the aging population, Medicare and the cost associated to healthcare in general, our nation's national debt crisis needed these attempts to right the ship. Our debt situation was so severe that the Balanced Budget Act of 1997 was supposed to be one of the most significant changes to the nation's Medicare program since its commencement. "Certainly, the president and Congress intended for the BBA to dramatically alter Medicare reimbursements. The Congressional Budget Office (CBO) originally estimated the bill would reduce Medicare spending by $113 billion over five years, thereby extending the viability of the Medicare Part a trust fund by 10 years and bringing the budget into balance by 2002." (McKeon, 2004)

But, our nation's debt crisis involves more than our heavy Medicare spending. A recent USA Today poll created a consolidated financial statement for taxpayers, similar to what corporations give shareholders to put it all into perspective. USA Today's results were as follows: "Total hidden debt. Federal, state and local governments today have debts and "unfunded liabilities" of $53 trillion, or $473,456 per household. An unfunded liability is the difference, valued in today's dollars, between what current law requires the government to pay and what current law provides in projected tax revenue. Social Security. The retirement program has $12.7 trillion in obligations it cannot meet for current workers and retirees at the current Social Security tax rate. Medicare. The health care program has a $30 trillion unfunded liability for people now in the system as workers or beneficiaries. The $30 trillion reflects the value today of the more than $200 trillion in deficits over 75 years to cover current workers and retirees at existing levels of benefits, tax rates and premiums. Medicare's new prescription-drug benefit, which starts in 2006, accounts for $6.9 trillion of the program's financial ill health." (Cauchon & Waggoner, 2004) to put this into more understandable terms -- our nation's gross domestic product in 2003 was eleven trillion dollars -- an unfunded liability of fifty three trillion is therefore a bit overwhelming at the least. The debt crisis is this report's general topic of concern. The report is broken down into to two parts. Part I attempts to provide insights into the affects of the debt crisis has on industries and both large and small companies. Part II aims to discuss risks and valuations for companies and the instruments used to evaluate risk and valuation methodologies.

Part I

The American public and private sectors debt problems are out of hand. "Never before in the modern era has the public sector had its debt problem nicely in hand while the private sector is drowning in obligations. The government has forgone its nasty way of piling on debt, whilst corporate and individual debt must be measured in numbers usually used to describe the distance between the stars." (Von Hoffman, 2004) There is concern that the government will some day be unable to borrow from the public. "Deficit spending creates new bank deposits and reserves in the amount of that spending." (Hummel, 2004)

The governmental debt is high but American corporations are also in deep with a record four and half trillion dollars in debt of their own. and, not to be outdone, the American people have tried to keep pace by borrowing more than six trillion dollars. The national crisis is to a point where borrowing is the only alternative. "The money lost lending to the fiber-optics industry and telecoms have been put at the trillion-dollar level." (Von Hoffman, 2004)

All this debt does affect corporate America. Consider the mortgage industry and the affects of debt on the financial viability of lenders. "Conseco, this one company, has $26 billion tied up in trailer mortgages-money it had to borrow, so that there's a chain of borrowers and lenders running off over the horizon, all of whom must take the loss if and when the subprimates default on their mortgages. The prospect of Conseco's customers paying back those loans is considered so poor that the people who follow finance are bracing for the company's going bankrupt sometime next summer." (Von Hoffman, 2004) the situation is made worse by those individuals who will need to file for bankruptcy protection. It is estimated that the typical bankruptcy will protect more than fifty thousand dollars of debt.

In this debt ridden economy, manufactures of all kinds have been searching for new opportunities to strategically reduce costs and increase revenues. Manufacturing automobiles is no exception as the manufactures move to cheap labor and emerging markets. Companies like the Ford Motor Company, General Motors and Chrysler have all began relocating and restructuring their processes to reduce debt. Layoffs, downsizing and corporate re-structuring have become all too common place. Debt is the name of the games as new plants are needed to meet the world demand. "Ford Motor Company expects sourcing for parts and components from China to reach $1 billion by the middle of next year and it can rise to more than $10 billion by mid-decade, as part of its overall drive to cut costs." (Ford to Spend $1bn a Year in China)

The airline industry has also been swamped with debt. Large carriers like American Airlines, Delta, United and Continental have all been required to tighten their belts in order to fight inflation, the effects of past and potential future acts of terrorism and the debt ridden United States and world economies. Many want to blame 9/11 but the problems of debt were already present before those tragic events.. "The seeds of this disaster at United were sown long before September 11, and no amount of denial or obfuscating will change that." (Unavailable, the Washington Times, 2003) These companies also are facing other internal debt and economic problems such as ever increasing jet fuel prices, the pressure of maintaining and replacing aging fleets as well as human resource concerns like salaries, healthcare costs and tough competition. The outlook for the debt ridden airline industry looks bleak for the immediate and long-term future. "The global appetite for crude in 2003 will grow by a robust 1.9%, or 1.44 million barrels a day, and in 2004 by 1.5%, or 1.16 million barrels a day. The IEA raised its estimates for daily demand growth in the two years by 160,000 barrels and 90,000 barrels, respectively." (Stanley)

Debt is all consuming in both the public and private sectors. "The $53 trillion is what federal, state and local governments need immediately -- stashed away, earning interest, beyond the $3 trillion in taxes collected last year -- to repay debts and honor future benefits promised under Medicare, Social Security and government pensions. And like an unpaid credit card balance accumulating interest, the problem grows by more than $1 trillion every year that action to pay down the debt is delayed. (Cauchon & Waggoner, 2004)

Introduction Part II

The second part of this report aims to discuss the risks and valuations of companies and their valuation instruments methodologies and risks associated with the constant drain of debt. The focus of these methodologies is on the debt markets, investment banking and the secondary mortgage markets, valuing the risks and returns of companies and instruments.

Inflation

The business newspaper the Investment Business Daily contents that throughout the fourth quarter of 2004, our economy will expand at an unbelievable rate of seven point two percent (7.2%). Although these statistics put the economic recovery in a good position compared with the past twenty years or more, debt constraints will sour many economic forecasts. For example, corporate America is still in the midst of huge unemployment figures, a large number of loans, credit card and other debt failures including a high number of personal bankruptcies. To ward of the price of the debt, the government is in the process of creating new money as the congress recently approved the debt ceiling to be raised.

When the economy suddenly has more money circulating around there is the threat of inflation. "The Federal Reserve is expected to hold its main short-term interest rate at a 45-year low of 1% at its last meeting of the year in December, as well as into part of 2004, economists predict. Holding short-term rates at such low levels might motivate consumers and businesses to spend and invest more, something that would lift economic growth." (Aversa)

Methodologies

The national debt crisis has required a new look at corporate America in regard to valuing the risks and returns of companies and instruments. Many investors apply the Warren Buffet philosophy. Buffett seems to believe that thorough analysis of each company, patient purchasing at the lowest possible price and holding for the long-term will weed out the dogs. Warren Buffet is one of the richest men in America with probably only Bill Gates ahead of him in overall wealth. "So businessmen like Warren Buffett, Bill Gates, Jeff Bezos of Amazon.com, Michael Dell, the founder of Dell Computers, Bernard Marcus and Arthur Blank of Home Depot, and mutual fund manager Michael Price have been lionized in the press. Each became a billionaire, or near billionaire, in the 1990s." (Gross, 2000) Therefore, the Buffett approach of investing in companies provides an excellent opportunity to reduce risk levels. The approach follows:

First do a thorough Background on the company. Evaluate brand recognition and types of companies considered a monopoly by consumers. The company must be able to adjust prices to meet inflation so it makes money irregardless of economic climate. The company should make products that are understood so you can comprehend the exact business of the company. Earnings must be predictable so any year's earnings per share (EPS) must be positive. Debt must be low. And finally, the Return on Equity (ROE) must be high and expenditures down.

An industry outlook: The industry should not be able to do a thing without first going through the company for example Coca-Cola, McDonald's, or American Express in their respective industries.

Once a company is identified, market price determines whether to invest in the company because initial price is very influential on the overall returns in the long run. There are three parts to section two: ROE method, EPS growth method and is to average both returns to create a final return.

Determine the per share growth rate and per share earnings for the past 5 yrs

Calculate the return of equity, PE ratio, rate of compounding and retained earnings

Include the future plans of company

Choose to buy/Pass

Another major valuation methodology for verifying the effects of debt on corporate America or individual companies both large and small would be to utilize the Return on Investment approach. The objective should always be to identify companies with quantifiable, reliable, and accurate measurements for the Return on Investment (ROI). The key to producing a credible ROI is ascertaining the hard cost and the revenue impact. Hard benefits can be measured and do affect the company's gain/loss statement. The best approach when verifying debt is to exclude soft benefits, which are operational benefits that cannot be easily quantified and audited and do not affect the company's gain/loss. Return on investment analysis is a crucial decision-making tool and can be used to evaluate the expected return of companies by comparing the size of an investment and the inherent timing of expected savings or increased revenue based on investments in the company. In this time of debt, this tool can be widely used to help guide decisions for purchases, investments, and improvements.