Deleveraging: What It Means to Corporate America

To deleverage means to reduce the amount of debt that a company carries, usually by taking major steps quickly. It is the opposite of leverage, which refers to taking on debt to fund business goals.

Deleveraging is a term that comes to the forefront during and after times of economic turmoil, whether that’s a downturn, an all-out recession, or a depression. It can also occur due to company mismanagement.

It applies to businesses (and people) that try to clean up their balance sheets by reducing their debt. Thus, it can be very useful and important to U.S. corporations. Governments can also become involved in deleveraging.

What else does deleveraging mean to corporate America? To explain, it helps to start with leverage.

Key Takeaways

• Deleveraging occurs when a firm reduces its financial leverage (debt) by raising capital, selling off assets, and/or cutting spending where necessary.
• Deleveraging strengthens balance sheets because it rids a company of certain financial liabilities.
• Firms with so-called toxic debt can face a substantial blow to their balance sheets if the market for those fixed-income investments collapses. 
• When deleveraging affects the economy, the government may step in to buy assets and put a floor under prices, or to encourage spending. 
• Investors may be alarmed when a company has to deleverage because they may believe it failed to grow enough to pay its obligations.

What Is Leverage?

Leverage has become an integral aspect of our society. The term refers to borrowing money and using it to increase the possibility of a return.

Businesses use leverage to finance their operations, fund expansions, and pay for research and development (R&D).

By borrowing money to obtain capital rather than issuing more stock, businesses can pay their bills without diluting shareholders’ equity.

For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million. This is money the company uses to operate.

If the company then borrows $20 million, the company now has $25 million to use as needed. It could invest in capital budgeting projects and other opportunities to increase value for the fixed number of shareholders.

Operating and Financial Leverage

There are two main types of leverage: operating leverage and financial leverage. Operating and financial leverage make income and profits more sensitive to business cycles.

This can be a good thing during periods of economic expansion and a bad thing during economic contraction. That’s because leverage equals debt which equals interest payments.

Interest payments can be handled well during healthy economic periods. But if the economy weakens and a company makes less revenue, interest payments owed to creditors could be hard to make.

What Is Deleveraging?

The old adage “everything in moderation” applies perfectly to the concept of leverage.

If companies incur too much leverage, or debt, they can run into trouble because of the excessive interest payments they face. That’s when deleveraging—getting rid of debt—comes into play.

Deleveraging occurs when a firm executes a strategy to pay off any or all existing debts.

To deleverage, a company can raise capital that it then uses to wipe off the debt from its balance sheet. Or it can sell assets to raise the money. It can also reduce its spending and apply the savings to its debt. But, as noted below, reducing spending may entail difficult choices and affect the lives of employees.

However, without deleveraging, an entity could default on its debt, as the financial burden may become unbearable.

Pros and Cons

For businesses, deleveraging has positive and negative aspects. On the one hand, deleveraging strengthens balance sheets by removing liabilities. And it can improve the financial ratios that investors use to gauge the financial health of a company.

Also, lenders will like what they see and be more likely to lend to the deleveraged company in the future.

It is a sound course of action to get a company back on track toward growth without owing too much money, if any.

On the other hand, deleveraging isn’t always pretty. To pay off its debt, a company needs extra cash. So it may have to lay off workers, close plants, slash R&D budgets, and sell assets. It may have to sell some part of its business at a less than optimal price.

Investors can become concerned about a company that failed to achieve enough growth to pay what it owed. And such efforts could affect the price of a company’s stock.

Important

Leverage and deleveraging both can be good for corporate America. Careful leveraging can provide funds needed to grow a business that aren’t obtained by diluting shareholder ownership. Deleveraging and paying off debt that’s become to much too handle supports the financial health of a company and appeals to investors.

Wall Street’s Response to Deleveraging

Wall Street generally greets successful deleveraging with a warm embrace. Announcements of massive layoffs can send corporate costs falling and share prices rising.

However, deleveraging doesn’t always go as planned. When the need to raise capital to reduce debt levels forces firms to sell off assets they don’t wish to sell at fire sale prices, the price of a company’s shares generally suffers in the short run.

In addition, when investors learn that a company has debts that it has become unable pay, they may decide that the company isn’t a good investment and sell their shares.

Toxic Debt and Deleveraging

Toxic debt is any debt that has little chance of being repaid (both principal and interest).

The inability to sell or service debt can result in business failure. Firms that hold toxic debt in the form of fixed-income securities issued by failing companies can face a substantial blow to their balance sheets as the market for those investments collapses.

Such was the case for firms holding the debt of the investment banking firm Lehman Brothers prior to its 2008 collapse.

The Deleverage Process for Banks

Banks are required to have a specific percentage of their assets held in reserve to help cover their obligations to creditors, including depositors that may make withdrawal requests.

They are also required to maintain certain ratios of capital to debt. To do so, banks deleverage when they fear that the loans they made will not be repaid or when the value of assets they hold declines.

When banks are concerned about getting repaid, as during the financial crisis, they slow down their lending. When lending slows, consumers can’t borrow money, so they are less able to buy products and services from businesses.

Similarly, businesses can’t borrow to expand, so hiring slows and some companies are forced to sell assets at a discount to repay existing bank loans.

The Deleverage Effect on Security Prices

If many banks deleverage at the same time, stock prices fall as companies that can no longer borrow from the banks are revalued based on the price of assets that they are trying to sell at a discount.

Debt markets may potentially crash as investors become reluctant to hold the bonds from troubled companies or to buy investments into which debt is packaged.

The Government and Deleveraging

When deleveraging creates a downward spiral in the economy, the government may be forced to step in. Governments take on leverage to buy assets and put a floor under prices, or to encourage spending.

For example, the government might:

• Buy mortgage-backed securities (MBS) to prop up housing prices and encourage bank lending
• Issue government-backed guarantees to prop up the value of certain securities
• Take financial positions in failing companies
• Provide tax rebates directly to consumers
• Subsidize the purchase of appliances or automobiles through tax credits

The Federal Reserve (Fed) can also lower the federal funds rate to make it less expensive for banks to borrow money from each other, push down interest rates, and encourage banks to lend to consumers and businesses.

Does Deleverage Apply to Individuals?

It can. If an individual borrows money that at some point they have trouble paying back, they may be forced to sell assets to raise funds to pay off large chunks of that debt, if not the entire amount at one time. Before selling one or more assets, they may also try spending less each month and apply the savings to their debt payments.

Is Deleveraging Good or Bad?

In general, it’s good if it is undertaken to alleviate a burdensome amount of debt, is successful at doing so, and prevents an even worse situation (such as bankruptcy). However, it’s important for a company to assess the factors that got it to the point where it had to deleverage.

Is Deleveraging an Extreme Measure?

Yes, a company that finds itself unable to make payments on the money it has borrowed usually has to take extreme steps to right its situation. The company must quickly come up with cash to pay off its debts. That can mean taking major steps such as selling company assets at fire sale prices, laying off workers, and issuing more shares of stock.

The Bottom Line

Deleveraging by corporations and other businesses involves executing a strategy to raise funds rapidly to pay off debt that has become burdensome.

In times of financial crises, the government may have to step up to buy certain amounts of this debt. But it can’t do so without restraint, as government debt must eventually be repaid by taxpayers.

Broadly speaking, it’s a good idea for the financial health of companies and the economy that the responsible parties in business and the government implement internal controls and policies to prevent future downward spirals and the need for deleveraging.