Ending Overlending

Bruce A Ramsay
CcLober 2011
ENDING OVER-LENDING
Applylng uebL Lo Cash llow 8aLlos Lo naLlons
as a means of Avoldlng llnanclal CalamlLles

Copyr|ght 8ruce A kamsay, 2011. A|| r|ghts reserved.

1he followlng charlLles are recommended ln conslderaLlon of Lhe download or sharlng of Lhls documenL:
Foodcupboard.org | KootenayKids.ca | NelsonMuseum.ca

!"#$%$& %() *$+,"-./ 0%(%)% 0%1%2345"(4 "( 65#2"+%1"3(
8amsay, 8ruce A., 1936-
Lndlng over-lendlng : applylng debL Lo cash flow raLlos Lo naLlons as a means of
avoldlng flnanclal calamlLles / 8ruce A 8amsay.

lncludes blbllographlcal references.
lS8n 978-0-9878197-0-3

1. uebLs, ubllc. 2. Cash flow. 3. MoneLary pollcy.
4. lnLernaLlonal flnance. 3. Lconomlc forecasLlng.
6. llnanclal crlses-revenLlon. l. Cascadla MoneLary 8esearch. ll 1lLle.

P!8013.834 2011 336.3'4 C2011-906937-1

ubllshed by Cascadla MoneLary 8esearch, ChesLermere, AlberLa, Canada.
CcLober, 2011
8A8[LndlngCverLendlng.com
www.LndlngCverLendlng.com

1he auLhor would llke Lo acknowledge Lhe valuable efforLs of Mlchael l. Plll, wlLhouL whose asslsLance
Lhls paper would noL have been compleLed. 1hank you as well Lo Annellse L. Spafford and Lo several LesL
readers who asslsLed ln Lhe process.

1hls paper ls besL consldered a work-ln-progress and Lhe auLhor accepLs responslblllLy for errors,
overslghLs, lncompleLe fooLnoLes, and oLher shorLcomlngs.

CcLober 2011

8ruce A 8amsay CopyrlghL 2011
Abstract

1he purpose of Lhls research ls Lo explore how Lhe uebL Lo Cash llow raLlo (uebL/Cl") can be applled Lo
a naLlon as a monlLor of lLs flscal healLh. uebL/Cl ls known Lo be an effecLlve predlcLor of corporaLe loan
covenanL vlolaLlons and bankrupLcy. Lndlng Cver-Lendlng examlnes Lhe merlLs of Lhls Lool ln measurlng
Lhe lndebLedness of naLlons, Lhe debL-carrylng capaclLy of naLlons, and Lhe early warnlng slgnals Lo averL
flnanclal crlses of naLlons.

MoLlvaLlon Lo conducL Lhls research was found ln on-golng flnanclal crlses globally and Lhe resulLlng
search for new approaches Lo Lhese evenLs. A second moLlvaLlng facLor was LhaL prlor papers
conLemplaLlng Lhe use of uebL/Cl raLlos for naLlons were noL locaLed. Lndlng Cver-Lendlng ls lnLended
Lo presenL a unlque and poLenLlally far-reachlng approach Lo undersLandlng Lhe debL loads of naLlons.

lurLher moLlvaLlon for Lhls paper arose from observaLlon of llmlLaLlons ln currenL popular debL sLaLlsLlcs.
1he commonly avallable CovernmenL ueflclL / Cu and CovernmenL uebL/Cu only accounL for
governmenL debL, whlle lgnorlng Pousehold, CorporaLe and 8anklng secLor debL. AddlLlonally, debL-Lo-
Cu conLrasLs Lhe debL agalnsL Lhe 'revenue' of Lhe economy. ln flnanclal analysls, debLs are normally
compared Lo anoLher accounLlng measure--cash flow--whlch ls more dlrecLly llnked Lo an enLlLy's
leverage.

lf Cash llow has a well-known dlrecL connecLlon Lo Lhe ablllLy Lo servlce and repay debL, can relaLlng Lhe
cash flow generaLed by a naLlon Lo lLs LoLal debL provlde a meanlngful meLrlc?

Addresslng Lhls research quesLlon lnvolved gaLherlng Llme serles daLa for measures of cash flow and
debL for corporaLlons, uLlllLles, banks, lndusLrles, households, and naLlons. 1he paper explalns how Lhe
uebL/Cl meLrlc ls calculaLed. uebL/Cl raLlos for Lhe daLa groups are Lhen examlned hlsLorlcally Lo assess
levels of opLlmum versus problemaLlc leverage. nexL, Lhe paper provldes a sample calculaLlon of a
uebL/Cl raLlo for a naLlon. uebL/Cl raLlos and sLaLlsLlcal Lrends for 20 counLrles are Lhen examlned.
llnally, Lhe 20 naLlons are grouped lnLo 4 caLegorles of leverage--lnefflclenL, CpLlmum, Warnlng, and
CalamlLy--accordlng Lo a lour Zone lramework proposed by Lhe auLhor.

8ased on Lhe research, Lndlng Cver-Lendlng characLerlzes Lhe uebL/Cl raLlo as a slmple, rellable,
predlcLlve meLrlc LhaL should be consldered ln assesslng Lhe flnanclal healLh of a naLlon.

CcLober 2011

8ruce A 8amsay CopyrlghL 2011
Tabl e of Contents

A81 1 - uebL/Cash llow - Ceneral 8ackground and CorporaLe 8rand name Analysls ............................. 2
A81 2 - uebL/Cl Analysls Applled Lo lndusLry Croups ............................................................................... 3
A81 3 - Macroeconomlc lmpacLs .............................................................................................................. 7
A81 4 - llnanclal SecLor ............................................................................................................................. 8
A81 3 -ueflnlng uebL/Cl Zones ............................................................................................................... 10
A81 6 - LnLerlng Lhe CalamlLy Zone ........................................................................................................ 12
A81 7 - uS Pousehold 8orrowlng CapaclLy ............................................................................................. 16
A81 8 - uebL/Cl Applled Lo naLlons ........................................................................................................ 18
A81 9 - ueLermlnlng Lhe uebL/Cl for a naLlon ....................................................................................... 23
arL 10 - uebL/Cl Analysls of naLlons ....................................................................................................... 27
A81 11 - Summary and Concluslons ........................................................................................................ 36
8eferences ................................................................................................................................................. 38
noLes .......................................................................................................................................................... 41

L|st of I|gures

llgure 1 - uebL/Cl 8aLlos for uS lndusLry Leaders ....................................................................................... 3
llgure 2 - PlsLorlcal uebL/Cl 8aLlos for uS lndusLry Croups ....................................................................... 3
llgure 3 - PlsLorlcal Medlan uebL/Cl for S& lndusLry Croups ................................................................... 6
llgure 4 - lmpacL of 8ecesslonary erlods on uebL/Cl of S& lndusLrlal Croups ....................................... 7
llgure 3 - uebL/Cl PlsLory of uS uomesLlc llnanclal SecLor ........................................................................ 8
llgure 6 - uebL/Cl 8aLlos wlLh lour Zone lramework for SelecLed uS LlecLrlc uLlllLy Companles ........... 11
llgure 7 - uS LlecLrlc uLlllLy Companles LnLerlng Lhe CalamlLy Zone and Survlvlng .................................. 12
llgure 8 - llnanclally ulsLressed uLlllLy Companles LnLerlng Lhe CalamlLy Zone and lalllng .................... 14
llgure 9 - uebL/Cl 8aLlo of uS Pouseholds and non-proflL lnsLlLuLlons ................................................... 16
llgure 10 - Cross Savlngs Marglns for SelecLed CounLrles ......................................................................... 20
llgure 11 - neL Lendlng/8orrowlng of SelecLed CounLrles ........................................................................ 21
llgure 12 - PlsLorlcal uebL/Cl 8aLlo for Lhe unlLed SLaLes ........................................................................ 24
llgure 13 - PlsLorlcal uebL/Cl for 20 SelecLed naLlons ............................................................................. 27
llgure 14 - naLlons ln Lhe lnefflclenL Zone ................................................................................................ 29
llgure 13 - naLlons ln Lhe CpLlmum Zone ................................................................................................. 30
llgure 16 - naLlons ln Lhe Warnlng Zone ................................................................................................... 32
llgure 17 - naLlons ln Lhe CalamlLy Zone ................................................................................................... 34
CcLober 2011

8ruce A 8amsay CopyrlghL 2011 age 1

INTRODUCTION
Aggregate Debt]Cash I|ow as a ract|ca| Measure of the I|nanc|a| nea|th of a
Nat|on
8ecenL flnanclal crlses have spurred conslderable analysls, research, lnqulrles and publlcaLlons,
addresslng noL only whaL preclplLaLed Lhe evenLs, buL also how Lo avold such crlses ln Lhe fuLure.

AuLhors such as 8elnharL & 8ogoff
l
and Shlller,
ll
as well as lnLernaLlonal agencles responslble for
economlc and flnanclal overslghL,
lll
have explored or expressed lnLeresL ln alLernaLlve measures Lo assess
Lhe flscal healLh of counLrles. Several sLudles and commenLarles concluded LhaL LradlLlonal lndlcaLors
and meLhods dld noL adequaLely forewarn of Lhe 2008 flnanclal crlsls.
lv
ln response, Lhere has been an
lnvlLaLlon by varlous organlzaLlons Lo ldenLlfy new 'early warnlng slgnals'.

Measures such as CovernmenL uebL/Cu and ueflclL/Cu are frequenLly used lndlcaLors of Lhe
flscal healLh of a counLry. 1he exLenL of underlylng hlsLorlcal daLa for Lhese measures ls slgnlflcanL, buL
only accounLs for governmenL debL, noL household, corporaLe nor flnanclal secLor debL. More recenLly,
1oLal CounLry uebL/Cu has been used
v
(capLures all four secLors' debLs), alLhough Lhls daLa ls much
less exLenslve and more dlfflculL Lo obLaln. Lach of Lhese debL-Lo-Cu lndlcaLors relaLes debL agalnsL Lhe
LoLal revenue (Cu) of an economy. 8evenue may noL compare Lo an economy's LoLal debL as well as
oLher accounLlng measures.

AlLernaLlvely, relaLlng Lhe aggregaLe cash flow generaLed by a naLlon Lo lLs 1oLal CounLry uebL may
lnLulLlvely provlde a more meanlngful meLrlc. Cash llow has a well known dlrecL connecLlon Lo Lhe
ablllLy of an enLlLy Lo servlce or repay debL. Cash flow also accounLs for Lhe savlngs marglns of a naLlon
(Cu does noL). A naLlon's cash flow ls known as Cross Savlngs and Lhe daLa ls readlly avallable.

uebL Lo Cash llow (uebL/Cl") has been a long sLandlng and common measure Lo assess Lhe borrowlng
capaclLy and flnanclal healLh of corporaLlons.

1he auLhor proposes LhaL Lhe uebL/Cl raLlo for a naLlon ls a slmple, rellable predlcLlve meLrlc LhaL
should be consldered ln assesslng lLs flnanclal healLh: 1oLal CounLry uebL / Cross Savlngs.

1he purpose of Lhls documenL ls Lo share Lhls concepL wlLh experLs, sollclL feedback regardlng Lhe exLenL
Lo whlch Lhls approach has merlL, and conLemplaLe nexL sLeps Lo furLher develop Lhe concepL.

Lndlng Cver-Lendlng explores how Lhe uebL/Cl raLlo can be applled Lo naLlons as a monlLor of flscal
healLh. 1o seL conLexL for Lhe analysls on naLlons, Lhe early secLlons of Lhe paper explaln how Lhe
uebL/Cl meLrlc ls calculaLed and Lhen complle uebL/Cl raLlos for lndlvldual corporaLlons, lndusLry
groups, banks and households. nexL, Lhe paper provldes a sample calculaLlon of a uebL/Cl raLlo for a
naLlon. uebL/Cl raLlos and sLaLlsLlcal Lrends for 20 counLrles are Lhen examlned. llnally, Lhe 20 naLlons
are grouped lnLo 4 caLegorles of leverage-lnefflclenL, CpLlmum, Warnlng, and CalamlLy-accordlng Lo a
lour Zone lramework proposed by Lhe auLhor. ulscusslon concernlng early warnlng lndlcaLors ls
presenLed, along wlLh some concludlng remarks.
CcLober 2011


PART 1 Debt/Cash Fl ow General Background and
Corporate Brand Name Anal ysi s

1he uebL/Cl raLlo expresses Lhe LoLal Lhlrd parLy debLs owed by an enLlLy, ln relaLlon Lo Lhe amounL of
cash flow generaLed by Lhe enLlLy. 1he hlgher Lhe raLlo, Lhe more 'levered' Lhe enLlLy. ln lLs mosL
slmpllsLlc form, Lhe uebL/Cl raLlo measures Lhe number of years of cash flow requlred Lo reLlre
ouLsLandlng debL (assumlng 100 of cash flow ls applled Lo Lhls purpose).
1

1o calculaLe Lhe uebL/Cl raLlo, Lhe lnlLlal secLlons of Lhls paper uLlllze balance sheeL 1oLal LlablllLles" for
Lhe debL measuremenL, and Cash llow lrom CperaLlons" for Lhe cash flow measuremenL.

ln a corporaLe enLlLy conLexL, 1oLal LlablllLles lncludes all shorL and long Lerm debL, payables, and may
lnclude cerLaln oLher lLems such as Lax obllgaLlons. LqulLy caplLal and neL worLh are noL lncluded.

Cash llow from CperaLlons ls generally expressed as Lhe sum of neL afLer-Lax proflL plus depreclaLlon
and amorLlzaLlon, and oLher non-cash lLems.
2
1hls aggregaLe cash flow generaLed by Lhe enLlLy ls
avallable Lo servlce prlnclpal repaymenL obllgaLlons on debL, lnvesL back lnLo Lhe buslness as caplLal
expendlLures, or reLurn Lo shareholders.

CerLaln varlaLlons are posslble ln Lhe calculaLlon of Lhe uebL/Cl raLlo, such as wheLher cash on hand ls
deducLed Lo arrlve aL a 'neL debL' raLher Lhan uslng LoLal debL. Slmllarly, Lhere are alLernaLe measures of
cash flow whlch could be lncorporaLed. Such varlaLlons have only been consldered Lo a llmlLed degree ln
researchlng Lhls paper.
3

1
Applylng 100 of cash flow Lo debL reLlremenL means LhaL no caplLal expendlLures of any form are made Lowards
new or replacemenL sLrucLures (excepL by way of lncremenLal borrowlng).
2
Changes ln worklng caplLal are normally lncluded.
3
1oLal LlablllLles was selecLed as Lhe analysls parameLer due Lo daLa avallablllLy and Lo ensure comparaLlve
conslsLency across companles and lndusLrles. MosL varlaLlons ln Lhe calculaLlon of Lhe raLlo have Lhe effecL of
lowerlng Lhe resulLlng uebL/Cl raLlo. uLlllzlng 1oLal LlablllLles for debLs porLlon of Lhe uebL/Cl calculaLlon ln Lhe
corporaLe secLlons of Lhls paper may presenL a more sLrlngenL form of Lhe uebL/Cl resulLs (somewhaL hlgher).
CcLober 2011


7"45$. 8 presenLs uebL/Cl raLlos for several brand name companles consldered leaders ln Lhelr
respecLlve lndusLry secLors.

I|gure 1 - Debt]CI kat|os for US Industry Leaders

As lllusLraLed ln llgure 1, slx of Lhe nlne brand name companles operaLe wlLh uebL/Cl raLlos of 3.0x or
less. 1he remalnlng Lhree companles appear generally ln Lhe 3 Lo 10x range, wlLh some excepLlon years.
1he negaLlve uebL/Cl raLlo for cotetplllot ls assoclaLed wlLh negaLlve cash flow ln 2002-2004.
4

LxcepLlon years lnclude 2007 wlLh respecL Lo uS, and 2009 wlLh respecL Lo uow Chemlcal. 8oLh
companles show a splke ln uebL/Cl raLlo due Lo Lhe lmpacL of a year of poor cash flow resulLs, wlLh
lmmedlaLe correcLlons or reverslons ln Lhe raLlo Lhe followlng year back Lo levels conslsLenL wlLh
hlsLorlcal paLLerns.

4
CaLeplllar cash flows were negaLlve ln Lhe years 2002-2004, resulLlng ln a negaLlve uebL/Cl raLlo for Lhose years.
negaLlve raLlos are generally consldered 'meanlngless', however, Lhey do porLray LhaL cash flow ls lnsufflclenL for
corporaLe purposes. ln Lhe balance of Lhls paper, negaLlve debL/Cl raLlos are excluded or LreaLed as a large
uebL/Cl raLlo (= 30x) 1he negaLlve raLlos have been lnLenLlonally lefL ln llgure 1 ln order Lo convey Lhe derlvaLlon
of Lhe raLlo ln Lhe clrcumsLances of negaLlve cash flows (cash ouLflow). 1he lmpllcaLlons are very negaLlve as lf Lhe
daLa polnLs resLed very hlgh - ln Lhe upper area of Lhe graph.

CcLober 2011


As a general rule, organlzaLlons wlLh sLeady, predlcLable cash flow and long-llfe asseLs (e.g. uLlllLles) are
able Lo supporL relaLlvely hlgher debL levels as compared Lo organlzaLlons LhaL have, or may face hlgh
volaLlllLy cash flow or earnlngs (e.g. Lechnology or commodlLy lndusLrles such as oll and gas). llgure 1
shows LhaL Lhe uLlllLy 5ootbeto compooy operaLed wlLh a uebL/Cl raLlo averaglng 9.8x over Lhe pasL 10
years. ln conLrasL, Mlctosofts uebL/Cl raLlo averaged 1.3x, Iobosoo & Iobosoo averaged 2.23x, whlle
xxoo averaged 2.8x over Lhe same 10 year perlod.

As a maLLer of corporaLe flnanclal pollcy, companles Lend Lo LargeL accepLable debL levels wlLhln Lhelr
caplLal sLrucLure. ConslderaLlon ls glven Lo a number of facLors lncludlng avallablllLy of debL, cosL of
debL, and Lhe ablllLy Lo servlce and evenLually reLlre or roll-over debL. A company's cash flow ls a key
measure used among corporaLlons, advlsors, and lenders Lo assess (lmpllclLly or expllclLly) Lhe shorL and
long Lerm borrowlng capaclLy of Lhe company.

A recenL sLudy lndlcaLed LhaL Lhe uebL/Cl raLlo ls Lhe second mosL common Lype of covenanL used ln
llnes of credlL (afLer coverage covenanLs), and Lhe raLlo was lncluded ln 49 of llnes wlLh flnanclal
covenanLs.
vl
lurLher, Lhls sLudy and oLhers
vll
have concluded LhaL cash flow raLlos lncludlng Lhe uebL/Cl
raLlo are effecLlve predlcLors of loan covenanL vlolaLlons and bankrupLcy.

WheLher dlrecLly deployed as a flnanclal managemenL Lool, an early warnlng slgnal, or uLlllzed lndlrecLly
Lo measure Lhe ouLcome of oLher Lools (such as coverage raLlos), uebL/Cl ls a powerful and wldely used
meLrlc.

CcLober 2011

PART 2 Debt/CF Anal ysi s Appl i ed to Industry
Groups

1he lndlvldual companles comprlslng an lndusLry are generally sub[ecL Lo Lhe same underlylng economlc
fundamenLals affecLlng Lhe group's overall flnanclal performance. As a consequence, a debL flnancler's
deslre Lo lend and Lhe assoclaLed lendlng condlLlons demanded are llkely Lo be consldered aL boLh Lhe
lndusLry level as well as Lhe lndlvldual parLlclpanL level.

7"45$. 9 presenLs uebL/Cl raLlos for each of Lhe nlne lndusLry Croups comprlslng SLandard and oor's
ComposlLe lndex, wlLh Lhe excepLlon of llnanclals
3
(whlch are dlscussed separaLely). As shown, Lhe
varlous lndusLry secLors are able Lo supporL and operaLe wlLh dlfferenL uebL/Cl raLlos.
6

I|gure 2 - n|stor|ca| Debt]CI kat|os for US Industry Groups

llgure 2 lllusLraLes LhaL corporaLlons comprlslng Lhe lndusLry aggregaLes of Lhe S& Lend Lo operaLe wlLh
uebL/Cl raLlos subsLanLlally less Lhan 13x. Cnly ln excepLlonal years of poor cash flow, colncldenL wlLh
recesslonary perlods (dlscussed below), have Lhe lndusLry average raLlos Lemporarlly exceeded 13x. 8y
way of example, Lhe 2008-2009 recesslon caused a uebL/Cl splke for Lhe Consumer ulscreLlonary
segmenL ln 2009 as a consequence of sharply reduced cash flow ln Lhls secLor. MosL lndusLry secLors are
clusLered ln Lhe 3x Lo 10x uebL/Cl range.

3
S& provldes llmlLed segmenLed resulLs for Lhe S& llnanclal SecLor and does noL provlde Lhe SecLor's cash flow
resulLs.
6
Caps ln daLa (e.g. lnformaLlon 1echnology ln 2001) are years of negaLlve cash flow, whlch have been excluded.

CcLober 2011

llgure 2 also presenLs lnlLlal evldence LhaL followlng a dlsrupLlon (a splke upward), Lhe average uebL/Cl
for an lndusLry Croups Lends Lo reverL Lo back Lo a lower level (Loward a longer Lerm mean).

llgure 2 furLher conflrms Lhe lmpllcaLlons of llgure 1 ln LhaL Lhe mosL sLable lndusLrles such as uLlllLles
and lndusLrlals are characLerlzed by uebL/Cl raLlos aL Lhe hlgher end of Lhe specLrum, whereas Lhe more
volaLlle Lnergy and lnformaLlon 1echnology secLors' raLlos are concenLraLed aL Lhe lower end.

ln ascendlng order, Lhe 1992-2009 medlan uebL/Cl for Lhe S& SecLors are presenLed ln 7"45$. :.

I|gure 3 - n|stor|ca| Med|an Debt]CI for S& Industry Groups

llgure 3 presenLs an approxlmaLlon of an expecLed long Lerm uebL/Cl raLlo for each of Lhe lndusLry
Croups presenLed. uLlllLles, wlLh more sLable cash flows and long llfe asseLs, are able Lo manage hlgher
uebL/Cl raLlos Lhan more volaLlle lndusLrles wlLh shorLer llfe or depleLlng asseLs.

ln addlLlon Lo revlewlng Lhe uebL/Cl of S& SecLors, oLher daLa sources segmenLlng uebL/Cl raLlos by
lndusLry groups were analyzed. lor example, Lhe uS 8ureau of Lhe Census whlch uLlllzes Lhe norLh
Amerlcan lndusLry ClasslflcaLlon SysLem (nAlCS), has four ma[or caLegorles: Mlnlng, 8eLall 1rade,
ManufacLurlng and Wholesale 1rade. Cver Lhe pasL 10 years, Lhe medlan uebL/Cl raLlos for Lhese uS
lndusLry aggregaLes were 3.12x, 6.31x, 8.17x, and 10.93x respecLlvely, broadly conslsLenL wlLh Lhe S &
lndusLry volaLlllLy gradaLlon.
vlll

An analysls of sample nAlCS subgroups also reLurned resulLs parallellng Lhe S& daLa ln Lerms of sLable
lndusLry uebL/Cl raLlos versus more volaLlle lndusLry raLlos.
7

7
lor example, ln Lhe Chemlcals area of nAlCS manufacLurlng classlflcaLlons, Lhe more sLable 8aslc Chemlcals
rendered a 10 year 13.7x medlan raLlo, compared Lo harmaceuLlcals and Medlclnes' 10 year medlan of 4.8x.
21

CcLober 2011

PART 3 Macroeconomi c Impacts

1he lmpacL of macroeconomlc facLors such as recesslons on Lhe uebL/Cl raLlos of lndusLrles ls lllusLraLed
ln 7"45$. ;.

I|gure 4 - Impact of kecess|onary er|ods on Debt]CI of S& Industr|a| Groups

As expecLed, corporaLe uebL/Cl level correlaLes wlLh economlc acLlvlLy.
lx
8ecesslons Lyplcally brlng
decllnlng cash flows, whlch ln Lurn wlll cause Lhe uebL/Cl raLlo Lo splke upwards or be negaLlve (as
opposed Lo slgnlflcanL lncreases ln debL belng Lhe cause). ln some cases shown, Lhe lmpacL on Lhe raLlo
occurs wlLh a shorL lag relaLlve Lo n8L8's speclfled offlclal Llmlng of Lhe recesslon.

1he auLhor posLulaLes LhaL uebL/Cl raLlos Lend Lo regress back Lo a mean level over Llme. 1hese
reverslons may resulL from companles proacLlvely managlng Lhelr affalrs, from Lhe lmposlLlons of
lenders and LrusLees, or from oLher causes. 1hls hypoLhesls ls furLher supporLed ln arL 6.

CcLober 2011

PART 4 Fi nanci al Sector

1he uebL/Cl meLrlc can be applled Lo Lhe uomesLlc llnanclal SecLor
8
wlLh daLa obLalned from Lhe uS
lnLegraLed Macroeconomlc AccounLs,
x
lederal 8eserve and oLher sources.

7"45$. < provldes a hlsLory of Lhe uomesLlc llnanclal SecLor uebL/Cl raLlo. 1wo Lypes of daLa were used
for Lhe debL aspecL of Lhe raLlo calculaLlon - 1oLal LlablllLles of Lhe secLor, and CredlL MarkeL uebL
CuLsLandlng.
9
1he calculaLlon based on 1oLal LlablllLles provldes Lhe larger uebL/Cl raLlos (rlghL axls).
1wo sources for cash flow were LesLed agalnsL CredlL MarkeL uebL ln Lhe slmllarly Lracklng resulLs (lefL
axls).
10

I|gure S - Debt]CI n|story of US Domest|c I|nanc|a| Sector

8
uS sLaLlsLlcal auLhorlLles, lncludlng Lhe lederal 8eserve, segmenL Lhe uS domesLlc economy lnLo four caLegorles:
Pouseholds, CorporaLe, llnanclals, and CovernmenL.
9
8oLh of Lhese debL measures were sourced from (and are deflned by) Lhe lederal 8eserve. uue Lo Lhe unlque
naLure of llnanclal SecLor balance sheeLs, uLlllzlng credlL markeL debL ouLsLandlng may represenL Lhe closesL maLch
Lo non-flnanclal corporaLlons presenLaLlon earller ln Lhls paper. 8egardlng 1oLal LlablllLles, Lhe lederal 8eserve
presenLaLlon ls such LhaL an argumenL can be made Lo remove cerLaln equlLy componenLs of Lhe SecLor daLa. 1he
effecL of Lhls alLeraLlon would be Lo reduce Lhe raLlo by approxlmaLely 20 ln 2010 (Lhe mulLlple shown of 184.4x
would reduce Lo 146.8x).
10
Sourced from lnLegraLed Macroeconomlc AccounLs of Lhe unlLed SLaLes, and secondly from lederal 8eserve
daLa.

CcLober 2011

1he perlod from 1932 unLll Lhe end of Lhe 1970s shows slgnlflcanL uebL/Cl sLablllLy ln Lhe uS flnanclal
secLor on a 1oLal LlablllLles basls (approxlmaLely 130x), whlle a sLandard uebL/Cl raLlo rose gradually (le.
based on CredlL MarkeL uebL CuLsLandlng). A serles of uS flnanclal mlshaps are graphlcally evldenL ln
Lhe laLLer porLlon (posL 1970s) of llgure 3. erlods of slgnlflcanL escalaLlon and volaLlllLy ln Lhe raLlo
occurred ln Lhe 1980s (concurrenL wlLh Lhe S&L crlsls) and agaln ln Lhe 1990s (Long 1erm CaplLal fallure
and Lechnology boom-busL). 1he collapse of Lhe uS banklng sysLem ln 2008 ls clearly lndlcaLed as a sharp
splke and prellmlnary reverslon. As ouLllned ln Lhls documenL, Lhese hlgh uebL/Cl feaLures are
commonly assoclaLed wlLh dlsLress and collapse slLuaLlons lrrespecLlve of enLlLy.
11

1he closlng of Lhe uS Cold Wlndow ln 1971,
12
Lhe blurrlng of Lhe llnes beLween Lhe LradlLlonal four
flnanclal plllars ln Lhe 1980s,
13
and Lhe 2004 relaxaLlon ln flnanclal holdlng company caplLal
requlremenLs
14
could be furLher researched for lmpacL on llnanclal SecLor uebL/Cl.

1he auLhor posLulaLes LhaL llnanclal enLlLles are sub[ecL Lo long run uebL/Cl raLlo ranges relaLed noL
only Lo Lhe enLlLy, buL also Lo Lhe sLablllLy of a naLlon's flnanclal sysLems. Several processes of mean
reverslon appear evldenL ln llgure 3
13
and furLher research could subsLanLlaLe and dellneaLe Lhls
Lendency.

11
1he llnanclal SecLor uebL/Cl raLlos based on CredlL MarkeL uebL CuLsLandlng are on a basls roughly equlvalenL
Lo non-flnanclal corporaLlons (and secLors). lurLher research assesslng Lhe gap beLween Lhe llnanclals (whlch are
much hlgher uebL/Cl) and Lhe uebL/Cl of oLher secLors may be useful, parLlcularly concernlng Lhe slmllarlLy of
mulLlples from 1932 Lo Lhe 1970s, and Lhe subsequenL dlvergence. llnanclal secLor uebL/Cl may be able Lo remaln
hlgher durlng perlods of credlL expanslon Lhan ln perlods of sLablllLy or deleveraglng.
12
under resldenL nlxon, Lhe unlLed SLaLes LermlnaLed Lhe converLlblllLy of Lhe uS dollar lnLo gold pursuanL Lo
8reLLon Woods currency arrangemenLs.
13
1he four LradlLlonal plllars of Lhe flnanclal servlces secLor were banks, LrusL companles, lnsurers, and securlLles
dealers.
14
ln 2004, Lhe SLC relaxed caplLal requlremenLs for cerLaln large flnanclal corporaLlons.
13
lor example, 1oLal LlablllLles/Cash llow ls reasonably conslsLenL durlng Lhe 1932 Lo 1979 perlod, averaglng
132.2x. lollowlng Lhe bulges and splkes ln Lhe laLLer years, Lhe raLlo reLurned Lo 136.6x ln 1991, Lo 167.9 ln 2003,
and Lo 184.2 ln 2010 (and may conLlnue falllng as 8asll and oLher regulaLory caplLal rules are lmplemenLed).
CcLober 2011

PART 5 Defi ni ng Debt/CF Zones

WlLhln a parLlcular lndusLry, Lhe uebL/Cl raLlos of Lhe parLlclpanL companles can be caLegorlzed lnLo
four Zones" as follows:

lnefflclenL Zone - Lhe corporaLlon ls operaLlng wlLh Loo conservaLlve a caplLal sLrucLure (l.e., ls
under-levered). CaplLal ls lnefflclenLly deployed and Lhe corporaLlon ls Lhereby produclng
subopLlmal reLurns for lLs sLakeholders.
CpLlmum Zone - Lhe corporaLlon's caplLal sLrucLure carrles an opLlmum level of debL (l.e., ls
approprlaLely levered). 1he reLurns Lo sLakeholders are maxlmlzed Lo Lhe exLenL posslble, whlle
sLlll properly and prudenLly mlLlgaLlng agalnsL rlsks LhaL may lead Lo debL defaulL. 1he concepL of
an opLlmal caplLal sLrucLure has been well explored ln academlc llLeraLure.
xl

Warnlng Zone - Lhe corporaLlon's caplLal sLrucLure ls over welghLed Lo debL (l.e., ls over-
levered). 1he corporaLlon ls llkely carrylng a greaLer level of debL relaLlve Lo lLs lndusLry peers,
and Lhe ablllLy Lo servlce lLs debL ls sLarLlng Lo be called lnLo quesLlon. CorporaLlons ln Lhls Zone
would be expecLed Lo have lower bond raLlngs Lhan companles ln Lhe CpLlmum Zone.
CalamlLy Zone - Lhe corporaLlon's caplLal sLrucLure ls conslderably over leveraged. 1he enLlLy ls
now aL serlous flnanclal rlsk or lndeed experlences a flnanclal calamlLy (l.e. enLers ChapLer 11).
WheLher or noL a clear and reasonably qulck paLh back Lo approprlaLe leverage levels ls
avallable wlll ln parL deLermlne lf a collapse ls avoldable.

A peer group of LwenLy uS elecLrlc uLlllLles were ploLLed based on uebL/Cl raLlos uslng Lhe above Zone
framework. 1he levels of Lhe demarcaLlons beLween Zones are lllusLraLlve only. More deflnlLlve Zone
ranges could be deLermlned based on furLher analysls.

1he Zones deflned for an lndlvldual company should be evaluaLed based on LhaL company's unlque
clrcumsLances, buL also can be referenced Lo lndusLry-wlde uebL/Cl Zones.

CcLober 2011

7"45$. = presenLs Lhe uebL/Cl lour Zone lramework applled Lo companles ln Lhe LlecLrlc uLlllLles
lndusLry.

I|gure 6 - Debt]CI kat|os w|th Iour 2one Iramework for Se|ected US L|ectr|c Ut|||ty Compan|es

llgure 6 lndlcaLes only a few uLlllLy companles occaslonally Louchlng Lhe blue lnefflclenL Zone (under-
levered). 1he CpLlmum Zone ls Lhe green range where mosL of Lhe companles reslde mosL of Lhe Llme
(prudenLly levered). Company vlslLs Lo Lhe yellow Warnlng Zone are Lyplcally Lemporary as wlll be
dlscussed below. Lven fewer lncldenLs of companles ln Lhe red CalamlLy Zone are reglsLered.

1he auLhor posLulaLes LhaL slmllar ranklngs wlLhln Lhe four uebL/Cl Zones could be underLaken for any
company wlLhln any lndusLry. AddlLlonal lnvesLlgaLlon ls requlred Lo supporL Lhe above Zone concepL
and Lo esLabllsh general Zone demarcaLlon ranges for oLher lndusLrles.

lurLher conslderlng llgure 3 (see arL 2), Lhe more volaLlle energy, Lechnology, healLhcare lndusLrles
would be expecLed Lo have CpLlmum Zones cenLered on a 4.0x Lo 3.0x mulLlple. uLlllLles and lndusLrlals
on Lhe oLher end manage 10x Lo 11x mulLlples and would be expecLed Lo have CpLlmum Zones cenLered
aL approxlmaLely 10x.

CcLober 2011

PART 6 Enteri ng the Cal ami ty Zone

Companles wlLh a hlgh debL componenL ln Lhelr caplLal sLrucLure run Lhe rlsk of conLlnulng ln an
escalaLlng paLLern from CpLlmum Zone Lo Warnlng Zone and sooner or laLer enLerlng Lhe CalamlLy Zone.
Some of Lhese companles wlll survlve and oLhers wlll fall.

Companles may reach a uebL/Cl raLlo ln Lhe CalamlLy Zone, yeL sLlll survlve. ClrcumsLances may be such
LhaL a company sLays ln Lhe CalamlLy Zone for a brlef perlod buL ls able Lo reverL Lo a lower, manageable
uebL/Cl level (Lhrough lncreased cash flow or decreased debL or boLh) and hence averL danger.

neverLheless, ln Lhe CalamlLy Zone rlsks are hlgh LhaL credlLors wlll soon reach Lhe concluslon (dlrecLly
or lndlrecLly) LhaL Lhere ls lnsufflclenL currenL and/or fuLure cash flow avallable Lo servlce and/or repay
ouLsLandlng debL.

7"45$. > presenLs a peer group of LlecLrlc uLlllLy Companles who have enLered Lhe CalamlLy Zone buL
were able Lo avold flnanclal collapse.

I|gure 7 - US L|ectr|c Ut|||ty Compan|es Lnter|ng the Ca|am|ty 2one and Surv|v|ng

ln llgure 7, Lhe LlecLrlc uLlllLy peer group ls presenLed ln order Lo examlne companles LhaL have enLered
Lhe CalamlLy Zone buL were able Lo avold a formal resLrucLurlng process. 1he Lwo excepLlons Lo Lhls are
C&L and Ll aso whlch were lefL ln Lhe flgure for comparaLlve purposes.
16

16
1he company daLa selecLed ls for lllusLraLlve purposes only and does noL deplcL Lhe enLlre unlverse of companles
LhaL were ln a slmllar slLuaLlon.

CcLober 2011

llgure 7 lllusLraLes how companles LhaL enLer lnLo Lhe CalamlLy Zone buL survlve Lend Lo reverL back Lo
uebL/Cl raLlos wlLhln Lhe CpLlmum Zone qulckly, and Lo a level conslsLenL wlLh Lhelr peer group. llgure
7 also lndlcaLes slLuaLlons (e.g. CenLral vermonL) where uebL/Cl raLlo peaks are llkely due Lo one-off
evenLs (accounLlng or operaLlonal) affecLlng corporaLe cash flow.

1he elghL companles clLed ln llgure 7 remalned ln Lhe CalamlLy Zone for an average of 1.23 years.

8ased on Lhe exLenslve Lnergy lnformaLlon Agency daLa, a peer group of over 100 uLlllLy Companles was
examlned ln deLall. ln parLlcular, lncldenLs of companles enLerlng lnLo ChapLer 11 were selecLed.

1ab|e 1 presenLs uLlllLy Companles ldenLlfled Lo have enLered Lhe CalamlLy Zone and gone on Lo
experlence flnanclal relaLed resLrucLurlng or a formal flnanclal collapse (e.g. ChapLer 11).
17

1ab|e 1- Ut|||ty Compan|es |n Iorma| D|stress roceed|ngs

17
lnnacle WesL, LnLergy Arkansas and llllnols ower were pro-acLlve crlsls managemenL evenLs and noL ChapLer
11 evenLs.
Company Year Event
Pinnacle West Capital Corp 1990 Restructuring of debt
Allegheny Energy Inc. 2002 Announced prospect of Chapter 11 in December
2002 - entered Chapter 11 in 2003
Entergy Arkansas 1985 Suspended dividends, restructured costs
Tucson Electric Power Company 1991 Entered Chapter 11, January
PG&E 2001 Entered Chapter 11, April
El Paso Electric Corp 1992 Entered Chapter 11 - Duration 4 years
Calpine Corp 2005 Entered Chapter 11 - Duration 3 years
Illinois Power Co 1989 Financial difficulty, suspended dividends, cost
restructuring
Mirant Corp 2003 Entered Chapter 11 - Duration 3 years
NRG Energy Inc. 2003 Entered Chapter 11 - Duration < 1 years
Northwestern Corp 2003 Entered Chapter 11
Public Service Co /NH 1988 Entered Chapter 11
Reliant Energy 2007 Entered Chapter 11
British Energy Group 2002 Approached British government for bailout/debt
restructuring, government bailout in 2004
Source: Company news releases, chapter11library.com
CcLober 2011

1he respecLlve uebL/Cl daLa for Lhe uLlllLy companles llsLed ln 1able 1 was complled for Lhe 10 years
precedlng and 10 years subsequenL Lo Lhe announcemenL of a formal dlsLress evenL. 7"45$. ? presenLs
Lhls analysls.

I|gure 8 - I|nanc|a||y D|stressed Ut|||ty Compan|es Lnter|ng the Ca|am|ty 2one and Ia|||ng

1he daLa suggesLs LhaL followlng or as parL of Lhe concluslon of ChapLer 11, Lhe companles Lend Lo
reverL lnLo a uebL/Cl raLlo Zone LhaL ls generally slmllar Lo Lhe CpLlmum Zone for Lhelr peer group as
ldenLlfled ln llgure 4 (l.e., reverslon Lo Lhe lndusLry mean of approxlmaLely 10x).

1he average Llme perlod from enLerlng Lhe Warnlng Zone, Lo crosslng lnLo Lhe CalamlLy Zone ls
approxlmaLely Lwo years. A furLher Lwo years on average Lhen Lransplres prlor Lo Lhe ChapLer 11
announcemenL. 1he average Llme perlod for re-enLerlng Lhe CpLlmum Zone afLer Lhe calamlLy evenL
occurs ls four years. 1he average round Lrlp from CpLlmum Zone Lo ChapLer 11 and back ls
approxlmaLely elghL years.

1he verLlcal demarcaLlon of Lhe Zones ln llgure 8 ls based on Lhe average uebL/Cl raLlo of Lhe group
analyzed. As has been dlscussed prevlously, Lhe demarcaLlon of Lhe Zones for a parLlcular company wlll
vary dependlng on lLs speclflc clrcumsLances.

1he daLa supporLs Lhe concepL LhaL companles sLepplng ouLslde Lhe lndusLry CpLlmum Zone are
generally forced back lnLo Lhe approprlaLe range elLher on a volunLary (dlrecLors acLlng prudenLly, or
due Lo hlgher cosLs of debL) or lnvolunLary basls (ChapLer 11).

LnLlLles ln Lhe Warnlng Zone or CalamlLy Zone whose debLs are of relaLlvely shorLer duraLlon (exLenslve
maLurlLles ln Lhe shorL-Lerm) are placed aL hlgher rlsk of a calamlLy acLually occurrlng.
xll

CcLober 2011

1he auLhor posLulaLes LhaL Lhe facL a company enLers a Warnlng Zone may, ln lLself, represenL a
reasonable lndlcaLlon of Lhe need Lo conslder poLenLlal revlLallzaLlon or resLrucLurlng acLlons. An
lncreaslng uebL/Cl Lrend ls a poLenLlal lndlcaLor of decllnlng flscal healLh. ln addlLlon, Lhe raLe of change
of Lhe uebL/Cl raLlo may be lndlcaLlve of Lhe severlLy of poLenLlal problems.

CcLober 2011

PART 7 US Househol ds Borrowi ng Capaci ty

1he uebL/Cl Zone approach was furLher LesLed by appllcaLlon ln a conLexL away from Lyplcal corporaLe
and lndusLry flnanclal analysls. uS Pouseholds
18
cash flow daLa, referred Lo as Cross Savlngs, ls avallable
as ls Lhe LoLal debLs of Lhe Pousehold secLor, permlLLlng a sLandard uebL/Cl calculaLlon.
19

ln 7"45$. @, a hlsLory of Lhe uS Pouseholds secLor uebL/Cl raLlo ls deplcLed.
20

I|gure 9 - Debt]CI kat|o of US nouseho|ds and Non-prof|t Inst|tut|ons

18
Pouseholds are one of Lhe sLandard four segmenLs of Lhe uS economy: Pouseholds, CorporaLlons, llnanclals,
and CovernmenL.
19
Cross Savlngs and relaLed concepLs are furLher explalned ln arL 8. Pousehold CredlL MarkeL uebL CuLsLandlng ls
used as Lhe uebL componenL. 1oLal LlablllLles of Pouseholds were also LesLed whlch produced an lmmaLerlal
dlfference ln resulLs.
20
8ased on daLa from Lhe uS lnLegraLed Macroeconomlc AccounLs, 8LA, ueparLmenL of Commerce.

CcLober 2011

1he flgure lllusLraLes Lhe plauslblllLy of applylng a uebL/Cl Zone approach Lo Lhe Pouseholds secLor.
21
uS
Pouseholds malnLalned a poslLlon ln a suggesLed CpLlmum Zone for Lhe Lhree decades 1960s Lo 1980s.
Pouseholds enLered Lhe Warnlng Zone ln 1993 (deplcLed as 10x and hlgher), and 8 years laLer crossed Lo
Lhe CalamlLy Zone ln 2001 (20x and hlgher). 1he resulLlng calamlLy and oLher evenLs underlylng Lhls daLa
have been covered exLenslvely ln Lhe press.

8ased on Lhe Llmlng of Pouseholds crosslng Zone boundarles, Lhe Zone approach may have merlL as an
early warnlng Lool agalnsL lmpendlng flnanclal dlfflculLles. ApproxlmaLely 7 years Lransplred from
Pouseholds enLerlng Lhe CalamlLy Zone Lo Lhe crlses of 2008. ln sum, Lhe duraLlon from leavlng Lhe
CpLlmum Zone unLll Lhe calamlLles occurred was approxlmaLely 13 years.

1he Zones applled Lo Pouseholds were ad[usLed downward from Lhe uLlllLy secLor analyzed earller (l.e.
wlLh Lhe CpLlmum Zone cenLered on 7.3x lnsLead of 10x). 1he Warnlng Zone ls deplcLed as 10x Lo 20x,
alLhough ongolng severe dlfflculLles for Lhe uS Pousehold secLor ln years subsequenL Lo 2008 suggesL
Lhe boundary beLween Warnlng and CalamlLy Zones could poLenLlally be seL lower (13x for example).
Zones speclflc Lo Lhe Pouseholds secLor could be ldenLlfled Lhrough furLher research.
22

1he qulck reLurn by Pouseholds Lo a uebL/Cl of approxlmaLely 16x ln recenL years suggesLs a process of
reverslon Lo mean may be underway. ln Lhls case Lhe reverslon ls llkely Lhe resulL of boLh wrlLe-offs of
morLgage and consumer debLs by banks (reduclng Lhe numeraLor), and lncreased savlngs on Lhe parL of
Pouseholds (lncreaslng Lhe denomlnaLor). CovernmenL lncome and houslng programs may also affecL
(oversLaLe) Lhe speed aL whlch Lhe Pouseholds secLor ls lndlcaLed Lo reverL Lowards sLable long-Lerm
mean raLlos. lurLher research and daLa would be requlred Lo furLher valldaLe Lhese observaLlons.

1he uebL/Cl hlsLory of Lhe uS Pouseholds secLor also speaks Lo Lhe ublqulLous naLure of Lhe uebL/Cl
raLlo as a measure of flnanclal healLh. 1he analysls supporLs Lhe use of Lhe lour Zone lramework as a
means of dellneaLlng uebL/Cl levels as prudenL or problemaLlc.

21
A commonly used Pouseholds leverage lndlcaLor ls uebL/ulsposable lncome. 1hls meLrlc ls prlor Lo
consumpLlon declslons made by Pouseholds. 1he Pouseholds uebL/Cross Savlngs raLlo Lakes lnLo accounL all
consumpLlon declslons and hence may be a useful addlLlonal meLrlc.
22
1he auLhor posLulaLes LhaL Lhe CpLlmum Zone for Pouseholds ls llkely cenLered aL a lower uebL/Cl level Lhan for
uLlllLles. 1he Pouseholds secLor ls an aggregaLe of lndlvldual households, and lssues such as lncome and wealLh
dlsLrlbuLlon would be expecLed Lo affecL Lhe deLermlnaLlon of approprlaLe Zones.

CcLober 2011

PART 8 Debt/CF Appl i ed to Nati ons

1he auLhor hypoLheslzes LhaL Lhe uebL/Cl raLlo has merlL as a Lool Lo measure Lhe relaLlve lndebLedness
of naLlons, Lhe ongolng debL-carrylng capaclLy of naLlons, and as early warnlng slgnals Lo averL flnanclal
crlses of naLlons.

A reasonably Lhorough revlew of publlshed llLeraLure was conducLed buL prlor papers whlch
conLemplaLe Lhe use of uebL/Cl raLlos for naLlons were noL locaLed.
xlll
Whlle llLeraLure clLlng Lhe use of
Lhe uebL/Cl meLrlc for naLlons may lndeed exlsL, Lhls concepL would cerLalnly noL appear Lo be ln
common usage.
23

Slmllar Lo corporaLe analysls, lenders can assess Lhe percelved securlLy of a counLry's cash flow. A
naLlon's ablllLy Lo generaLe a sLeady, rellable cash flow ls a funcLlon of Lhe underlylng sLrengLh or
dynamlcs of lLs economy. As a naLlon's cash flow and sLablllLy of cash flow lncreases, Lhe debL carrylng
capablllLy of LhaL naLlon also lncreases. 8aLlng Agencles apparenLly do noL uLlllze Lhe uebL/Cl raLlo ln Lhe
evaluaLlon of soverelgn debL.
xlv

1he uebL/Cl raLlo for a naLlon ls derlved by complllng Lhe aggregaLe ouLsLandlng lndebLedness for Lhe
naLlon, and dlvldlng by Lhe aggregaLe cash flow produced by LhaL counLry. A naLlon's 1oLal CounLry uebL
conslsLs prlmarlly of Lhe credlL markeL debL obllgaLlons,
24
whlle cash flow ls measured by Lhe Cross
Savlngs generaLed by LhaL counLry.

varlous auLhors have complalned abouL Lhe llmlLed avallablllLy of aggregaLe debL daLa lnLernaLlonally,
xv

however Lhe provlslon of Lhls daLa, alLhough ln lLs lnfancy, ls now becomlng avallable.
xvl

Cross Savlngs, on Lhe oLher hand, has been a long sLandlng concepL lnLernaLlonally (ln Lhe naLlonal
lncome and roducL AccounLs), and Lhe daLa ls wldely avallable. 1he CLCu, for example, Lracks Cross
Savlngs for counLrles ln Lhe naLlonal AccounLs daLa.
xvll

23
1he auLhor would appreclaLe belng apprlsed of such maLerlals, as well as oLher maLerlal dlrecLly or lndlrecLly of
lnLeresL, please use 8A8[LndlngCverLendlng.com.
24
CLher lLems can lnclude Lrade payables, Laxes payable, securlLy credlL and mlscellaneous.
CcLober 2011

1ab|e 2 summarlzes comparable Lermlnology of key flnanclal and economlc measures for households,
corporaLlons and counLrles.

1ab|e 2 - 1erm|no|ogy Lqu|va|ents
nouseho|ds Corporat|ons Nat|ons

lncomes 8evenues Cu
neL Savlngs neL roflL neL Savlngs
CaplLal ConsumpLlon
Allowance
uepreclaLlon and
AmorLlzaLlon
CaplLal ConsumpLlon
Allowance
Cross Savlngs Cash llow Cross Savlngs
Cross Savlngs Margln Cash llow Margln Cross Savlngs Margln
1oLal uebL 1oLal LlablllLles 1oLal CounLry uebL
8ankrupLcy ChapLer 11 llnanclal CalamlLy

1he uebL/Cl meLrlc for a naLlon may provlde addlLlonal lnslghL over LradlLlonal measures such as 1oLal
CounLry uebL/Cu
23
and CovernmenL uebL/Cu.
26
8y way of example, 1ab|e 3 provldes lllusLraLlve
calculaLlons for sample naLlons A and 8.

1ab|e 3 - Compar|son of Nat|ons A and 8
naLlon A naLlon 8

Cu 1,000 1,000
Cross Savlngs 230 100
Cross Savlngs Margln 23 10
1oLal CounLry uebL 2,300 2,300
uebL /Cu ln 230 230
uebL /Cl 10.0x 23.0x

naLlons A and 8 have ldenLlcal Cu and level of uebL. naLlon A ls a savlngs drlven economy. ln conLrasL,
naLlon 8 has lower savlngs and perhaps ls a more consumer based economy. 8oLh counLry's uebL/Cu
ls 230,
27
however, Lhe Lwo naLlons are very dlfferenLly levered.

naLlon A has hlgh cash flow marglns of 23 whlle naLlon 8 has low cash flow marglns of 10. As a
consequence, naLlon A wlLh a uebL/Cl raLlo of 10x, ls slgnlflcanLly less levered Lhan naLlon 8, wlLh a 23x
raLlo.

23
A Mcklnsey Clobal lnsLlLuLe sLudy (p. 20) concluded LhaL overall measures of debL Lo Cu for a naLlon are a
mlsleadlng gulde and LhaL debL levels musL be examlned on a secLor level.
26
CovernmenL uebL/Cu ls useful ln LhaL Lhe raLlo speaks Lo Lhe exLenL of lncremenLal burden LhaL Lhe cash
flow produclng secLors (Pouseholds and CorporaLe) musL carry.
27
8y convenLlon Lhls sLaLlsLlc ls reporLed as a percenLage.
CcLober 2011

7"45$. 8A presenLs Lhe Cross Savlngs Margln as a of Cu for several naLlons. varlaLlon among
counLrles' savlngs levels ls slgnlflcanL. 1he cash flow of a naLlon dlrecLly lmpacLs lLs ablllLy Lo carry debLs.

I|gure 10 - Gross Sav|ngs Marg|ns for Se|ected Countr|es

norway ls currenLly experlenclng very sLrong Cross Savlngs Marglns of over 30. Cn Lhe oLher hand
Creece's margln ls comparaLlvely low, and has fallen ln recenL years Lo Lhe 3 level.

!apan ls known Lo have a hlgh savlngs raLe. !apan's 1oLal CounLry uebL/Cu ls approxlmaLely 300, yeL
Lhe counLry's very hlgh savlngs raLe has asslsLed wlLh carrylng Lhls hlgh level of debL. Creece's 1oLal
CounLry uebL/Cu was 260 ln 2009, roughly half of Lhe uebL/Cu of !apan, buL Creece suffered a
flnanclal collapse.

1he uk and uS have followed slmllar paLhs slnce 1970, wlLh naLlonal Cross Savlngs Marglns lnlLlally 20
or more, decllnlng Lo approxlmaLely 13 slnce 2000, and more recenLly slldlng below Lhe 13 level.

A useful exLenslon of Lhls analysls ls Lo dlvlde uebL/Cu by Cross Savlngs Margln, Lhe resulL of
whlch ls an esLlmaLe for Lhe uebL/Cl raLlo for Lhe naLlon.
28

28
norway has a uebL/Cu of 386 ln 2009 and a Cross Savlngs Margln of 33. ulvldlng Lhe 386 by Lhe 33
correcLly calculaLes a uebL/Cl raLlo of norway of 11.6x. 1hls lndlrecL rouLe Lo calculaLe uebL/Cl raLlos ls a
secondary approach and noL Lhe prlmary meLhod of calculaLlon uLlllsed for Lhls paper.

CcLober 2011

ln 7"45$. 88, Lhe neL Lendlng/8orrowlng of slx naLlons ls presenLed.

I|gure 11 - Net Lend|ng]8orrow|ng of Se|ected Countr|es

Lach year Lhe naLlonal AccounLs of a counLry deLermlne wheLher neL Lendlng or 8orrowlng has
occurred. neL 8orrowlng (shown above as a negaLlve percenLage of Cu) colncldes wlLh Lhe
accumulaLlons of debL.
29
SlmpllsLlcally, naLlons are neL 8orrowers when cash flow (Cross Savlngs) ls less
Lhan caplLal lnvesLmenL. As a resulL, Lhe Cu of a counLry durlng LhaL year ls hlgher Lhan would
oLherwlse be Lhe case, as Lhe naLlon essenLlally spends (consumes) Lhe borrowed funds. ln effecL Lhls
porLlon of Cu ls 'unearned'.

ln Lhe case of years of neL Lendlng, a naLlon would have surplus funds (Cross Savlngs beyond caplLal
lnvesLmenLs). 1hese naLlons have earned 100 of lLs Cu, plus have excess cash flow avallable Lo pay
down debL or lend lnLernaLlonally.

lrom 1929 unLll 1976 Lhe uS osclllaLed beLween neL 8orrowlng and neL Lendlng, ln mosL years belng
marglnally (less Lhan 1 of Cu) elLher a borrower or a lender. Slnce 1977, Lhe uS has been a neL
8orrower ln every year. lrom 2000 Lo 2010, Lhe unearned porLlon of uS Cu averaged 4.3.

1hree of Lhe four lCS naLlons are deplcLed ln llgure 11. orLugal averaged 3.6 of Cu as unearned ln
Lhe Len years slnce 2000. lrom 1970 Lo 2000, lreland was sLrong - a neL lender ln every year excepL Lwo.
SLarLlng ln 2001, lreland became a sLeady neL borrower, averaglng 3.0 unearned Cu subsequenLly.

29
neL 8orrowlng does noL necessarlly accounL for Lhe enLlre lncrease ln a naLlon's debL each year. lncremenLal
debLs can also accumulaLe ln con[uncLlon wlLh lncreased asseL borrowlngs.

CcLober 2011

Creece has hlsLorlcally been a neL 8orrower, wlLh only seven years slnce 1970 as a lender. ln Lhe Len
years from 2000 Lo 2009, Creece borrowed an average of 11.2 (l.e. unearned Cu of 11.2 per year).
1he Len year (2000-2009) average unearned Cu for Spaln was 3.6 (noL deplcLed).

lceland had a very slgnlflcanL porLlon of lLs Cu unearned, as lllusLraLed ln llgure 11. 1he uk on Lhe
oLher hand, has been a sLeady, buL mlnor neL 8orrower ln Lhe pasL wlLh an average of 2.1 of
unearned Cu ln Lhe Len years from 2000 Lo 2009.

Sweden, norway, SwlLzerland, and Cermany are all examples of naLlons whose Cu has been 100
Larned ln recenL years (Lhese counLrles have been neL Lenders and do noL experlence unearned Cu).
30

30
naLlons relylng on unearned Cu are more llkely Lo have unsLable Cross Savlngs, ln Lurn sub[ecLlng Lhe uebL/Cl
Lo rlsks of a splklng raLlo.
CcLober 2011

PART 9 Determi ni ng the Debt/CF for a Nati on

1he followlng compllaLlon of a uebL/Cl raLlo hlsLory of Lhe unlLed SLaLes serves Lo demonsLraLe Lhe
process of compuLlng and analyzlng a counLry's uebL/Cl raLlo.

ln Lhe unlLed SLaLes, 1able L1 of Lhe lederal 8eserve 8oard llow of lunds AccounLs
xvlll
reporLs 1otol
cteJlt Motket uebt OotstooJloq".
31
1he daLa has been reporLed ln Lhls formaL slnce 1932.
32

xlx

1he domesLlc porLlon of 1oLal CounLry uebL daLa ls Lyplcally segmenLed lnLo four caLegorles: Pousehold
uebL, CorporaLe uebL, llnanclal SecLor uebL, and CovernmenL uebL. Several prlor reporLs have
dlscussed and demonsLraLed Lhe accumulaLlons of debLs among Lhese secLors.
xx

Whlle oLher naLlons' reporLlng meLhodology may dlffer somewhaL, comparaLlve lnLernaLlonal debL daLa
has become avallable ln recenL years Lhrough Lhe CLCu llnanclal AccounLs, Lu AccounLs, and dlrecL
from cenLral banks.
33

ln Lhe unlLed SLaLes, 1able 3.1 of Lhe 8ureau of Lconomlc Analysls 5otvey of cotteot 8osloess reporLs
Cross Savlngs. 1he daLa ls reporLed ln Lhls form daLlng from 1929.

1he Cross Savlngs calculaLlon flrsL adds Lhe naLlon's corporaLe and banklng proflLs LogeLher wlLh
household savlngs, and deducLs governmenL deflclLs (a governmenL surplus would be added). 1o Lhls
neL Savlngs amounL for Lhe naLlon, a caplLal consumpLlon allowance (l.e., a depreclaLlon equlvalenL) ls
added Lo arrlve aL Cross Savlngs. An analogy for a naLlon's cash flow calculaLlon ls Lhe corporaLe realm
(see 1able 2) where neL proflL afLer Lax plus depreclaLlon equals Lhe operaLlng cash flow of Lhe
buslness.
34

1he Cross Savlngs of a naLlon represenLs Lhe cash generaLed from all secLors comblned. ConcepLually,
Lhese funds are avallable Lo repay currenL debL prlnclpal repaymenLs, consLrucL physlcal asseLs, rebulld
sLrucLures needlng replacemenL, and so forLh.

7"45$. 89 presenLs Lhe hlsLorlcal uebL/Cl for Lhe unlLed SLaLes.

31
unfunded LlablllLles are noL lncluded.
32
1he Lyplcal source for pre-1932 daLa has been ueparLmenL of Commerce daLa clLed ln Lconomlc 8eporL of Lhe
resldenL (1970s). uLlllzlng Lhls parLlcular hlsLorlcal daLa was challenged as Lechnlcally wrong and analyLlcally
meanlngless" by CredlL-Sulsse, who offered a 'spllced' verslon of Lhe daLa provldlng some marglnal dlfferences. lor
Lhe purposes of Lhls paper, Lhe years of overlap (1932-1973) were compared Lo deLermlne a medlan dlfferenLlal of
13.8 (average was 13.1, wlLh a range of 11.9 Lo 17.3) beLween Lhe Lwo daLa sLreams. 1hls dlfferenLlal was
Lhen applled Lo Lhe pre-1932 daLa ln order Lo emulaLe (by lowerlng Lhe pre-1932 daLa) Lhe CredlL MarkeL LlablllLles
CuLsLandlng basls.
33
1oLal CounLry uebL has been proposed Lo lnclude lLems whlch go beyond CredlL MarkeL uebL obllgaLlons such as
Lrade payables, Laxes owlng or oLher lLems, dependlng on Lhe deLall of Lhe deflnlLlon. 1hls broader flgure ls
becomlng clLed as uomesLlc uebL. Paver AnalyLlcs, for example, publlshes uomesLlc uebL and uomesLlc uebL/Cu
ln ln collaboraLlon wlLh cerLaln CenLral 8anks.
34
Changes ln worklng caplLal are Lyplcally lncorporaLed, whlch Lend Lo 'average ouL' over Llme frames and are Lhus
noL consldered maLerlal for purposes of Lhls paper.
CcLober 2011


I|gure 12 - n|stor|ca| Debt]CI kat|o for the Un|ted States

1he hlsLorlcal uebL/Cl raLlo for Lhe unlLed SLaLes fall lnLo four eras as ouLllned ln 1ab|e 4.

1ab|e 4 - Un|ted States Debt]CI Lras
uurlng Lhe 1920s, Lhe unlLed SLaLes experlenced Lhe boom perlod descrlbed as Lhe 8oarlng 20s. ln 1929,
aL Lhe end of Lhe perlod, aggregaLe debL amounLed Lo some $170 bllllon,
33
whlle Cross Savlngs were
approxlmaLely $19.3 bllllon, resulLlng ln a uS uebL/Cl raLlo of 8.8x.

33
As dlscussed ln fooLnoLes ln Lhe prlor secLlon, CredlL MarkeL uebL CuLsLandlng daLa prlor Lo 1932 requlres
esLlmaLlon. ln a paper wrlLLen durlng Lhe uepresslon, lrvlng llsher uLlllzed a flgure of $200 bllllon for 1929 (a
uebL/Cl raLlo of 10.4x). llsher, l. (1933).1he $170 bllllon uLlllsed ln Lhls paper compares Lo a Mary Meeker
esLlmaLe of approxlmaLely $190 bllllon (a uebL/Cl of 10.0x). (lnLerpolaLlon from Meeker, M. A. (2011 lebruary).
u.5.A. loc.. A 8oslc 5ommoty of Ametlco's lloooclol 5totemeots

CcLober 2011

unforLunaLely, uS Cross Savlngs proved very unsLable as Lhe uepresslon unfolded, and fell rapldly Lo
$3.3 bllllon by 1932. A recovery ln Cross Savlngs Lo $9.6 bllllon by 1933 Lhen occurred. 1hls exLreme
volaLlllLy caused by Lhe hlghly unsLable Cross Savlngs ls responslble for Lhe splke ln uS uebL/Cl Lo over
43x ln 1932 and 1933. 1he raLlo proceeded Lo fall successlvely Lo 23.7x ln 1934, 16.1x ln 1933, and 13.9x
ln 1936. MosL of Lhls decllne was Lhe resulL of lmproved Cross Savlngs, however, 1oLal CounLry uebL
ouLsLandlng dld decllne Lo $133 bllllon by 1933
36
as a resulL of exLenslve bank fallures.

8y pre-war 1940, Cross Savlngs had recovered Lo $18.3 bllllon. uebL had grown only modesLly Lo $167.9
bllllon. 1he uS uebL/Cl raLlo decllned Lo 9.1x. World War ll efforLs broughL rapld debL growLh, more
Lhan doubllng ouLsLandlng debL. AL Lhe same Llme savlngs were hlgh and grew such LhaL Lhe uebL/Cl
raLlo rose only modesLly, Lo 12.0x ln 1943.

A long, sLable perlod of over 30 years accompanled Lhe laLe 1940s unLll Lhe laLe 1970s. lrom 1932 Lo
1969 Lhe uS uebL/Cl raLlo was very sLable, averaglng 7.0x, and sLaylng wlLhln a LlghL range (a hlgh of
7.3x and a low of 6.2x durlng Lhe 18 year perlod). 1hls sLablllLy conLlnued even Lhrough recesslons, Lhe
early vleLnam War and oLher macroeconomlc evenLs. AggregaLe debL grew, buL Cross Savlngs lncreased
proporLlonaLely.

uurlng Lhe 1970s, a perlod of conslderable lnflaLlon occurred.
37
1he uS debL/cash flow raLlo lncreased Lo
8.18x for Lhe decade. varlous commenLaLors have lndlcaLed Lhe closlng of Lhe uS Cold Wlndow ln 1971
as Lhe source of boLh subsequenL lnflaLlon and Lhe escalaLlon ln leverage.
38

uurlng Lhe 1980s, debL levels almosL Lrlpled, such LhaL 1oLal CounLry uebL ouLsLandlng was $13.8 Lrllllon
ln 1990. A promlnenL feaLure of Lhese years was Lhe Savlngs & Loans Crlsls.
39
As Lhls debL growLh
ouLsLrlpped Cross Savlngs galns, uS debL/Cl raLlo lncreased Lo an average 11.3x for Lhe decade. 1he
raLlo escalaLed Lo reach 13.0x ln 1990.

1he average raLlo for Lhe 1990s was 13.3x. uurlng Lhe 1990s, debL levels lncreased approxlmaLely 70,
however, Cross Savlngs almosL doubled. 8ased on Cross Savlngs growLh ouLwelghlng debL
accumulaLlon, year 2000 uebL/cash flow dropped Lo 13.0x. A slgnlflcanL dlsrupLlon Lo Lhe flnanclal
sysLem and markeLs occurred ln Lhe 1990s when Lhe Long 1erm CaplLal ManagemenL enLlLy collapsed.
40

ln 2000, uS Cross Savlngs were $1.8 Lrllllon, buL decreased Lo $1.7 Lrllllon ln 2010. 1oLal CounLry uebL
more Lhan doubled durlng Lhe 10 year perlod Lo $32.6 Lrllllon ln 2010. noLable asseL prlce lnflaLlon
(houslng ln parLlcular) occurred as a resulL of Lhe rapld accumulaLlon of debL.
xxl
uurlng 2008, Lhe uS
banklng sysLem falled and was requlred Lo be 'balled ouL' by Lhe uS lederal CovernmenL and Lhe
lederal 8eserve. 1he 2010 uebL/Cash llow raLlo for Lhe uS was 30.9x, afLer reachlng a modern era hlgh
of 34.1x ln 2009.

36
An lnLerpolaLlon of Lhe Mary Meeker esLlmaLe for 1933 debL approxlmaLed $163 bllllon.
37
Cne explanaLlon for lnflaLlon has been clLed as a process LhaL beglns wlLh an lncrease ln money and credlL above
whaL ls needed for Lhe producLlon of goods and servlces" 8oeckh, !. A. (2010) page 4. CLher exLreme aspecLs of
lnflaLlon are expored ln SargenL, 1. !. (1981), 1be oJs of loot 8lq loflotloos.
38
See for example Wlklpedla.
39
1he Savlngs and Loan Crlsls requlred a governmenL ballouL of LhrlfL lnsLlLuLlons, announced by resldenL 8ush ln
lebruary 1989 (www.lulC.gov/bank/hlsLorlcal/s&l/).
40
1he fallure of a hedge fund Long 1erm CaplLal ManagemenL sLemmed from 8usslan defaulL on 8uble debLs.
CcLober 2011

1he average uS uebL/ Cash llow raLlo durlng 2000 Lo 2010 was 23.3x. 1he speclflcs by year are provlded
ln 1ab|e S below.

ln response Lo Lhe flnanclal crlsls, Lhe lederal 8eserve cuL lnLeresL raLes Lo hlsLorlcally low levels.
41

LxLenslve credlL markeL debL purchases were also underLaken, and conLlnued lnLo a second round of
purchases known as CuanLlLaLlve Laslng ln 2010-2011.

SubsequenL Lo Lhe crlsls, Lhe Luropean CenLral 8ank
42
(and oLhers) have proposed LhaL naLlons should
'lean agalnsL Lhe wlnd' of asseL bubbles. 1hls approach ls ln conLrasL Lo Lhe percelved uS pracLlce of
allowlng asseL lnflaLlons and cleanlng up afLerwards ln Lhe evenL of a flnanclal mlshap.
xxll

1ab|e S - Un|ted States Debt]CI rof||e 2000-2010

41
led Chalrman 8en 8ernanke wroLe ln a column: Lasler flnanclal condlLlons wlll promoLe economlc
growLh..hlgher sLock prlces wlll boosL consumer wealLh and help lncrease confldence, whlch can also spur
spendlng. lncreased spendlng wlll lead Lo hlgher lncomes and proflLs LhaL, ln a vlrLuous clrcle, wlll furLher supporL
economlc expanslon." 8ernanke, 8. S. (2010, november 3). AlJloq tbe cooomy. wbot tbe leJ ulJ ooJ wby.
42
See for example Luropean CenLral 8ank. (2010, november 11). Asset ltlce 8obbles ooJ Mooetoty lollcy
kevlslteJ.
CcLober 2011

Part 10 Debt/CF Anal ysi s of Nati ons

7"45$. 8: provldes a vlew of Lhe hlsLorlcal uebL/Cl raLlo for 26 naLlons. 1he naLlons chosen for analysls
were largely based on Lhe avallablllLy of CLCu or equlvalenL daLa.
43

I|gure 13 - n|stor|ca| Debt]CI for 20 Se|ected Nat|ons

Analogous Lo Lhe corporaLe and lndusLry secLor dlscusslon earller, a slmllar lour Zone lramework can be
applled Lo a parLlcular naLlon. 1he same four Zones are conLemplaLed for naLlons: lnefflclenL, CpLlmum,
Warnlng, and CalamlLy.

1he demarcaLlon of Lhe four Zones aL Lhe aggregaLe naLlon level ls LenLaLlve only. lurLher research of
varlous aspecLs of Lhe uebL/Cl raLlos of naLlons ls necessary Lo draw speclflc concluslons. ln Lhls conLexL,
raLher Lhan Lhln llnes dellmlLlng beLween Zones, Lhe concepL ls beLLer concelved as wlde grey areas of
overlap.

43
CredlL MarkeL uebL CuLsLandlng and Lhe equlvalenL CLCu sLaLlsLlcs are uLlllsed Lo measure 1oLal CounLry uebL,
as Lhls meLrlc offered Lhe greaLesL conslsLency of daLa. 1he lncluslon of addlLlonal lLems, ln parLlcular 1rade
ayables, (such as ln Lhe 'uomesLlc uebL' compllaLlons) could be deployed once greaLer lnLernaLlonal conslsLency
of Lhe sLaLlsLlc ls achleved, or a broadly accepLed deflnlLlon for 1oLal CounLry uebL ls ln place. Accordlng Lo LesLlng
ln con[uncLlon wlLh Lhls paper, addlng 1rade ayables would have Lhe effecL of lncreaslng Lhe uebL/Cl mulLlples
raLlos for Lhe uS by an average of 9.7 slnce 1932. 1haL ls, an example raLlo of 10.0x would lncrease Lo 10.97x.

CcLober 2011

As wlLh a corporaLlon, Lhe Zones deflned for a parLlcular counLry would be relaLed Lo LhaL counLry's
parLlcular clrcumsLances. ConLrlbuLlng facLors could lnclude Lhe counLry's slze, llquldlLy of lLs markeLs,
sLablllLy of reglme, savlngs versus consumpLlon orlenLaLlon, among oLher facLors. lnLulLlvely, counLrles
wlLh more dlverslfled economles may be able Lo carry hlgher uebL/Cl raLlos Lhan counLrles wlLh
narrower economles (e.g. commodlLy based counLrles llke Canada and AusLralla).

1he Zone ranges chosen for Lhe presenLaLlon of naLlons are Lhose of Lhe uLlllLy peer groups analyzed
earller. 1he argumenL for Lhe slmllarlLy ls based on uLlllLles havlng relaLlvely sLable and conslsLenL cash
flow levels. naLlons presumably en[oy some beneflL of dlverslflcaLlon of componenL cash flows, wlLh Lhe
aLLendanL beneflL of reduced volaLlllLy of aggregaLe Cross Savlngs. lurLher sLudy ln Lhls regard ls
requlred. lor example, an argumenL could be advanced LhaL Lhe approprlaLe u/Cl for a naLlon should
reflecL Lhe welghLed average u/Cl of Lhe componenL lndusLry secLors. ln Lhe lnLerlm, adopLlng Lhe
uLlllLy secLor Zones as a 'peer' comparlson Lo a naLlon ls funcLlonal.

lurLher 'peers' can be referenced for approprlaLe Zones for naLlons. 8erkshlre PaLhaway, consldered
one of Lhe besL-managed companles ln Lhe world, averaged a uebL/Cl raLlo of 12.3x over Lhe 10 years
slnce 2001, and ln 2010 Lhe raLlo was 11.7x.
44
A naLlon may noL be capable Lo manage affalrs as well as
Warren 8uffeL and hls Leam, and Lherefore a more conservaLlve (lower) uebL/Cl LargeL Lhan 12.3x for a
naLlon may be prudenL.

ln llgures 14 Lhrough 17 Lhe uebL/Cl raLlos for varlous counLrles are presenLed over Llme and
segmenLed accordlng Lo Zone.

44
8ershlre PaLhaway flnanclal sLaLemenLs.
CcLober 2011

7"45$. 8; deplcLs Lhree naLlons consldered Lo be ln Lhe lnefflclenL Zone.

I|gure 14 - Nat|ons |n the Ineff|c|ent 2one

naLlons ln Lhe lnefflclenL Zone may be under-levered Lo Lhe exLenL LhaL debL caplLal ls belng
underplayed, and Lhelr economy may Lherefore noL be operaLlng aL lLs opLlmum poLenLlal. erhaps such
a counLry 'learned a lesson' as a consequence of a recenL calamlLy and has become relucLanL Lo borrow.
AlLernaLlvely, perhaps lenders are relucLanL Lo lend due Lo hlsLorlcal, pollLlcal, soclal or oLher lssues. 1he
sLaLe of developmenL of caplLal markeLs and llquldlLy would also lnfluence Lhe avallablllLy of debL
caplLal.

Mexlco, oland and Czech 8epubllc would all be presumed Lo be ln a safe, buL posslbly under-levered
flnanclal poslLlon.

1he upper dellmlL of Lhe lnefflclenL Zone ls a level aL whlch a naLlon crosses from under-levered Lo
approprlaLely levered.

CcLober 2011

LlghL naLlons wlLh uebL/Cl under 13x on Lhe basls of 2009 (or Lhe laLesL daLa avallable), consldered Lo
be ln Lhe CpLlmum Zone are lllusLraLed ln 7"45$. 8<.

I|gure 1S - Nat|ons |n the Cpt|mum 2one

naLlons ln Lhe CpLlmum Zone are presumed Lo be characLerlzed as havlng a prudenL level of overall
leverage ln Lhelr economles. lor counLrles whlch operaLe ln Lhe CpLlmum Zone, economlc crlses are less
llkely, wlll be less severe, occur less ofLen and can be more easlly managed.
xxlll

norway's sLrong Cross Savlngs Margln (llgure 10) conLrlbuLes Lo lLs lncluslon ln Lhe CpLlmum Zone
group. AusLrla adopLed Lhe Luro slmllar Lo Creece, orLugal and lreland, buL dld noL follow down Lhe
paLh of excesslve leverage and has remalned ln Lhe CpLlmum Zone.

llnland and AusLralla's economles, welghLed Lo commodlLles, may be sub[ecL Lo greaLer volaLlllLy of
Cross Savlngs, buL are presumed Lo be ln a prudenL poslLlon.

Pungary suffered a banklng crlsls ln 1991-1993
xxlv
whlch was followed by a flve year perlod where Lhe
uebL/Cl raLlo resLed near Lhe boLLom of Lhe CpLlmum Zone range.
43

43
AlLhough Lhe daLa for Lhe early years of Lhe banklng crlsls ln Pungary was noL readlly avallable, Lhe decllnlng
uebL/Cl raLlos for Lhe years shown may lnvolve Lhe Lall end of a reverslon Lo mean (or an overshooL of a reverslon)
afLer Lhe dlsrupLlon.

CcLober 2011

AlLhough allocaLed Lo Lhe CpLlmum Zone, aL leasL Lwo of Lhese naLlons' banklng sysLems needed Lo be
rescued aL Lhe peak of Lhe 2008 flnanclal crlsls (Cermany and SwlLzerland). lndlvldual secLors wlLhln a
counLry can be sLruggllng, buL Lhe naLlon may be able Lo wlLhsLand a shock from a slngle segmenL.
Cermany and SwlLzerland experlenced calamlLles wlLhln Lhe flnanclal secLor (Lhe lnLernaLlonal
Lransmlsslon of credlL unworLhlness), buL were well enough poslLloned wlLhln Lhe CpLlmum Zone Lo
escape naLlon-wlde calamlLy.

1he upper dellmlL of Lhe CpLlmum Zone ls a level aL whlch a naLlon crosses from approprlaLely leveraged
Lo belng somewhaL over-levered. Crosslng Lhls level acLs as a naLlon's flrsL warnlng sLage ln Lhe guard
agalnsL adverse evenLs.

arL 3 revlewed Lhe lmpacLs of recesslonary perlods on lndusLry Croups. As ls vlslbly evldenL ln llgure
13, Lhe recenL CreaL 8ecesslon and 2008 flnanclal collapse lmpacLed naLlons ln a slmllar macro
fashlon.
xxv
1he counLrles deplcLed appear Lo collecLlvely mlgraLe from Lhe 10x level pre-crlsls, Lowards
Lhe 13x level.

CcLober 2011

7"45$. 8= lllusLraLes naLlons segmenLed lnLo Lhe Warnlng Zone on Lhe basls of a 2009 (or Lhe laLesL daLa
avallable) uebL/Cl raLlo above 13x buL below 23x.

I|gure 16 - Nat|ons |n the Warn|ng 2one

Many of Lhe naLlons currenLly ln Lhe Warnlng Zone have mlgraLed upwards wlLh Lhe recenL global
recesslon and were prevlously poslLloned ln Lhe CpLlmum Zone. A reason for Lhls Lrend may be
lncreased debL Lo fund sLlmulus programs, whlle Cross Savlngs has fallen as a resulL of Lhe recesslon.

Spaln ls Lhe only lCS
46
counLry Lo have avolded calamlLy Lhus far, alLhough lLs sLeady upward Lra[ecLory
may be cause for conLlnulng concern.

lrance, uenmark, and 8elglum have followed a slmllar paLLern of a 10 year perlod of reasonable sLablllLy
followed by Lhe recenL rlse lnLo Lhe Warnlng Zone ln con[uncLlon wlLh Lhe global recesslon.

lLaly's uebL/Cl has floaLed near upper boundary of Lhe CpLlmum Zone, and ln 2009 crossed lnLo Lhe
Warnlng Zone.

46
orLugal, lreland, Creece and Spaln.

CcLober 2011

!apan was Lhe flrsL naLlon ln Lhe posL war perlod Lo experlence a 'balance sheeL recesslon'.
xxvl
Well
documenLed corporaLe deleveraglng ln Lhe mld-1990s
xxvll
asslsLed !apan ln conLalnlng debL loads,
however governmenL debLs conLlnued Lo escalaLe. 1hroughouL Lhe perlod, !apan has malnLalned
relaLlvely hlgh Cross Savlngs Marglns (above 23, see llgure 10) whlch has asslsLed ln carrylng Lhe
naLlon's debL load.

Canada prevlously enLered Lhe Warnlng Zone ln Lhe early 1990s. uurlng Lhls perlod, Canada's federal
governmenL debL was roughly 70 of Cu and Lhe budgeL deflclL had peaked aL 9.2 of Cu.
xxvlll
1he
counLry losL lLs Lrlple A debL raLlng wlLh references made Lo Canada's currency as a 'norLhern peso'.
47

AlLhough deplcLed above as ln a Warnlng Zone, Canada's speclflc Zones may be relaLlvely lower due Lo
Lhe commodlLy orlenLaLlon of Lhe economy (poLenLlal hlgher volaLlllLy) - Lhe lmpllcaLlon belng LhaL
Canada may acLually have been closer Lo Lhe CalamlLy Zone Lhan appears ln llgure 16. CounLer
measures were Laken ln Lhe mld-1990s and Canada sLeadled lnLo Lhe CpLlmum Zone for approxlmaLely
13 years. Canada re-enLered Lhe Warnlng Zone ln con[uncLlon wlLh Lhe 2008-2009 recesslon.

lurLher research could assess wheLher a counLry ls able Lo survlve exLended perlods ln Lhe Warnlng
Zone, wlLh no furLher hardshlp. Whlle Lhe expecLaLlon for a collapse ls progresslvely greaLer ln Lhe
Warnlng and CalamlLy Zones, a flnanclal calamlLy could ln facL occur Lo a counLry ln any Zone.

Several auLhors have complled Lables llsLlng naLlons whlch experlenced flnanclal calamlLy evenLs
Lhrough Llme.
xxlx
1hese llsLs are very long, keep growlng and show LhaL Lhe calamlLles of naLlons are noL
black swan evenLs.
xxx

Some counLrles are able Lo supporL hlgher debL levels relaLlve Lo oLhers. AL some polnL, however,
excesslve debL relaLlve Lo cash flow may reach a Llpplng polnL,
xxxl
characLerlzlng Lhe 'Mlnsky MomenL'
when a counLry falls or falls lnLo crlsls, parLlcularly afLer an exLended perlod of speculaLlon and
unsusLalnable growLh.
xxxll

47
ln reference Lo severe flnanclal dlfflculLles ln Mexlco ln Lhe same Llme frames.
CcLober 2011

7"45$. 8> provldes a grouplng of counLrles wlLh uebL/Cl raLlos of 23+, consldered Lo be ln Lhe CalamlLy
Zone.

I|gure 17 - Nat|ons |n the Ca|am|ty 2one

All seven naLlons allocaLed Lo Lhe CalamlLy Zone have experlenced calamlLles wlLhln Lhe precedlng Lhree
years.
48
lceland collapsed ln dramaLlc fashlon ln 2008 as a resulL of an over exLended banklng sysLem.

ropheLlcally, Lhree of Lhe named lCS naLlons are now fully engulfed ln flnanclal calamlLy (Creece,
lreland, and orLugal).
49
1hese naLlons had galned a new level of credlblllLy wlLh Lhe adopLlon of Lhe
Luro
xxxlll
as currency, and wlLh eager lnvesLmenL banklng asslsLance accumulaLed unsusLalnable debLs.
30

1he remalnlng Lhree CalamlLy Zone counLrles - neLherlands, uk and uS - were all forced Lo rescue
banklng sysLems ln Lhe 2008 flnanclal crlsls, alLhough a soverelgn debL calamlLy has noL occured.

48
lurLher research on 1oLal CounLry uebLs (all secLors) and Cross Savlngs of naLlons who hlsLorlcally have
experlenced a calamlLy, would provlde useful daLa regardlng Lhe reverslon Lo mean hypoLhesls proposed ln Lhls
paper. (Sweden ln Lhe early 1990s for example).
49
ln Lhese cases, Lhe Luropean unlon and lnLernaLlonal MoneLary lund have provlded emergency fundlng, whlle
forclng Lhe lmplemenLaLlon of ausLerlLy measures.
30
A sLlpulaLlon Lo malnLaln deflclLs of noL greaLer Lhan 3 as parL of adopLlng Lhe Luro proved Lo be lnadequaLe
defence agalnsL over-leverage. ConcepLs of over-borrowlng and over-lendlng may be exempllfled here.

CcLober 2011

1he neLherlands ls unlque ln Lhls CalamlLy Zone group as Lhe only naLlon Lo conslsLenLly have been a neL
Lender raLher Lhan neL 8orrower ln recenL years.
31
1he commonallLy of Lhe remalnlng slx naLlons
suggesLs Lhe usefulness of Lhe neL Lendlng/8orrowlng as a predlcLor of soverelgn debL defaulLs. AnoLher
common facLor among Lhe group of naLlons are low or decllnlng Cross Savlngs Marglns.

1he unlLed klngdom has had a Lrend of escalaLlng uebL/Cl slnce Lhe counLry deparLed Lhe CpLlmum
Zone ln 1992. AfLer Lwelve years ln Lhe Warnlng Zone, Lhe uk became Lhe flrsL naLlon Lo cross lnLo Lhe
CalamlLy Zone ln 2004. 1he uk has been argued Lo have a hlgh componenL of llnanclals secLor debL as a
proporLlon of overall debL, aLLrlbuLed Lo lLs off-shore banklng role. As a consequence, a sLudy by
Mcklnsey Clobal lnsLlLuLe provlded an alLernaLe calculaLlon for uk debL ln whlch an amounL equal Lo Lhe
banks forelgn asseLs was deducLed.
xxxlv
1hls meLhodology had Lhe effecL of reduclng uk debL by 18.
lurLher sLudy ls requlred concernlng Lhls approach, buL under such assumpLlons, Lhe 2009 uk uebL/Cl
raLlo would be reduced from 44.2x Lo 36.0x (l.e., sLlll ln Lhe CalamlLy Zone).
32

ln Lhe case of Lhe uS, as noLed ln arL 4, banklng sysLem uebL/Cl raLlos reLrenched ln Lhe 2000-2002
perlod buL began escalaLlng agaln ln 2003. ColncldenLally, as Lhe obverse of Lhe same coln, Pousehold
debL levels expanded beyond prudenL levels, as presenLed ln arL 7. 1he uS corporaLe secLors were
largely prudenLly levered aL Lhe Llme, buL Lhe slmulLaneous collapse of Lhe banklng and houslng secLors
was caLasLrophlc. 1he uS crossed lnLo Lhe Warnlng Zone ln 2000, and experlenced lLs CalamlLy elghL
years laLer ln 2008. noLe LhaL Lhe uS uebL/Cl raLlo decllned from 2009 Lo 2010 and perhaps furLher
decllnes could be aLLalned.

Cn average, 8.7 years Lransplred beLween Lhe naLlons leavlng Lhe CpLlmum Zone unLll Lhe CalamlLy
occurred. 1he shorLesL of Lhese was lceland whlch collapsed wlLhln Lwo years of deparLlng Lhe CpLlmum
Zone.
33
1he longesL runnlng was Lhe uk, whlch exlLed Lhe CpLlmum Zone ln 1992.
34
lurLher research ln
Lhls regard could asslsL ln Lhe developmenL of more speclflc early warnlng Lools.

8eyond Lhe monlLorlng and early warnlng aLLrlbuLes of Lhe uebL/Cl raLlo, macro-prudenLlal pollcles
could be devlsed and deployed.
33

31
ulscussed ln arL 8.
32
Mcklnsey lLself presenLed counLer argumenLs relaLlng Lo Lhe approprlaLeness of Lhe ad[usLmenL.
33
lceland lmplemenLed relaxed banklng regulaLlons ln 2003, whlch seL off a banklng and borrowlng bubble. 1he
collapse occurred ln 2008. lceland's uebL/Cl was only 11.9x ln 2006. 1he Cross Savlngs underlylng Lhls raLlo were
unsusLalnable and unsLable, belng based on Lhe consumpLlon of rapldly expandlng credlL and rely on hlgh levels of
unearned Cu (llgure 11).
34
1he mosL dangerous bubbles may Lend Lo be Lhose LhaL accumulaLe slowly over long Llme perlods.
33
lollowlng Lhe 2008 flnanclal crlsls, Lhe need for new macro-prudenLlal pollcles almed Lo prevenL bubbles has
been called for by several groups, see for example vlnals, !. eL al, (2010 CcLober). lMl 5toff losltloo Notes.
www.lmf.org
CcLober 2011

PART 11 - Summary and Concl usi ons

uebL/Cl has been a long sLandlng measuremenL Lool Lo assess Lhe borrowlng capaclLy and flnanclal
healLh of corporaLlons. Cash flow raLlos lncludlng Lhe uebL/Cl raLlo are known Lo be effecLlve predlcLors
of loan covenanL vlolaLlons and bankrupLcy.

1he uebL/Cl hlsLory of Lhe uS Pousehold SecLor presenLed ln Lhls documenL demonsLraLes Lhe
ublqulLous naLure of Lhe uebL/Cl raLlo as a measure of flnanclal healLh.

1he auLhor proposes Lhe hypoLhesls LhaL uebL/Cl raLlos can be applled Lo naLlons. 8ased on Lhe resulLs
presenLed, Lhe uebL/Cl can be characLerlzed as a slmple, rellable, predlcLlve meLrlc LhaL should be
consldered ln assesslng Lhe flnanclal healLh of a naLlon.

1he lour Zone lramework provldes scope for Lhe flnanclal managemenL of Pouseholds, CorporaLlons,
llnanclals, and naLlons.
36
1he analysls supporLs Lhe use of Lhe lour Zone lramework as a means of
dellneaLlng uebL/Cl levels as prudenL or problemaLlc.

1he uebL/Cl raLlo can be used as a leadlng lndlcaLor Lo assess wheLher an enLlLy ls nearlng a flnanclal
dlsLress slLuaLlon. 1he slope of Lhe Lra[ecLory and level wlLhln Lhe Zone framework should forewarn as Lo
Lhe severlLy of poLenLlal rlsks.

1he auLhor also proposes LhaL uebL/Cl raLlos Lend Lo regress back Lo a mean level over Llme. 1hese
reverslons may resulL from enLlLles proacLlvely managlng Lhelr affalrs (e.g. Pouseholds savlng more and
borrowlng less), from Lhe lmposlLlons of lenders and LrusLees (e.g. corporaLe ChapLer 11 evenLs), or
from oLher causes. A sLudy of uLlllLy companles has verlfled Lhls hypoLhesls.

1he paper has shown a Lendency for Lhe Llme perlods for uebL/Cl cycles and reverslons Lo be longer on
average for naLlons Lhan for corporaLlons.

Lach counLry should conslder esLabllshlng a LargeL CpLlmum Zone. 1he lower bound of Lhe CpLlmum
Zone would be seL aL Lhe uebL/Cl raLlo vlewed as prudenL and conservaLlve leverage, buL noL under-
levered. 1he upper bound would be deLermlned by Lhe counLry's ablllLy Lo safely mlLlgaLe Lhe poLenLlal
lmpllcaLlons of an economlc or moneLary shock. Llke oLher prudenLlal macroeconomlc Lools, Lhe
uebL/Cl raLlo can be managed aL Lhe counLry level uslng pollcy levers (lnLeresL raLes for example).
Macro-prudenLlal pollcles could be lmplemenLed Lo lnfluence Lhe uebL/Cl of a naLlon Lo remaln ln an
CpLlmum Zone of leverage.

1he auLhor proposes LhaL Lhe uebL/Cl raLlo can be used Lo beLLer manage Lhe llmlLs on Lhe elasLlclLy
37
of
Lhe moneLary sysLem
38
. lurLher work wlll be underLaken by Lhe auLhor Lo puL forLh and subsLanLlaLe Lhls
hypoLhesls.

36
CovernmenLs can be added Lo Lhls llsL.
37
ln 1913 resldenL Woodrow Wllson slgned lnLo law Lhe lederal 8eserve AcL Lo furnlsh an elasLlc currency". (1be
leJetol kesetve 5ystem. lotposes & looctloos !une 2003, page 2). ln essence, no macro-prudenLlal pollcles have
been lmplemenLed by Lhe uS Lo llmlL Lhe sLreLchlng of Lhe elasLlc sysLem.
38
1he moneLary sysLem lncludes boLh Lhe money supply and credlL. See for example 8oeckh, !. A. (2010).
CcLober 2011

1he concluslons presenLed hereln are prellmlnary and sub[ecL Lo furLher research and peer revlew.

1he auLhor would appreclaLe Lhe opporLunlLy Lo revlew Lhls concepL wlLh economlc and moneLary
research organlzaLlons Lo sollclL feedback and assess lnLeresL ln furLherlng Lhls research.

CcLober 2011

References

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8eserve: www.federalreserve.gov
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CcLober 2011

Notes

l
(8elnhard & 8ogoff, 2009)
ll
(Shlller, 2011)
lll
See for example (Luropean CenLral 8ank, 2010), page 76
lv
See for example (krugman, Pow uld LconomlsLs CeL lL So Wrong, 2009) . Also see, 1he uS llnanclal
Crlsls lnqulry 8eporL, whlch concluded Lhe fallures of credlL raLlng agencles were essenLlal cogs ln Lhe
wheel of flnanclal desLrucLlon" (llnanclal Crlsls lnqulry Commlsslon, 2011), page xxv
v
(Mcklnsey Clobal lnsLlLuLe, 2010)
vl
(Sufl, 2007)
vll
See for example (Cook, 1993)
vlll
(8ureau of Lhe Census)
lx
(8ernanke, Lssays on 1he CreaL uepresslon, 2000), page 47
x
(8ureau of Lconomlc Analysls - unlLed SLaLes ueparLmenL of Commerce)
xl
(Mlller, 2002)
xll
(8elnhard & 8ogoff, 2009), p. 39
xlll
Cne publlcaLlon locaLed lncluded an analysls uLlllzlng, ln parL, Lhe debL Lo gross savlngs raLlos of
munlclpallLles ln lrance (CllberL & CuenganL, 2002). A llnanclal 1lmes arLlcle by uanlel Cross enLlLled
'Creek burdens ensure some lCS won'L fly' commenLed LhaL gross naLlonal savlngs raLes are relevanL Lo
Lhe ablllLy Lo servlce debLs. (Cros, 2010)
xlv
(lnLernaLlonal MoneLary lund, 2010), page 100
xv
See for example (8elnhard & 8ogoff, 2009), page 277
xvl
See for example (Mcklnsey Clobal lnsLlLuLe, 2010)
xvll
(CLCu)
xvlll
(1he lederal 8eserve SysLem, 2011)
xlx
(8lodgeL, 2009)
xx
See for example (Mcklnsey Clobal lnsLlLuLe, 2010), page 39.
xxl
See for example (8oeckh, 2010) page 101
xxll
(Luropean CenLral 8ank, 2010), page 72
xxlll
Source sub[ecL Lo conflrmaLlon
xxlv
(8elnhard & 8ogoff, 2009), page 367
xxv
(8ernanke, Lssays on 1he CreaL uepresslon, 2000), page 47
xxvl
(koo, 2008), page 173
xxvll
(koo, 2008), page 12
xxvlll
(Peaney, 2010)
xxlx
See for example (8elnhard & 8ogoff, 2009)
xxx
(1aleb, 2007)
xxxl
(llsher, 1933) page 339
xxxll
lnvesLopedla.com
xxxlll
ConcepL from (8elnhard & 8ogoff, 2009).
xxxlv
(Mcklnsey Clobal lnsLlLuLe, 2010) page 36

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Bruce A Ramsay

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