Debt liquidation

  Underlying most of the current troubles in the financial markets is the mountain of debt piled up in the 1980s. Government, corporations, and individuals have all leveraged themselves to the hilt, and as the economy slows, more and more borrowers may find themselves unable to service their debt.

So far, we've seen a rolling, industry by industry, liquidation of bad debt: oil drillers, Texas commercial real estate, junk bonds, savings and loans. Although each has contributed to the demise of the next and the overall tab continues to rise as each domino falls, so far the individual problems have been contained and prevented from leading to a general credit crunch that could cause widespread bankruptcies. Obviously it will be harder to avoid such an outcome if a deep recession occurs.

The debt to equity ratio of so many companies may give the coming recession a very different character from those of the past. In a company with minimal debt, a business slowdown leads to layoffs, reduced inventory, postponing or canceling capital investment plans, etc. Each of these contributes to the slowdown of other businesses and spreads throughout the economy. But a highly leveraged company is very likely to hit the wall by defaulting on its debt very early in a recession. If the debtor takes the obvious step of filing Chapter 11, the business continues to operate while a reorganisation plan is developed and implemented. Chapter 11 reorganisations give a high priority to the company's operating facilities and employment, while wiping out equity investment and either writing down debt or transforming it into equity in some manner.

Although this shrinks the money supply by wiping out equity and debt investments, the overall consequences may be better for the economy than protracted shrinking of a company, slowly squeezing its suppliers and the communities in which it operates. Or, it may be disastrously bad, leading to a chain-reaction of bankruptcies and illiquidity in the debt markets just when debt financing is essential to recovery. I don't know which way it will go; the point is that it's a new situation so behaviour in previous recessions can't provide much guidance as to what will happen this time. It bears thought and careful watching.

In times of tight credit, a cash rich, debt free company such as Autodesk is king. If we enter a period of accelerated debt liquidation (and imagine how insane it would have sounded five or six years ago to talk about a half-trillion dollar collapse of the entire savings and loan industry), Autodesk should pay even closer attention to the quality of the investments in which its cash is placed. It is far better in uncertain times to forgo a fraction of a percent of interest than to lose one's money at the very moment it's most valuable from a strategic standpoint.