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In finance
Finance

The field of finance refers to the concepts of time, money and risk and how they are interrelated. Banks are the main facilitators of funding through the provision of credit, although private equity, mutual funds, hedge funds, and other organizations have become important....
, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant
Loan covenant

A loan covenant is a condition in a commercial loan or Bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met....
 (condition) of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt
Debt

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned....
. This can occur with all debt obligations including bonds
Bond (finance)

In finance, a bond is a debt security , in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest and/or to repay the principal at a later date, termed Maturity ....
, mortgage
Mortgage loan

A mortgage loan is a loan secured by real property through the use of a note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which security interest the loan....
s, loan
Loan

A loan is a type of debt. This article focuses exclusively on monetary loans, although, in practice, any material object might be lent. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the wiktionary:lender and the wiktionary:borrower....
s, and promissory note
Promissory note

A promissory note, also referred to as a note payable in accounting, is a contract where one party makes an unconditional promise in writing to pay a sum of money to the other , either at a fixed or determinable future time or on demand of the payee, under specific terms....
s.

term default should be distinguished from the terms insolvency
Insolvency

Insolvency means the inability to pay one's debts as they fall due.This is defined in two different ways:Cash flow insolvency -: Unable to pay debts as they fall due....
 and bankruptcy
Bankruptcy

Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a debtor in an effort to recoup a portion of what they are owed or initiate a restructuring....
.

Types of default
Default can be of two types: debt services default and technical default.






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In finance
Finance

The field of finance refers to the concepts of time, money and risk and how they are interrelated. Banks are the main facilitators of funding through the provision of credit, although private equity, mutual funds, hedge funds, and other organizations have become important....
, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant
Loan covenant

A loan covenant is a condition in a commercial loan or Bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met....
 (condition) of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt
Debt

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned....
. This can occur with all debt obligations including bonds
Bond (finance)

In finance, a bond is a debt security , in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest and/or to repay the principal at a later date, termed Maturity ....
, mortgage
Mortgage loan

A mortgage loan is a loan secured by real property through the use of a note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which security interest the loan....
s, loan
Loan

A loan is a type of debt. This article focuses exclusively on monetary loans, although, in practice, any material object might be lent. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the wiktionary:lender and the wiktionary:borrower....
s, and promissory note
Promissory note

A promissory note, also referred to as a note payable in accounting, is a contract where one party makes an unconditional promise in writing to pay a sum of money to the other , either at a fixed or determinable future time or on demand of the payee, under specific terms....
s.

Distinction from insolvency and bankruptcy

The term default should be distinguished from the terms insolvency
Insolvency

Insolvency means the inability to pay one's debts as they fall due.This is defined in two different ways:Cash flow insolvency -: Unable to pay debts as they fall due....
 and bankruptcy
Bankruptcy

Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a debtor in an effort to recoup a portion of what they are owed or initiate a restructuring....
.
  • "Default" essentially means a debtor has not paid a debt which he/she/it is required to have paid.
  • "Insolvency
    Insolvency

    Insolvency means the inability to pay one's debts as they fall due.This is defined in two different ways:Cash flow insolvency -: Unable to pay debts as they fall due....
    " is a legal term meaning that a debtor is unable to pay his debts.
  • "Bankruptcy
    Bankruptcy

    Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a debtor in an effort to recoup a portion of what they are owed or initiate a restructuring....
    " is a legal finding that imposes court supervision over the financial affairs of those who are insolvent or in default.


Types of default


Default can be of two types: debt services default and technical default. Debt service default occurs when the borrower has not made a scheduled payment of interest or principal. Technical default happens when an affirmative or a negative covenant is violated.

Affirmative covenants are clauses in debt contracts that require firms to maintain certain levels of capital or financial ratios. The most commonly violated restrictions in affirmative covenants are tangible net worth, working capital
Working capital

Working capital, also known as net working capital, is a financial metric which represents Accounting liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital....
/short term liquidity, and debt service coverage.

Negative covenants are clauses in debt contracts that limit or prohibit corporate actions (e.g. sale of assets, payment of dividends) that could impair the position of creditors. Negative covenants may be continuous or incurrence-based. Violations of negative covenants are rare compared to violations of affirmative covenants.

With most debt (including corporate debt, mortgages and bank loans) a covenant is included in the debt contract which states that the total amount owed becomes immediately payable on the first instance of a default of payment. Generally, if the debtor defaults on any debt to any lender, a cross default covenant in the debt contract states that that particular debt is also in default.

In corporate finance
Corporate finance

Corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions....
, upon an uncured default, the holders of the debt will usually initiate proceedings (file a petition of involuntary bankruptcy) to foreclose on any collateral securing the debt. Even if the debt is not secured by collateral, debt holders may still sue for bankruptcy, to ensure that the corporation's assets are used to repay the debt.,

There are several financial models for analyzing default risk, such as the Jarrow-Turnbull model, Edward Altman
Edward Altman

Edward I. Altman is a Professor of Finance at New York University`s Stern School of Business. He also teaches for the TRIUM Global Executive MBA Program, an alliance of NYU Stern, the London School of Economics and HEC School of Management....
's Z-score model, or the structural model of default by Robert C. Merton
Robert C. Merton

Robert Cox Merton is an American economist and Nobel laureate in economics....
 (Merton Model
Merton Model

The Merton model refers to a model proposed by Robert C. Merton in 1974 for assessing the credit risk of a company by characterizing the company's Shareholders' equity as a call option on its assets....
).

Sovereign defaults

Sovereign borrowers such as nation-state
Nation-state

The nation-state is a certain form of state that derives its legitimacy from serving as a Sovereignty entity for a nation as a sovereign territorial unit....
s generally are not subject to bankruptcy courts in their own jurisdiction, and thus may be able to default without legal consequences. One example is with North Korea
North Korea

North Korea, officially the Democratic People's Republic of Korea , is a state in East Asia, occupying the northern half of the Korean Peninsula....
, which in 1987 defaulted on some of its loans. In such cases, the defaulting country and the creditor are more likely to renegotiate the interest rate, length of the loan, or the principal payments. In the 1998 Russian financial crisis, Russia defaulted on its internal debt (GKO
GKO

GKO and OFZ are abbreviations for and , respectively. They are government bonds issued by the state of Russia.GKOs are short-term Zero coupon bond Russian Government Treasury Bills....
s), but did not default on its external Eurobond
Eurobond

A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. It can be categorised according to the currency in which it is issued....
s. As part of the Argentine economic crisis in 2002, Argentina
Argentina

Argentina, officially the Argentine Republic , is a country in South America, constituted as a federation of 23 provinces and an autonomous city....
 defaulted on $1 billion of debt owed to the World Bank
World Bank

The World Bank is a bank that provides financial and technical assistance to developing countries for development programs with the stated goal of reducing poverty....
.

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