Default (finance)

Default (finance)

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In finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

, 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.Typically,...

 (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
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...

. 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 to use 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 mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...

s, loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....

s, and promissory note
Promissory note
A promissory note is a negotiable instrument, wherein one party makes an unconditional promise in writing to pay a determinate sum of money to the other , either at a fixed or determinable future time or on demand of the payee, under specific terms.Referred to as a note payable in accounting, or...

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. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...

 and bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....

.
  • "Default" essentially means a debtor has not paid a debt which he or she is required to have paid.
  • "Insolvency
    Insolvency
    Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...

    " is a legal term meaning that a debtor is unable to pay his or her debts.
  • "Bankruptcy
    Bankruptcy
    Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....

    " 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 occurs 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 is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...

/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 the 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 the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...

, 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 is best known for the development of the Z-Score for predicting bankruptcy which he published in 1968...

's Z-score model, or the structural model of default by Robert C. Merton
Robert C. Merton
Robert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:...

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

).

Sovereign defaults



Sovereign borrowers such as nation-state
Nation-state
The nation state is a state that self-identifies as deriving its political legitimacy from serving as a sovereign entity for a nation as a sovereign territorial unit. The state is a political and geopolitical entity; the nation is a cultural and/or ethnic entity...

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
The Democratic People’s Republic of Korea , , is a country in East Asia, occupying the northern half of the Korean Peninsula. Its capital and largest city is Pyongyang. The Korean Demilitarized Zone serves as the buffer zone between North Korea and South Korea...

, 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 , OFZ are abbreviations for and , respectively. They are government bonds issued by the state of Russia.GKOs are short-term zero-coupon Russian Government Treasury Bills. OFZs are coupon-bearing Federal Loan Bonds...

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. London is one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world - for...

s. As part of the Argentine economic crisis in 2002, Argentina
Argentina
Argentina , officially the Argentine Republic , is the second largest country in South America by land area, after Brazil. It is constituted as a federation of 23 provinces and an autonomous city, Buenos Aires...

 defaulted on $1 billion of debt owed to the World Bank
World Bank
The World Bank is an international financial institution that provides loans to developing countries for capital programmes.The World Bank's official goal is the reduction of poverty...

.

Orderly defaults


In times of acute insolvency crises, it can be advisable for regulators and lenders to preemptively engineer the methodic restructuring of a nation's public debt- also called "orderly default" or "controlled default". Experts who favor this approach to solve a national debt crisis typically argue that a delay in organising an orderly default would wind up hurting lenders and neighboring countries even more.

Strategic default



When a debtor chooses to default on a loan, despite being able to service it (make payments), this is said to be a strategic default
Strategic default
A strategic default is the decision by a borrower to stop making payments on a debt despite having the financial ability to make the payments....

. This is most commonly done for non-recourse loans, where the creditor cannot make other claims on the debtor; a common example is a situation of negative equity
Negative equity
Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan. In the United States, assets with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".People...

 on a mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...

 in common law
Common law
Common law is law developed by judges through decisions of courts and similar tribunals rather than through legislative statutes or executive branch action...

 jurisdictions such as the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

, which is in general non-recourse. In this latter case, default is colloquially called "jingle mail" – the debtor stops making payments and mails the keys to the creditor, generally a bank.

Sovereign strategic default


As with Strategic default
Strategic default
A strategic default is the decision by a borrower to stop making payments on a debt despite having the financial ability to make the payments....

 when a debtor chooses to default on a loan sovereign borrowers such as nation-state
Nation-state
The nation state is a state that self-identifies as deriving its political legitimacy from serving as a sovereign entity for a nation as a sovereign territorial unit. The state is a political and geopolitical entity; the nation is a cultural and/or ethnic entity...

s also can choose to default on a loan. Ecuador's president Rafael Correa in 2008 had given the order not to approve a debt interest payment. See also Odious debt
Odious debt
In international law, odious debt is a legal theory that holds that the national debt incurred by a regime for purposes that do not serve the best interests of the nation, should not be enforceable. Such debts are, thus, considered by this doctrine to be personal debts of the regime that incurred...

.

Consumer default


Consumer default frequently concern arrears in rent or mortgage payments, consumer credit, or utility payments. A European Union wide analysis identified certain risk groups, such as single households, being unemployed – even after correcting for the (significant) impact
of having a low income -, being young (especially being younger than around 50 years old, with somewhat different results for the New Member States, where the elderly more often at risk as well), being unable to rely on social networks, etc. Even internet illiteracy has been associated with increased default, potentially caused by these households being less likely to find their way to the social benefits they are often entitled to. While effective non-legal debt counseling is usually the preferred -more economic and less disruptive- option, consumer default can end-up in legal debt settlement or consumer bankruptcy procedures, the last ranging from 1-year procedures in the UK to 6-year procedures in Germany.