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In
finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in the left corn ...

finance
, default is failure to meet the legal obligations (or conditions) of a
loan In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money avai ...
, for example when a home buyer fails to make a
mortgage A mortgage loan or simply mortgage () is a loan In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The recipient (i.e., the borrower) incurs a ...
payment, or when a corporation or government fails to pay a
bond Bond or bonds may refer to: Common meanings * Bond (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of ...
which has reached maturity. A national or
sovereign default A sovereign default is the failure or refusal of the government A government is the system or group of people governing an organized community, generally a State (polity), state. In the case of its broad associative definition, gov ...
is the failure or refusal of a government to repay its
national debt In public finance, government debt, also known as public interest, public debt, national debt and sovereign debt, is the total amount of debt owed at a point in time by a government A government is the system or group of people govern ...
. The biggest private default in history is
Lehman Brothers Lehman Brothers Holdings Inc. () was a global financial services firm founded in 1847. Before filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank Investment is the dedication of an asset to attain an increase in val ...

Lehman Brothers
, with over $600 billion when it filed for bankruptcy in 2008. The biggest sovereign default is
Greece Greece ( el, Ελλάδα, Elláda, ), officially the Hellenic Republic, is a country located in Southeastern Europe Southeast Europe or Southeastern Europe () is a geographical subregion A subregion is a part of a larger region In geogr ...

Greece
, with $138 billion in March 2012.


Distinction from insolvency, illiquidity and bankruptcy

The term "default" should be distinguished from the terms "
insolvency In accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been call ...
", illiquidity and "
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditor A creditor or lender is a party 300px, '' Hip, Hip, Hurrah!'' (1888) by Peder Severin Krøyer, a painting portraying an artists' par ...

bankruptcy
": * Default: A debtor has passed the payment deadline on a debt they were due to pay. *
Illiquidity In business Business is the activity of making one's living or making money by producing or buying and selling Product (business), products (such as goods and services). Simply put, it is "any activity or enterprise entered into for profit. ...
: A debtor has insufficient cash (or other "liquefiable" assets) to pay debts. *
Insolvency In accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been call ...
: A legal term meaning a debtor is unable to pay their debts. *
Bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditor A creditor or lender is a party 300px, '' Hip, Hip, Hurrah!'' (1888) by Peder Severin Krøyer, a painting portraying an artists' par ...

Bankruptcy
: 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 ratio A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statement Financial statements (or financial reports) are formal records of the financial activities and positio ...
s. The most commonly violated restrictions in affirmative covenants are tangible net worth,
working capital Working capital (abbreviated WC) is a financial metric which represents available to a business, organization, or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a ...
/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 A cross is a geometrical figure consisting of two intersecting lines or bars, usually perpendicular to each other. The lines usually run vertically and horizontally. A cross of oblique lines, in the shape of the Latin letter X, is also termed a ...
covenant in the debt contract states that that particular debt is also in default. In
corporate finance Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers a ...
, upon an uncured default, the holders of the debt will usually initiate proceedings (file a petition of involuntary bankruptcy) to foreclose on any
collateral Collateral may refer to: Business and finance * Collateral (finance) In loan agreement, lending agreements, collateral is a Borrower, borrower's pledge (law), pledge of specific property to a lender, to Secured loan, secure repayment of a loan. ...
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 I. Altman (born June 5, 1941) is a Professor of Finance, Emeritus, at New York University New York University (NYU) is a private research university in New York City New York City (NYC), often simply called New York, is the L ...
's
Z-score In statistics Statistics is the discipline that concerns the collection, organization, analysis, interpretation, and presentation of data Data (; ) are individual facts, statistics, or items of information, often numeric. In a ...
model, or the structural model of default by
Robert C. Merton
Robert C. Merton
(
Merton ModelThe Merton model, developed by Robert C. Merton in 1974, is a widely used credit risk model. Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing ...
).


Sovereign defaults

Sovereign borrowers such as
nation-state A nation state is a political unit where the state State may refer to: Arts, entertainment, and media Literature * ''State Magazine'', a monthly magazine published by the U.S. Department of State * The State (newspaper), ''The State'' (newsp ...
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
Greece Greece ( el, Ελλάδα, Elláda, ), officially the Hellenic Republic, is a country located in Southeastern Europe Southeast Europe or Southeastern Europe () is a geographical subregion A subregion is a part of a larger region In geogr ...

Greece
, which defaulted on an IMF loan in 2015. In such cases, the defaulting country and the creditor are more likely to renegotiate the interest rate, length of the loan, or the
principal Principal may refer to: Title or rank * Principal (academia) The principal is the chief executive and the chief academic officer of a university A university ( la, universitas, 'a whole') is an educational institution, institution of higher ...
payments. In the
1998 Russian financial crisis The Russian financial crisis (also called ruble crisis or the Russian flu) hit Russia on 17 August 1998. It resulted in the Russian government and the Russian Central Bank devaluing the Russian rouble, ruble and sovereign default, defaulting on its ...
, Russia defaulted on its internal debt (
GKO GKO (abbreviation for russian: Государственное Краткосрочное Обязательство, Gosudarstvennoye Kratkosrochnoye Obyazatyelstvo, Government Short-Term Commitments) are short-term Zero-coupon bond, zero-coupon g ...
s), but did not default on its external Eurobonds. As part of the
Argentine economic crisis Argentines (also known as Argentinians or Argentineans; es, masculine argentinos; feminine Femininity (also called womanliness or girlishness) is a set of attributes, behaviors, and roles generally associated with women and girls. Altho ...
in 2002,
Argentina Argentina (), officially the Argentine Republic ( es, link=no, República Argentina), is a country located mostly in the southern half of South America South America is a continent A continent is any of several large landmasse ...

Argentina
defaulted on $1 billion of debt owed to the
World Bank The World Bank is an international financial institution An international financial institution (IFI) is a financial institution that has been established (or chartered) by more than one country, and hence is subject to international law. Its o ...
.


Orderly default

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. This is most commonly done for nonrecourse loans, where the creditor cannot make other claims on the debtor; a common example is a situation of
negative equity Negative equity is a deficit of owner's equity, occurring 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 (particularly real estate Real estate is property consis ...
on a
mortgage loan A mortgage loan or simply mortgage () is a loan In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money ...
in
common law In law, common law (also known as judicial precedent or judge-made law, or case law Case law is the collection of past legal decisions written by courts and similar tribunal A tribunal, generally, is any person or institution with authority ...
jurisdictions such as the United States, 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

Sovereign borrowers such as
nation-state A nation state is a political unit where the state State may refer to: Arts, entertainment, and media Literature * ''State Magazine'', a monthly magazine published by the U.S. Department of State * The State (newspaper), ''The State'' (newsp ...
s can also choose to default on a loan, even if they are capable of making the payments. In 2008, Ecuador's president
Rafael Correa Rafael Vicente Correa Delgado (; born 6 April 1963), known as Rafael Correa, is an Ecuadorian politician and economist who served as List of heads of state of Ecuador, President of Ecuador from 2007 to 2017. The leader of the PAIS Alliance politi ...

Rafael Correa
strategically defaulted on a national debt interest payment, stating that he considered the debt "immoral and illegitimate".


Consumer default

Consumer default frequently occurs 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 were 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. Research in the United States has found that pre-purchase counseling can significantly reduce the rate of defaults.Pre-Purchase Counseling Benefits Banks and Homeowners
''American Banker''.


References


Bibliography

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