In
finance
Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...
, default is failure to meet the
legal obligations (or conditions) of a
loan
In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay interest for the use of the money.
The document evidencing the deb ...
, for example when a home buyer fails to make a
mortgage
A mortgage loan or simply mortgage (), in civil law (legal system), civil law jurisdictions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners t ...
payment, or when a corporation or government fails to pay a
bond which has reached
maturity. A national or
sovereign default is the failure or refusal of a government to repay its
national debt.
The biggest private default in history is
Lehman Brothers, with over $600 billion when it filed for bankruptcy in 2008 (equivalent to over $ billion in ). The biggest sovereign default is Greece, with
$138 billion in March 2012 (equivalent to $ billion in ).
Distinction from insolvency, illiquidity and bankruptcy
The term "default" should be distinguished from the terms "
insolvency
In accounting, insolvency is the state of being unable to pay the debts, by a person or company ( debtor), at maturity; those in a state of insolvency are said to be ''insolvent''. There are two forms: cash-flow insolvency and balance-sheet i ...
", illiquidity and "
bankruptcy
Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...
":
* Default: Debtors have been passed behind the payment deadline on a debt whose payment was due.
*
Illiquidity: Debtors have insufficient cash (or other "liquefiable" assets) to pay debts.
*
Insolvency
In accounting, insolvency is the state of being unable to pay the debts, by a person or company ( debtor), at maturity; those in a state of insolvency are said to be ''insolvent''. There are two forms: cash-flow insolvency and balance-sheet i ...
: A legal term meaning debtors are unable to pay their debts.
*
Bankruptcy
Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...
: A legal finding that imposes court supervision over the financial affairs of those who are insolvent or in default.
Types
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/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 is an area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analy ...
, 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's
Z-score model, or the structural model of default by
Robert C. Merton (
Merton Model).
Sovereign defaults
Sovereign borrowers such as
nation-states 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, officially the Hellenic Republic, is a country in Southeast Europe. Located on the southern tip of the Balkan peninsula, it shares land borders with Albania to the northwest, North Macedonia and Bulgaria to the north, and Turkey to th ...
, 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 payments.
In the
1998 Russian financial crisis
The Russian financial crisis (also called the ruble crisis or the Russian flu) began in Russia on 17 August 1998. It resulted in the Russian government and the Russian Central Bank devaluing the Russian rouble, ruble and sovereign default, defau ...
, Russia defaulted on its internal debt (
GKOs), but did not default on its external
Eurobonds. As part of the
Argentine economic crisis in 2002,
Argentina
Argentina, officially the Argentine Republic, is a country in the southern half of South America. It covers an area of , making it the List of South American countries by area, second-largest country in South America after Brazil, the fourt ...
defaulted on $1 billion of debt owed to the
World Bank
The World Bank is an international financial institution that provides loans and Grant (money), grants to the governments of Least developed countries, low- and Developing country, middle-income countries for the purposes of economic development ...
.
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 on a
mortgage loan
A mortgage loan or simply mortgage (), in civil law (legal system), civil law jurisdictions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners t ...
in
common law
Common law (also known as judicial precedent, judge-made law, or case law) is the body of law primarily developed through judicial decisions rather than statutes. Although common law may incorporate certain statutes, it is largely based on prece ...
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-states can also choose to default on a loan, even if they are capable of making the payments. In 2008, Ecuador's president
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 one-year procedures in the UK to six-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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