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In finance, 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 (condition) of the debt contract. A default is the failure to pay back a loan.[1] Default may occur if the debtor is either unwilling or unable to pay their debt. This can occur with all debt obligations including bonds, mortgages, loans, and promissory notes.

Contents

Distinction from insolvency and bankruptcy

The term default should be distinguished from the terms insolvency and bankruptcy.

  • "Default" essentially means a debtor has not paid a debt which they are required to have paid.
  • "Insolvency" is a legal term meaning that a debtor is unable to pay their debts.
  • "Bankruptcy" 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/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, 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).

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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 with North 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[2]. In the 1998 Russian financial crisis, 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 defaulted on $1 billion of debt owed to the World Bank.[3]

Strategic default

Strategic default on a mortgage is colloquially called jingle mail.

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 non-recourse loans, where the creditor cannot make other claims on the debtor; a common example is a situation of negative equity on a mortgage in common law jurisdictions such as the United States and the United Kingdom, which are 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.

References

  1. ^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 261. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4.  
  2. ^ Rahnama-Moghadam, Samavati, Dilts (1995). Doing Business in Less Developed Countries: Financial Opportunities and Risks. Quorum/Greenwood. pp. 108. ISBN 0899308546. http://books.google.com/books?id=C4Z6kHpadd4C&pg=PA108&lpg=PA108&dq=%22north+korea+defaulted%22&source=web&ots=wSBHZCbtMY&sig=P7n3fDbn1SiZMYFE4XHUs03dSlY.  
  3. ^ "Argentina in $1bn loan default". BBC. December 13, 2002. http://news.bbc.co.uk/2/hi/business/2573183.stm. Retrieved 2008-11-11. "Argentina will continue to default on $1bn of debt owed to the World Bank, a move which will effectively isolate the country from all major international lenders."  

Bibliography

  • de Servigny, Arnaud and Olivier Renault (2004). The Standard & Poor's Guide to Measuring and Managing Credit Risk. McGraw-Hill. ISBN 0-071-41755-6.  
  • Duffie, Darrell and Kenneth J. Singleton (2003). Credit Risk: Pricing, Measurement, and Management. Princeton University Press. ISBN 0-691-09046-7.  
  • Lando, David (2004). Credit Risk Modeling: Theory and Applications. Princeton University Press. ISBN 0-691-08929-4.  

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