Default (finance)

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In finance, default is failure to meet the legal obligations (or conditions) of a loan, [1] for example when a home buyer fails to make a mortgage 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.

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The biggest private default in history is Lehman Brothers, with over $600 billion when it filed for bankruptcy in 2008 (equivalent to over $830 billion in 2023). The biggest sovereign default is Greece, with $138 billion in March 2012 (equivalent to $192 billion in 2023). [2]

Distinction from insolvency, illiquidity and bankruptcy

The term "default" should be distinguished from the terms "insolvency", illiquidity and "bankruptcy":

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, 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, 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. [3] 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. [4]

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". [5] [6] 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. [7]

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 in common law 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". [8]

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. [9]

Research in the United States has found that pre-purchase counseling can significantly reduce the rate of defaults. [10] [11]

Related Research Articles

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 debtor.

<span class="mw-page-title-main">Debt</span> Obligation to pay borrowed money

Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. In financial accounting, debt is a type of financial transaction, as distinct from equity.

<span class="mw-page-title-main">Debt consolidation</span> Form of debt refinancing

Debt consolidation is a form of debt refinancing that entails taking out one loan to pay off many others. This commonly refers to a personal finance process of individuals addressing high consumer debt, but occasionally it can also refer to a country's fiscal approach to consolidate corporate debt or government debt. The process can secure a lower overall interest rate to the entire debt load and provide the convenience of servicing only one loan or debt.

Credit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

Debt restructuring is a process that allows a private or public company or a sovereign entity facing cash flow problems and financial distress to reduce and renegotiate its delinquent debts to improve or restore liquidity so that it can continue its operations.

A creditor or lender is a party that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property and service. The second party is frequently called a debtor or borrower. The first party is called the creditor, which is the lender of property, service, or money.

A debtor or debitor is a legal entity that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterpart of this debt arrangement is a bank, the debtor is more often referred to as a borrower.

In finance, unsecured debt refers to any type of debt or general obligation that is not protected by a guarantor, or collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment. Unsecured debts are sometimes called signature debt or personal loans. These differ from secured debt such as a mortgage, which is backed by a piece of real estate.

<span class="mw-page-title-main">Credit</span> Financial term for the trust between parties in transactions with a deferred payment

Credit is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately, but promises either to repay or return those resources at a later date. The resources provided by the first party can be either property, fulfillment of promises, or performances. In other words, credit is a method of making reciprocity formal, legally enforceable, and extensible to a large group of unrelated people.

In finance, a security interest is a legal right granted by a debtor to a creditor over the debtor's property which enables the creditor to have recourse to the property if the debtor defaults in making payment or otherwise performing the secured obligations. One of the most common examples of a security interest is a mortgage: a person borrows money from the bank to buy a house, and they grant a mortgage over the house so that if they default in repaying the loan, the bank can sell the house and apply the proceeds to the outstanding loan.

An individual voluntary arrangement (IVA) is a formal alternative in England and Wales for individuals wishing to avoid bankruptcy. In Scotland, the equivalent statutory debt solution is known as a protected trust deed.

Debt settlement is a settlement negotiated with a debtor's unsecured creditor. Commonly, creditors agree to forgive a large part of the debt: perhaps around half, though results can vary widely. When settlements are finalized, the terms are put in writing. It is common that the debtor makes one lump-sum payment in exchange for the creditor agreeing that the debt is now cancelled and the matter closed. Some settlements are paid out over a number of months. In either case, as long as the debtor does what is agreed in the negotiation, no outstanding debt will appear on the former debtor's credit report.

A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral, and if the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally loaned to the borrower. An example is the foreclosure of a home. From the creditor's perspective, that is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount.

Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay their creditors. In most cases personal bankruptcy is initiated by the bankrupt individual. Bankruptcy is a legal process that discharges most debts, but has the disadvantage of making it more difficult for an individual to borrow in the future. To avoid the negative impacts of personal bankruptcy, individuals in debt have a number of bankruptcy alternatives.

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.

A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full when due. Cessation of due payments may either be accompanied by that government's formal declaration that it will not pay its debts (repudiation), or it may be unannounced. A credit rating agency will take into account in its gradings capital, interest, extraneous and procedural defaults, and failures to abide by the terms of bonds or other debt instruments.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

A toxic asset is a financial asset that has fallen in value significantly and for which there is no longer a functioning market. Such assets cannot be sold at a price satisfactory to the holder. Because assets are offset against liabilities and frequently leveraged, this decline in price may be quite dangerous to the holder. The term became common during the financial crisis of 2007–2008, in which they played a major role.

A cram down or cramdown is the involuntary imposition by a court of a reorganization plan over the objection of some classes of creditors.

Financial law is the law and regulation of the commercial banking, capital markets, insurance, derivatives and investment management sectors. Understanding financial law is crucial to appreciating the creation and formation of banking and financial regulation, as well as the legal framework for finance generally. Financial law forms a substantial portion of commercial law, and notably a substantial proportion of the global economy, and legal billables are dependent on sound and clear legal policy pertaining to financial transactions. Therefore financial law as the law for financial industries involves public and private law matters. Understanding the legal implications of transactions and structures such as an indemnity, or overdraft is crucial to appreciating their effect in financial transactions. This is the core of financial law. Thus, financial law draws a narrower distinction than commercial or corporate law by focusing primarily on financial transactions, the financial market, and its participants; for example, the sale of goods may be part of commercial law but is not financial law. Financial law may be understood as being formed of three overarching methods, or pillars of law formation and categorised into five transaction silos which form the various financial positions prevalent in finance.

References

  1. ↑ O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey, USA: Pearson Prentice Hall. p. 261. ISBN   0-13-063085-3.
  2. ↑ Gillespie, Patrick (June 29, 2015). "Greece could be biggest national default in history". CNN Money.
  3. ↑ Rahnama-Moghadam; Samavati; Dilts (1995). Doing Business in Less Developed Countries: Financial Opportunities and Risks. Quorum/Greenwood. p. 108. ISBN   0-89930-854-6.
  4. ↑ "Argentina in $1bn loan default". BBC . December 13, 2002. 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.
  5. ↑ M. Nicolas J. Firzli, "Greece and the Roots the EU Debt Crisis" The Vienna Review, March 2010
  6. ↑ Nouriel Roubini, "Greece's best option is an orderly default" Financial Times, June 28, 2010
  7. ↑ Louise Armitstead, "EU accused of 'head in sand' attitude to Greek debt crisis" The Telegraph, 23 June 2011
  8. ↑ "Ecuador defaults on foreign debt". BBC News. December 13, 2008.
  9. ↑ "Managing household debts: social service provision in the EU". Eurofound.europa.eu. 2012-07-04. Retrieved 2013-10-14.
  10. ↑ Pre-purchase Counseling Is Getting Better All the Time Archived 2017-02-08 at the Wayback Machine . Freddie Mac.
  11. ↑ Pre-Purchase Counseling Benefits Banks and Homeowners. American Banker.

Bibliography

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