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Default: Failing To Meet
Your Legal Obligations

In finance, default occurs when a debtor has not met its legal obligations according to the debt contract, e.g. it has not made a scheduled payment, or violated a loan covenant (condition) of the debt contract. 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.

The term default should be distinguished from the terms insolvency and bankruptcy. "Default" essentially means a debtor has not paid a debt. "Insolvency" is a legal term meaning that a debtor is unable to pay his 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 is unable to make 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 continious or incurrance based. Violations of negative covenants are rare compared to the violation of affirmative covenants.

With most debt (including corporate debt, mortgages and bank loans) 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 any 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 the collateral securing the debt.

There is a rich array of financial models for analyzing default risk such as the Jarrow Turnbull Model, Altman Z-score or the structural model of default by Robert C. Merton.

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.

 


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