Default
From Financial Literacy Wiki
Default, in finance, 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 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" is different 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.
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 repayment of 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 accounting-based measures. The most commonly violated restrictions in affirmative covenants are net worth, working capital or current ratio, and leverage. Negative covenants are clauses in debt contracts that limit certain investment and financing activities unless specified conditions are met; for example, most loans or bonds will require that any new debt be of equal or lower seniority. 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 covenant in the debt contract states that that particular debt is also in default. This is referred to as cross default. In corporate finance, the holders of the debt will usually seize the collateral securing the debt, or file in court to force bankruptcy immediately after a default occurs, or both.
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.
