Default (Finance)

In finance, a default is a borrower's failure to meet the legal obligations of a debt. The most common form is missing a scheduled payment of interest or principal on a loan or bond, but a borrower can also default by breaking another term of the contract, such as a promise to keep its debt below a set level. Default can happen to individuals, companies, banks and governments.

The possibility of default is what lenders price as credit risk, and rating agencies summarise it in a credit rating. A default by a national government is usually discussed separately as a sovereign default, because no court can force a state into bankruptcy. Default is related to, but not the same as, insolvency: a solvent borrower can default because it is short of cash, and an insolvent one can keep paying for a while.

A default is a broken promise to pay. If you agree to repay a friend £100 on the first of the month and the day passes without the money, you have defaulted, even if you pay a week later. Breaking a side promise, such as agreeing not to borrow from anyone else and then doing so, can count as well.

What happens next depends on the agreement. Often the lender can demand the whole amount at once, take any property pledged as security, or sit down with the borrower to agree new terms. A lender who expects to get some money back, but not all, is said to be counting on a partial recovery. When several creditors are owed money, debt seniority decides who is paid first from whatever can be recovered, with senior lenders ahead of subordinated ones.

Default comes in several forms:

• Payment default. The borrower misses an interest or principal payment and does not cure it within any grace period, often 30 days for bond coupons.
• Technical default. The borrower breaches a covenant, such as a maximum debt-to-earnings ratio or a reporting deadline, without missing a payment.
• Distressed exchange. A struggling borrower offers creditors new securities worth less than the old ones; rating agencies usually treat this as a default even when it is voluntary.
• Cross-default. A clause in one loan treats a default on any other debt as a default on that loan too, so trouble spreads quickly.

For consumer loans, lenders and regulators use time-based tests: in banking supervision a loan more than 90 days past due is normally a non-performing loan.

A default usually lets lenders accelerate the debt, making all of it due at once. Secured lenders can then seize the collateral behind their loans. For companies, the outcome is either an out-of-court restructuring, in which creditors accept a haircut, longer maturities or shares in exchange for their claims, or a court process. In the United States, Chapter 11 of the Bankruptcy Code lets a company keep operating while it negotiates a reorganisation plan, and Chapter 7 liquidates it. Lehman Brothers' Chapter 11 filing on 15 September 2008 remains the largest US bankruptcy by assets.

Creditors are paid in order of priority: secured debt first, then senior unsecured, then subordinated debt, then preferred stock, and finally common shareholders. The share of face value creditors get back is the recovery rate. For corporate bonds, a default also triggers settlement of any credit default swap written on the issuer, under rules set by industry determinations committees.

Investors demand a higher yield from riskier borrowers. The extra amount over a government bond, the credit spread, reflects both the expected loss from default and a premium for bearing uncertainty. Defaults are rare among investment-grade bonds and much more common among junk bonds, and they cluster in a recession. For that reason a bond's yield to maturity, which assumes every payment arrives, is an upper limit on the return from a risky issuer rather than a forecast.

Banks set aside capital against expected defaults under Basel III rules, using estimates of probability of default, loss given default and exposure at default.

Some defaults reshaped markets. Russia's 1998 default on its domestic debt helped bring down the hedge fund Long-Term Capital Management. Argentina's default at the end of 2001 led to more than a decade of litigation with holdout creditors. Greece's 2012 debt exchange with private creditors was the largest sovereign restructuring on record and was supported by the IMF and euro-area governments. Among companies, the collapse of Enron in 2001 and of Lehman Brothers in 2008, at the height of the 2008 financial crisis, showed how quickly a large borrower can fail once lenders lose confidence. Arguments that some state debts should not be repaid at all are covered under odious debt.

• Investor.gov (SEC): Default
• United States Courts: Chapter 11 – Bankruptcy Basics