DEFAULT

Definition

In finance, default occurs when a borrower fails to meet the legal obligations of a debt agreement, such as missing a payment of principal, interest, or both. Default can apply to loans, bonds, mortgages, leases, or any contractual financial obligation.

Default is considered a serious credit event and may trigger legal actions, acceleration of repayment, asset seizure, or bankruptcy proceedings.

Origins

The word "default" comes from the Old French defaute, meaning "fault, deficiency, or failure", which in turn derives from the Latin fallere, meaning "to deceive". In the financial sense, the term became standardized in the late 19th and early 20th centuries with the development of bond markets and formalized loan agreements.

Usage

Default can be discussed in:

• Corporate finance – Company fails to make debt service payments.

• Sovereign debt – Government fails to pay bondholders (e.g., Argentina 2001, Sri Lanka 2022).

• Consumer finance – Individual defaults on mortgage, car loan, or credit card debt.

• Derivatives & CDS – Credit default swaps use default as a trigger event for payout.

How Default Works

Default typically follows a grace period after a missed payment. It can be:

• Monetary default – Failure to make payment.

• Technical default – Breach of a non-payment covenant (e.g., exceeding a leverage ratio).
  
  

Default Process Overview:

• Missed Payment or Breach – Borrower violates loan terms.

• Grace Period – Lender allows a short time to remedy the failure.

• Event of Default Declared – Formal notice sent by the lender.

• Remedies & Consequences – Loan acceleration, collateral seizure, or restructuring.

Types of Loan Covenants

1. Sovereign Default

• Country cannot repay external or domestic debt.

• Often leads to currency depreciation, inflation, and economic instability.
  
  

2. Corporate Default

• Business fails to meet bond or loan obligations.

• Can result in bankruptcy or restructuring.
  
  

3. Consumer Default

• Individuals fail to make personal loan or mortgage payments.

• Leads to credit score damage, repossession, or foreclosure.
     

4. Technical Default

• Breach of non-payment terms such as failing to maintain certain financial ratios.

Key Takeaway

• Default is not always due to insolvency—can result from temporary liquidity issues.

• Technical defaults can trigger the same legal remedies as payment defaults.

• Credit ratings are lowered after default, raising future borrowing costs.

• Early detection and negotiation can prevent escalation to bankruptcy.

Context in Financial Modeling

Incorporating default risk is essential for:

• Credit risk analysis – Estimating probability of default (PD).

• Loan loss provisioning – Setting reserves for expected losses.

• Bond pricing models – Adjusting yields for credit risk.

• Valuation models – Using higher discount rates for risky cash flows.
   

Nuances & Complexities

• Cross-Default Clauses – Default on one obligation can trigger default on others.

• Restructuring – Creditors may renegotiate terms instead of enforcing legal action.

• Regulatory Impact – Banks must maintain capital buffers for default exposures under Basel III.

• Difference from Delinquency – Delinquency is late payment; default is legal failure after remedies expire.
  
  

Mathematical Formulas

Probability of Default (PD):

$$PD = \frac{\text{Number of Defaults}}{\text{Total Borrowers at Start of Period}}$$

Expected Loss (EL):

$$EL = PD \times LGD \times EAD$$

Where:

• LGD = Loss Given Default

• EAD = Exposure at Default
  
  

Credit Spread Impact:

$$\text{Bond Yield} \approx \text{Risk-Free Rate} + \text{Credit Spread (Default Premium)}$$ $$\text{Overcollateralization Ratio} = \frac{\text{Collateral Value} - \text{Bond Value}}{\text{Bond Value}}$$

Related Terms

• Delinquency
  
  

•  Bankruptcy
  
  

•  Credit Risk
  
  

•  Non-Performing Loan (NPL)
  
  

•  Cross-Default
  
  

•  Restructuring
  
  

•  Credit Rating Downgrade
  
  

Real-World Applications

Example 1: Sovereign Default

In 2020, Argentina defaulted on $65B in sovereign debt, restructuring repayment terms with bondholders.

Example 2: Corporate Default

Lehman Brothers defaulted in 2008 when it filed for bankruptcy after failing to meet debt obligations amid the financial crisis.

Example 3: Consumer Default

A homeowner defaults on a mortgage after job loss, leading to foreclosure.

References & Sources

• Finance Strategists: What is Default Risk