Default is the failure to pay interest or principal on a loan or security when due. Default occurs when a debtor is unable to meet the legal obligation of debt repayment, and it also refers to cases in which one party fails to perform on a futures contract as required by an exchange.
If an individual fails to make his monthly mortgage payments, he defaults on the loan. Similarly, if a business issues bonds and it is unable to make coupon payments to its bondholders, the business is in default on its bonds. When deciding whether to issue a loan or invest in a debt security, lenders and investors must carefully consider the chance of default and must manage its risk.
How Lenders and Investors Deal With Default
When an individual, a business or even a nation defaults on a debt obligation, the lender or investor has some recourse to reclaim the funds, but it varies based on the type of security involved. For example, in cases of default, a mortgage lender can reclaim the home securing the mortgage. In contrast, a credit card issuer may simply have to write off the debt as bad.
If a business goes into bankruptcy, it effectively defaults on all its loans and its bonds. Creditors with loans secured by the business’s assets, such as buildings, inventory or vehicles, may reclaim those assets in lieu of repayment. If there are any funds left over, the company’s bondholders receive a stake in them, and shareholders are next in line.
Defaulting on a Futures Contract
Defaulting on a futures contract occurs when one party does not fulfill the obligations set forth by the agreement, and it usually involves failure to settle the contract by the required date. A person in the short position defaults if he fails to deliver the goods at the end of the contract, while the long position defaults when payment is not provided by the settlement date.
Also called national default, sovereign default occurs when a country cannot repay its debts. When a country defaults, its economy shrinks, potentially throwing the country into a depression and devaluing its currency. Sovereign default, like other types of default, happens for a variety of reasons. For example, Jamaica defaulted on $7.9 billion in 2010, due to government overspending, high debt loads and drops in tourism, the country’s key industry. In contrast, when Ecuador went into default in 2008 on $3.2 billion, it did so simply because its government did not want to repay its debts.
Consequences of Default
When a borrower defaults on a loan, it creates a negative mark on his credit report, reducing the chances of obtaining credit in the future. Similarly, when bond issuers default on bonds or exhibit other signs of poor credit management, ratings agencies lower their credit ratings. Credit ratings agencies such as Standard and Poor’s issue credit ratings for business, municipalities, countries and other entities.
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