What it means
A loan agreement is a set of promises: to pay interest on set dates, to repay principal on schedule, to keep the business within agreed financial limits, to provide information, and not to do certain things without the lender's consent. Default is the breaking of any of those promises.
Agreements list the events of default precisely, and the list is longer than most borrowers expect. Beyond non-payment it usually includes breach of a financial covenant, breach of any other undertaking, a misrepresentation in the information given to the lender, insolvency or the appointment of an administrator, a default on any other debt above a threshold (cross-default), a change of control of the borrower, and sometimes a material adverse change in the borrower's circumstances, a clause whose vagueness gives the lender wide discretion.
Most agreements distinguish between a default and an event of default. A default is the breach itself; it becomes an event of default when any grace period has expired without cure and any required notice has been given.
Payment defaults typically have short grace periods, a few business days, to allow for administrative error. Covenant breaches may have cure periods and, in leveraged loans, an equity cure right that lets shareholders inject money to be counted as earnings for the covenant test.
Once an event of default has occurred and is continuing, the lender may exercise its remedies: it is not obliged to, and in practice it usually negotiates first. The consequences escalate.
Default interest, usually one or two percentage points above the normal rate, applies to overdue amounts and sometimes to the whole loan. Acceleration allows the lender to declare all amounts immediately due, which converts a long-term loan into a demand for cash the borrower almost never has.
Enforcement lets a secured lender take possession of and sell the charged assets, or appoint a receiver or administrator to run the business for the creditors' benefit. Cross-default clauses in the borrower's other agreements mean that a default with one lender can trigger defaults with all of them, which is why a single missed payment can bring down a company that was otherwise solvent.
Borrowers in default lose access to new credit, see their ratings cut, and find suppliers and customers growing cautious. In practice, most defaults are resolved by negotiation.
Lenders generally prefer a performing loan to enforcement, which is slow, costly and often recovers less than the debt. The typical response to a technical default is a waiver, granted for a fee and often with tighter terms: higher margin, more frequent reporting, restrictions on dividends and capital expenditure, a cash sweep, additional security.
A payment default that reflects temporary cash difficulty may be met with a rescheduling. Where the business is fundamentally sound but overborrowed, a restructuring reduces or converts the debt.
Only where the business is not viable, or where the borrower has lost the lender's trust, does enforcement follow. For lenders and credit analysts, default is a statistical event to be predicted and priced.
Credit risk models estimate the probability of default over a period, the exposure at the time of default and the loss given default (the proportion not recovered after security and negotiation); the product is expected loss, which the lender's margin must cover along with its costs and its cost of capital. Credit ratings are ordinal estimates of the probability of default.
The historical record shows that default rates rise sharply in recessions, that recovery rates fall at the same time, and that leverage, cash flow volatility and weak liquidity are the strongest predictors, which is why loan agreements are built around exactly those measures.
In practice
Real-world examples.
Example
A bond issuer fails to pay a semi-annual coupon of $12,000,000 on the due date; after the 30-day grace period the trustee declares an event of default and bondholders' advisers begin restructuring talks.
Example
A retailer delivers its audited accounts six weeks after the deadline in its loan agreement, a technical default; the bank waives it for a $10,000 fee and a reminder that the next late delivery will not be waived.
Example
A property company's loan-to-value covenant is breached when a valuation falls, though rent is being paid in full; the lender requires a $3,000,000 partial repayment to restore the ratio.
Think of it
“Default is failing to meet your debt obligations-not paying or breaking loan agreement rules.
Formula
Calculation
Expected loss = Probability of default x Loss given default x Exposure at default
Loss given default = 1 minus Recovery rate
Default interest on an overdue amount = Overdue amount x Default margin x Days overdue / 365
Covenant headroom = (Actual ratio minus Covenant ratio) / Covenant ratio
Worked example: the lender's view. A bank lends $5,000,000 to a mid-sized company. Its internal rating implies a 2% annual probability of default; the loan is secured on assets expected to recover 55% of the exposure in a default, so loss given default is 45%.
- Expected loss = 2% x 45% x $5,000,000 = $45,000 a year, or 0.9% of the loan
- The bank's margin over its funding cost must cover the 0.9% expected loss plus operating costs and a return on the capital it holds against the loan, so the loan is priced at about 2.5% to 3.0% over the bank's funding cost
- If the loan were unsecured, with 30% expected recovery, loss given default would be 70% and expected loss $70,000, and the margin would be higher
Worked example: the borrower's view. The same company misses a $500,000 principal instalment and pays it nine days late, beyond the agreement's five-business-day grace period. Default interest is 2% above the normal rate.
- Default interest on the late instalment = $500,000 x 2% x 9 / 365 = about $250
- But the missed payment is an event of default, so the bank may also charge default interest on the whole $5,000,000 balance until the default is waived: $5,000,000 x 2% x 30 / 365 = about $8,200 for a month
- The bank charges a waiver fee of $25,000 and requires weekly cash reporting for six months
Worked example: covenant breach and equity cure. The company's agreement requires interest cover of at least 3.0 times. Operating profit falls to $2,600,000 against interest of $1,000,000: cover 2.6 times, a breach. The agreement permits an equity cure under which money injected by shareholders is added to operating profit for the test. Shareholders inject $400,000: deemed operating profit $3,000,000; cover 3.0 times; the breach is cured. The cure can be used at most twice over the life of the loan and not in consecutive periods.Case study
Seen in the real world.
A distribution company with a $5,000,000 term loan and a $2,000,000 equipment leasing facility missed a quarterly principal instalment of $500,000 because its largest customer paid a $1,200,000 invoice three weeks late. The finance manager assumed a few days' delay would not matter; the loan agreement's grace period was five business days, and the payment was made on the ninth. The bank's relationship manager, who had not been told in advance, was obliged to record an event of default.
The consequences spread beyond the bank. The leasing agreement contained a cross-default clause triggered by any default on other borrowings above $250,000, so the lessor was also entitled to terminate and repossess the equipment, and it wrote to say so.
The company's credit insurer, which monitored its accounts, reduced its cover, and two suppliers who used the insurer tightened terms. Within a fortnight a late customer payment had become a liquidity problem across the company's whole funding structure.
The resolution took a month. The bank waived the default for a $25,000 fee, applied default interest to the loan for the period until the waiver, and required weekly cash flow reporting for six months. The lessor accepted the bank's waiver as sufficient.
The company, chastened, put in place a $1,000,000 cash buffer, moved its largest customer to a direct debit arrangement, and adopted a rule that any risk of a late payment to any lender would be raised with the lender before the due date, not after. The finance manager's report to the board made the point that the loan had never been in doubt; the company had the money nine days late. What it had lacked was an understanding that a default is defined by the agreement, not by the borrower's intentions, and that lenders who are told in advance will almost always accommodate what lenders who are surprised must treat as a breach.
Watch out
Common mistakes.
- Assuming default means only non-payment; loan agreements define many events of default, and a covenant breach or a late set of accounts gives the lender the same rights as a missed payment.
- Paying late without telling the lender first; a few days' notice usually turns a default into an agreed short extension, while a surprise forces the lender to act.
- Overlooking cross-default clauses, which mean a default with one lender can trigger defaults with all of them and turn a local problem into a company-wide one.
Questions
People also ask.
What is the difference between default and bankruptcy?
Default is the breach of a loan agreement; bankruptcy or insolvency is a legal process for a business that cannot pay its debts. Default can lead to insolvency if the lender enforces and the borrower cannot pay, but most defaults are resolved by waiver or restructuring without it.
What is a technical default?
A breach of a non-payment term of the agreement, such as a financial covenant, a reporting deadline or a restriction on the borrower's actions. It gives the lender the same rights as a payment default, though lenders usually waive it on terms.
What happens to a company's credit rating after a default?
Rating agencies mark the issuer at their default grade and, after any restructuring, assign a new rating that reflects the reorganised position. Banks' internal ratings do the same, and the record affects the borrower's access to and cost of credit for years.
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