What is default?

Default is the failure to make scheduled, contractual payments. Depending on the amount and the delay involved, a default can be a non-event, a prelude to bankruptcy, or anything in between. Individuals, companies, defined-benefit pension plans, non-profit organizations, countries—any entity that has payment obligations—can default. For investors and creditors, default risk is one of the most important considerations. We explore the potential implications and causes of default.

People, companies, and other organizations can default

For individuals, a default can result in a warning from the bank, additional accrued interest to be paid, and a decrease in your credit score. If resolved rapidly, the damage can be limited. For companies, especially public ones, the implications are usually much greater in the event of default. It can have lasting consequences on borrowing costs and credit access, as markets tend to lose confidence in borrowers that don’t respect their contractual payment schedules.

  • Another type of default: technical default

    Technical default occurs when covenants (e.g., ownership structure, merger activities) or financial ratios (e.g., debt service ratio) are breached, even if the borrower hasn’t missed any debt payments. Upon a technical default, creditors can demand accelerated repayments of their loans. 

What’s the difference between default and bankruptcy?

While both individual and corporate default can lead to bankruptcy, companies will usually do everything in their power to avoid default. This means that when companies do default, they’re often also on the brink of bankruptcy. That’s why default and bankruptcy are frequently conflated, even though they have different meanings.

Default versus bankruptcy

Creditors involved and repayment

Default

Only creditors related to the defaulted debt are involved, and there’s still hope for them to get full repayment (plus accrued interest).

 

Borrowers and creditors can also agree on a loan extension or a different payment schedule to help the borrower get back on track.

Bankruptcy

Almost all assets and liabilities are involved in the event of a bankruptcy, and repayment is done through the disposition of assets.

 

Every creditor in the top tier must be paid in full before moving on to the next tier. If there’s not enough money to pay in full every creditor on the same tier, proceeds are distributed pro rata among them, and creditors ranked below get nothing. Owners (equity holders) are the lowest in priority.

Liquidation proceeds are usually distributed in the following order:
Infographic showing the order of creditor claims. Secured creditors are the highest in priority while equity shareholders have the lowest priority for recoveries.

Source: Manulife Investment Management. For illustrative purposes only.

Consequences on access to credit

Default

For individuals, a default as small as missing a credit card monthly payment can hurt your credit score, though the impact is usually short-lived.

 

For companies and countries, default can result in a credit rating downgrade, which increases borrowing costs and can lead to more stringent loan conditions in the future.

Bankruptcy

For individuals, a bankruptcy reduces your credit score more than a default, and it can take several years for it to be removed from your credit history.

 

Companies in the U.S. often file for Chapter 11 bankruptcy, which allows the company to still access the debt market and continue its operations under court supervision in an attempt to right the ship. If the reorganization is a success, creditors can regain market confidence fairly quickly. Hertz, for example, filed for Chapter 11 bankruptcy during the COVID-19 pandemic, and less than three years later, its credit rating was back to B.

What can cause default and bankruptcy?

Default often occurs when a borrower’s liquidity isn’t sufficient to cover an upcoming payment. The inability to generate enough cash flow is a common cause of defaults, and if the situation isn’t handled, defaults can turn into a bankruptcy.

But bankruptcy can also happen without an entity ever defaulting—there are factors or events that can hit so hard and fast that bankruptcy rapidly becomes the only option.

Bank runs

A bank run is when a relatively high concentration of customers suddenly and simultaneously withdraw deposits from a bank, out of fear that the bank is on its way to insolvency. Since banks keep only a fraction of the deposits liquid and invest (or lend out) the rest, a bank facing a run likely won’t have the cash on hand to meet large, abrupt withdrawals, and bank runs can dry up a bank’s liquidity relatively quickly.

That’s what happened to Silicon Valley Bank, for example: in a single day, investors and depositors tried to pull $42 billion. At the close of that day, the bank had a negative cash balance of $958 billion and was incapable of paying its obligations, resulting in the second largest bank failure in U.S. history.

Bank runs are often seen as self-fulfilling prophecies. As some depositors start withdrawing money because of a special event, others may start losing confidence in their bank and also start withdrawing money, fearing that their bank will become insolvent. As panic mounts, the run on the bank accelerates. 

Frauds

Despite stringent bank and securities regulations, nefarious financial actors have found ways throughout history to inflate profit numbers and fool regulators, investors, and creditors.

One of the most infamous cases of fraud culminated with the collapse of Enron in 2001. The energy and commodity services company, one of the largest in the world, artificially inflated its profits for years before its fraudulent accounting practices were exposed when the economy weakened, leading to the largest corporate bankruptcy ever at the time.

Top 10 largest bankruptcies in the United States, by assets at the time of bankruptcy (in billion USD)

Name

Assets

Date

Context

Lehman Brothers

691

09/15/2008

Global Financial Crisis

Washington Mutual

328

09/26/2008

Bank run

Silicon Valley Bank

209

03/10/2023

Bank run

Signature Bank

110

03/12/2023

Bank run

Worldcom Inc

104

07/02/2022

Fraud

General Motors

82

06/01/2009

Global Financial Crisis

Pacific Gas and Electric Company

71

01/14/2019

Wildfire liability

CIT Group

71

11/01/2009

Global Financial Crisis

Enron

66

12/02/2001

Fraud

Conseco

61

12/17/2002

Bad acquisition

Source: Manulife Investment Management, Statista, as of March 2023.

Widespread crises

The very nature of a crisis is that it’s unpredictable. Its cause and reach usually remain unknown until it’s too late. Take the COVID-19 pandemic, for example—the global economy went from expanding to contracting almost overnight, one of the sharpest and most sudden economic downturns since the Great Depression.

Airline companies, for example, were particularly hard hit by COVID-19 measures, and losses started to mount. Many airlines were injected with cash from their national governments to prevent bankruptcy. Others didn’t have that chance—a total of 64 airlines have ceased operations since 2020.

This introduces the concept of “too big to fail.” In some cases, the contagion and the economic impact would be too high for governments to let companies default on their debt, so they bail them out. This was the case with multiple banks and insurance companies during the Global Financial Crisis.

Too big to fail can also apply to countries. Greece, for example, received €110 billion in loans from the International Monetary Fund and the European Union to avoid default in 2010.

Minimizing default risk

While there’s always a chance that a borrower won’t meet a payment obligation, it’s crucial for investors and creditors to minimize default risk and reduce the likelihood of large losses within their portfolios. This can be achieved through diversification and a thorough due diligence process across geographic regions, sectors, and assets.

Ultimately, default risk can’t be eliminated, but investors and creditors should always assess the risk of default in their portfolios, and if they’re being rewarded for bearing it.

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