Types of default

Q:
How many types of default are there?

A:
Default can be of two types: debt services default and technical default. Debt service default occurs when the borrower is unable to make a scheduled payment of interest or principal. Technical default happens when an affirmative or a negative covenant is violated.

Affirmative covenants are clauses in debt contracts that require firms to maintain certain levels of capital or financial ratios. The most commonly violated restrictions in affirmative covenants are tangible net worth, working capital/short term liquidity, and debt service coverage.

Negative covenants are clauses in debt contracts that limit or prohibit corporate actions (e.g sale of assets, payment of dividends) that could impair the position of creditors. Negative covenants may be continious or incurrance based. Violations of negative covenants are rare compared to the violation of affirmative covenants.

With most debt (including corporate debt, mortgages and bank loans) the total amount owed becomes immediately payable on the first instance of a default of payment. Generally, if the debtor defaults on any debt to any lender, a cross default covenant in the debt contract states that that particular debt is also in default.

In corporate finance, upon an uncured default, the holders of the debt will usually initiate proceedings (file a petition of involuntary bankruptcy) to foreclose on the collateral securing the debt.

There is a rich array of financial models for analyzing default risk such as the Jarrow-Turnbull model, Altman Z-score or the structural model of default by Robert C. Merton.

Sovereign borrowers such as nation-states generally are not subject to bankruptcy courts in their own jurisdiction, and thus may be able to default without legal consequences.