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CREDIT DEFAULT

In finance, default occurs when a debtor has not met his/her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant (condition) of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt. The term default should be distinguished from the terms insolvency. “Default” essentially means a debtor has not paid a debt which they are required to have paid. “Insolvency” is a legal term meaning that a debtor is unable to pay their debts.

Types of default

Default can be of two types: debt services default and technical default. Debt service default occurs when the borrower has not made 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. Negative covenants are clauses in debt contracts that limit/prohibit corporate actions (e.g. sale of assets, payment of dividends) that could impair the position of creditors. Upon default, the holders of the debt will usually initiate proceedings (file a petition of involuntary bankruptcy) to foreclose on any collateral securing the debt.

When a debtor chooses to default on a loan, despite being able to service it (make payments), this is said to be a strategic default. This is most commonly done for non-recourse loans, where the creditor cannot make other claims on the debtor.Sovereign borrowers such as countries generally are not subject to bankruptcy courts in their own jurisdiction, and thus may be able to default without legal consequences. In such cases, the defaulting country and the creditor are more likely to renegotiate the interest rate, length of the loan, or the principal payments.

FORECLOSURE

Foreclosure is the legal process by which a lender obtains a court ordered termination of a mortgagor’s equitable right of redemption. Usually a lender obtains a security interest from a borrower who pledges an asset to secure the loan. If the borrower defaults and the lender tries to repossess the property, courts can grant the borrower the equitable right of redemption if the borrower repays the debt. While this equitable right exists, the lender cannot be sure that it can successfully repossess the property, thus the lender seeks to foreclose the equitable right of redemption. Other lien holders can also foreclose the owner’s right of redemption for other debts, such as for overdue taxes, unpaid contractors’ bills.

The foreclosure process as applied to loans is a bank or other secured creditor selling or repossessing real property (immovable property) after the owner has failed to comply with an agreement between the lender and borrower. When the process is complete, the lender can sell the property and keep the proceeds to pay off its loan and any legal costs, and it is typically said that “the lender has foreclosed its mortgage. The process of foreclosure can be rapid or lengthy and varies from state to state. Other options such as refinancing, a short sale, alternate financing, temporary arrangements with the lender or even bankruptcy may present borrowers with ways to avoid foreclosure.

Types of foreclosure

The mortgage holder can usually initiate foreclosure at a time specified in the mortgage documents typically some period of time after a default condition occurs. Judicial foreclosure involves the sale of the mortgaged property under the supervision of a court, with the proceeds going first to satisfy the mortgage; then other lien holders; and finally the borrower if any proceeds are left. Under this system, the lender initiates foreclosure by filing a lawsuit against the borrower. Non judicial foreclosure is authorized if a power of sale clause is included in the mortgage. This process involves the sale of the property by the mortgage holder without court supervision. This process is generally much faster and cheaper than foreclosure by judicial sale. As in judicial sale, the mortgage holder and other lien holders are respectively first and second claimants to the proceeds from the sale.

Acceleration

Acceleration allows the mortgage holder to declare the entire debt of a defaulted mortgagor due and payable, when a term in the mortgage has been broken. The mortgage holder will also include any unpaid property taxes and delinquent payments in this amount. Lenders may also accelerate a loan if there is a transfer clause, obligating the mortgagor to notify the lender of any transfer, whether; a lease-option, lease-hold, land contracts, agreement for deed, transfer of title or interest in the property. The holder of a mortgage without the acceleration clause has only two options: either to wait until all of the payments come due or convince a court to compel a sale of some parts of the property in lieu of the past due payments. Alternatively, the court may order the property sold subject to the mortgage, with the proceeds from the sale going to the payments owed the mortgage holder.

Contesting a foreclosure

To keep the right of redemption, the debtor may petition the court for an injunction. If repossession is imminent the debtor must seek a temporary restraining order. However, the debtor may have to post a bond in the amount of the debt. This protects the creditor if the attempt to stop foreclosure is simply an attempt to escape the debt. A debtor may also challenge the validity of the debt in a claim against the bank to stop the foreclosure and sue for damages. In a foreclosure proceeding, the lender also bears the burden of proving they have standing to foreclose

Renegotiation alternative

In the wake of the United States housing bubble and the subsequent subprime mortgage crisis there was increased interest in renegotiation or modification of the mortgage loans rather than foreclosure, and some commentators have speculated that the crisis was exacerbated by the “unwillingness of lenders to renegotiate mortgages”. Renegotiations can include lowering the principal due or temporarily reducing the interest rate.

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