Technical Default

Technical default is defined as a type of breach of contract where the borrower fails to fulfil certain pre-determined terms of the loan. In such a case, the lender can demand the full repayment of the loan or provide a period within which the borrower should fulfil the condition.

It is important to note that non-payment of interest on a loan will not be considered a technical default but a financial one. A decrease in the borrower's debt-to-income ratio and a change in ownership of the entity borrowed are some examples of defaults that lenders consider technical.

• Technical default is the violation of terms of a loan agreement by the borrower or the debtor, other than failure to make regular interest payments.
• The lender initially lays out the terms of the agreement. n, then the borrower accepts it before processing the loan. But during the term of the loan, some borrowers might default.
• The technical default consequences depend on the creditor and the debtor's financial situation. Hence, once a default occurs, the creditor's course of action can depend on that.

Technical default is one of the common issues many lending institutions face. When debtors approach them for credit, they provide loans subject to certain conditions. These conditions are known as covenants and reflect the lenders' best interests and show the borrower's ability to repay the loan at any time.

Hence, if a debtor initially fulfills the conditions and later does not, owing to increased commitments or financial burden, it can affect their ability to repay the loan. This is why creditors keep a watch on the debtors.

The covenants can be standard or non-standard. Standard covenants are those which are general to most loans and obvious. For example, the borrower should have a good financial standing or adequate assets insurance.

Non-standard assets, on the other hand, are specific to the loan. For example, while approaching a bank for a mortgage loan, the bank will demand maximum insurance coverage, maintenance, and repair requirements.

There are positive and negative covenants as well. Positive covenants indicate what the debtor can or must do, whereas negative covenants direct what the debtor should not do. For instance, 'The owner should not transfer property during the loan period is a negative covenant. In contrast, 'The company should always maintain a debt-to-equity ratio of less than 1.5 is a positive covenant.

Now, let's discuss the technical default consequences. It is a serious issue, but the action depends on the bank. If the bank realizes that the borrower has a good financial background, they might let them get away with it for some time. But some banks might demand accelerated repayment of the full loan amount. However, technical and financial default accompanied together is an alarming situation.

There are two common types of technical defaults.

#1 – Mortgage loans

Mortgage loans might be subject to many provisions to which the debtor has agreed to adhere to. For example, building repairs and maintenance, occupancy, non-transfer of ownership, homeowners' insurance, property tax payment, etc. So, it defaults even if a person makes timely interest payments towards the mortgage but doesn't properly maintain the house.

#2 – Business loans

Firms borrowing from banks or other institutions should fulfill financial and operational ratios like current ratio, quick ratio, assets, working capital, etc. These indicate the stability and performance of the company, which would assure the lender of proper repayment of the loan.

Let's discuss some examples of technical defaults.

Example #1

Consider this hypothetical example of Mark, who wants to buy a car. He approaches the bank for an auto loan. The bank puts forward some conditions:

• First, the car's ownership should not be transferred during the life of the loan.
• The car should be regularly maintained and repaired as the car dealer recommends.
• Third, the car must be under insurance coverage.
• Fourth, the mark must make timely premium payments.
• Finally, Mark's debt-to-income ratio should always be at 35-40%.

Mark agrees to the conditions and signs the agreement. However, six months after buying the car, Mark buys another car on loan, which makes his debt-to-income ratio 45%. The bank warns Mark about the violation of the condition and gives him a two-month window to rectify the issue.

Example #2

Here's the case of Russian technical default. The United States, in May 2022, decided to block Russian debt payments. This will increase the odds of Russia defaulting on payments. The country owes its foreign investors an estimated $20 billion in sovereign debt. However, the government declared that it had no intention to default.

Nevertheless, many Russian companies already in debt are technically defaulting due to the Russia-Ukraine war and the subsequent sanctions on Russia.

A monetary or financial default directly concerns the money involved. Hence, monetary default means the non-payment of monthly interest on the loan in the case of borrowing. Most defaults other than this are technical. Therefore, monetary defaults are considered a bit more serious than technical ones.

Technical defaults are violations of conditions that may or may not affect the borrower's financial capability at a future date. But monetary defaults can lead to a loss for the lender. Hence, if the borrower defaults on the payment, banks might take strict action.

This has been a guide to What is Technical Default and its meaning. We explain its types, examples, and comparisons with monetary default. You may also find some useful articles here -

• Negative Covenants
• Lending vs Borrowing
• Debt Default