A quick overview of lending process and the meanings of bankruptcy, default and insolvency

There’s been a lot of talk about bankruptcy, insolvency, and default in the news recently.  One might initially be inclined to think that these three words are synonyms.  However, this is not the case.  Each is a part of a larger debt repayment process.

Whenever a company or an individual, borrows money from a reputable lender, there is usually a lot of paperwork.  This paperwork, which is often called the indenture, exists to make sure that the terms of the deal are clear.  The borrower needs to have the rates, amounts, and the payment schedule firmly set forth before they agree to the loan.  The lender needs to know that the borrower will promise to pay, and if they can’t, exactly what they can do to recoup their investment.  The borrower can either provide collateral that the lender can seize in the event of nonpayment (for instance a house, securities, or a car), or the lender can make what’s called an unsecured pledge, which is just a pledge against the borrower’s assets in general.  

If the borrower is making a secured (collateralized) pledge, then the lender will probably ask for certain restrictions on what can be done with the collateral; how it is used and how it is cared for.  For instance, if you borrow against your collection of valuable cheeses, the bank would need to make sure you weren’t eating them.  Likewise, if the borrower makes an unsecured pledge, the lender will probably require them to limit their indebtedness so that they don’t borrow more then they can repay.  The lender may also require other conditions and restraints.  These requirements usually compose what are called the covenants of the indenture.

Now what happens if a borrower misses a payment?  If the borrower is unable to repay their debts, they become "insolvent." If a borrower misses a payment, they are considered to be in default on their loan.  Furthermore, if the borrower violates the covenants of their indenture, by taking on too much debt, failing to care for their collateral (eating their cheese), or any other violations, they are also considered to be in default.  In this case it is referred to as a technical default.  For individuals, the consequences for missing a payment are usually not that severe at first; there could be an additional charge, and maybe an increase interest rates.  For a corporation, especially a large corporation, borrowers are usually much less lenient in dealing with defaults.  

A borrower who defaults might first try to work with their lenders to restructure their loan so they can repay it.  They may extend the loan to lower the rate, or in the case of a company, offer to exchange some of the debt for some stock or ownership in the company.  

However, if the borrower and lender are unable on agree to a restructuring deal, generally, either the borrower will declare bankruptcy, the lender will force them into bankruptcy or the lender will directly attempt to seize their assets.  While in bankruptcy, the courts protect the borrower’s assets as they create a plan to reorganize to better repay their loans.  This plan which must be approved by the creditors must satisfy certain criteria depending on the bankruptcy.  The bankruptcy plans and negotiations often  require both sides compromising, with the lenders forgiving some debt, and the lenders agreeing to repay the rest at higher terms. 

If no realistic way for the borrower to repay their loans can be foreseen, the courts will usually force the borrower into liquidating their assets to repay loans.  The courts may also do this if no plan can be agreed upon, although in this case they may also forgive the loans. 

Hopefully though the bankruptcy proceedings will go well, and the borrower will eventually emerge from bankruptcy after restructuring and repaying their lenders as best they can.