The term ‘default’ may create anxiety for many investors but the truth is, there is no such thing as a risk-free investment: not in the equity market (stocks) and not in the debt market (loans). Here, we take a look at the general concept of a defaulted investment, what a default entails, and what it means for investors.
A loan agreement is a binding contract between a Lender and a Borrower that formalizes the loan process, terms, and conditions.
In the simplest terms, a default occurs when the Borrower fails to comply with a material term of the underlying loan agreement, which the Borrower cannot cure, and the Lender formally declares an “event of default” and puts the Borrower on notice of the Lender’s intent to enforce its rights over the loan and the underlying collateral.
Defaults most commonly stem from the Borrower’s failure to do one of the following:
In asset-backed lending, the Borrower must provide some form of collateral to support a loan. Depending on the terms of the loan agreement, if a default is declared, the Lender is typically able to seize the collateral by enforcing its rights through the foreclosure process, or through an alternative workout strategy deemed appropriate for the specific situation. The loan collateral is thus sold to satisfy the outstanding debt, interest, and fees. If the proceeds of the sale loan collateral are insufficient to repay the outstanding amounts, the Lender may pursue recovery against other assets of the Borrower and the guarantors.
Terms of the loan
Say a Borrower pledges real estate as collateral for a $10M loan. The Lender evaluates the collateral and agrees to charge a 12% simple interest rate (not discounted) over a period of four years. In this case, the monthly interest payments would be $100,000 for 48 months. When the four years are up, the Borrower will have to pay back the entire principal balance of $10M that was originally borrowed.
Fifteen months into the loan period, the Borrower encounters financial difficulties and is unable to pay the $100,000 monthly interest payment. When the payment is missed, the Lender notifies the Borrower that their payment is past the contractual grace period. The Borrower admits that they’ve experienced significant financial losses and will not be able to repay the loan under the previously agreed-upon terms in the loan agreement.
In order to reserve their rights to potentially call a future default, the Lender immediately issues the Borrower a Reservation of Rights Letter. This is done to clearly document that no discussions with the Borrower can impede on the Lender’s ability to later enforce its rights over the loan and the underlying collateral.
Work out strategy
After discussions with the Borrower, and depending on the Borrower’s track record, the Lender may decide to permit a loan modification or a payment deferral, for example. The Lender agrees to allow the Borrower to make monthly interest payments at a reduced interest rate of 6% while deferring payment of the remaining 6%.
This is referred to as a Payment Deferral, which allows Borrowers to temporarily pay at a reduced interest rate. The unpaid interest balance, or “deferred” portion, continues to accrue while being capitalized and added to the principal balance on a monthly basis.
After making a few of the adjusted monthly interest payments, the Borrower defaults on its due payment again. Following discussions with the Borrower, the Lender opts to formally declare an Event of Default and demands immediate repayment of the loan or “loan acceleration”. The Lender then submits a Notice of Default to the Borrower.
After assessing its options, the Lender commences the foreclosure process and submits the appropriate notices to the Borrower. It’s important to note that foreclosure law and the associated processes (and timeline) can vary greatly from state to state. If necessary to first obtain summary judgment, the Lender applies to a court for a judgment that it is entitled to the outstanding principal and interest. Otherwise, the Lender may be able to wholly recover the outstanding balance of the loan (principal + accrued interest) through a foreclosure sale of the underlying collateral, outside of the judicial process.
Please note that the above is strictly an example used for illustrative purposes. We encourage you to review the default recovery process as every default workout strategy should be tailored to the facts and circumstances of each situation.
No. All defaults are not the same. The above example is just a single example. Ultimately, what may constitute a default, and thus may entitle but not obligate the Lender to declare a default, is defined by the specific terms set forth in the loan agreement at issue. For this reason, in general, it is said that defaults constitute a breach of contract. Below are a few of the most common types of defaults:
The maturity date is the date on which the principal amount of a debt instrument becomes due. A maturity default occurs when the Borrower fails to pay the Lender the outstanding principal balance due at the loan’s stated maturity date.
Payment defaults occur when the Borrower is unable to make the periodic principal or interest payment (typically monthly or quarterly) when due, after any applicable grace periods have expired. The situation outlined above is an example of a payment default.
All loan agreements include some form of covenants. Covenants are either conditions that the Borrower is required to meet (affirmative covenants) or actions that the Borrower is forbidden to take (negative covenants) during the term of the loan. Oftentimes, covenants are used to assess the performance of the Borrower or the underlying collateral, such as Debt Service Coverage Ratio (DSCR), Debt Yield, LTV (loan-to-value) tests, or construction milestones. Covenant defaults may occur when a Borrower breaks one of these.
The following are examples of negative and affirmative covenants:
Any and all lending carries some level of default risk. Lenders are always faced with the fact that there is a risk that the Borrower may not be able to comply with the terms of the loan agreement. However, there are ways that Lenders can go about trying to mitigate the risk of default. Among other things, the Lender considers whether the Borrower has a sufficiently strong loan history with no prior unsatisfied liens or litigations with creditors, for example. The Lender might also look to see if there is any other credit support such as personal guarantees, insurance or other structural enhancements in place. Most importantly, Lenders consider whether the underlying asset is of high value, relative to the loan amount (low LTV).
At Yieldstreet, we either work with Originators who bring us opportunities for evaluation or directly act as loan originators through a Yieldstreet entity or affiliate. The Originator in our investments is the Lender, which means that they are responsible for underwriting the loan and the Borrower, monitoring the performance of the underlying loan, communicating with the Borrower, and taking the actions required to work things out in the event of a default.
Yieldstreet assesses the terms and conditions of the underlying investment during its due diligence process but relies on the external Originators to conduct the due diligence and underwriting of the underlying loan as well as to handle the day-to-day management of the loan.
The investments that launch on the Yieldstreet platform are introduced by Originators with a vetted track record and are disclosed in offering documents so prospective investors understand the opportunity and the risks. Investments are targeted to perform in-line with the expectations set forth in the underlying loan agreement. However, those expectations are not guaranteed, and the investors who participate in investments are still exposed to the risk of default, as is true with any investment.
Essentially, a default means that the underlying loan, on which the investor’s investment depends, has been called into default by the Lender. An investor’s ability to be paid back in full now rests on the assessed recovery strategy which the Lender has implemented. Having a defaulted investment may cause frustration for investors, but when the investment involves a collateral-backed loan, a default does not necessarily mean that the investor will suffer the loss of their principal.
When an event of a default is declared, Yieldstreet works with the Originator of the loan to come up with an effective strategy that is tailored to the specific scenario. During these times, Yieldstreet’s approach is based on an investor-first mindset to help ensure that an appropriate plan of action is being implemented. While it is important for the Originator to work closely with the Borrower to find an out-of-court, or expedited, solution, it is important for the Originator to reserve their rights to take legal action at a future date. Yieldstreet works closely with all Originators to ensure that the implemented workout strategy is always in the investors’ best interest.
Defaults are a possibility in any investment ecosystem. This is true for any and all investments whether they be stocks, bonds, ETFs, funds, indices, peer-to-peer lending, or any of the other myriad investment opportunities to which an individual investor might have access.
It is important that investors educate themselves and consider as many aspects of any investment they are interested in before participating. An investor should also consider consulting a financial advisor when assessing an investment.
Investors must diligently research each potential investment and should also exercise their own judgment as they consider things like investment diversification, risk tolerance, time horizons, and setting personal and family financial goals.
When it comes to investing on Yieldstreet, we aim to provide you with the material necessary for you to educate yourself and make an informed decision. We strongly encourage all of our investors to spend time familiarizing themselves with our asset classes and products to develop a thorough understanding of the offering before investing and to always consider their own risk tolerance as an investor.
To learn more about the steps taken in the event of default, please read our article on the default loan process. If you have additional questions, please contact us at [email protected].
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