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Distinguish insolvency from default and from bankruptcy.

FRM® Part II · Credit Risk Measurement and Management · Fundamentals of Credit Risk · FRM2.CR.1.b

The idea

These three words describe different things, and exam questions turn on keeping them apart. Insolvency is a financial condition. The debtor cannot pay its debts as they fall due (the cash-flow test), or its liabilities exceed its assets (the balance-sheet test). Default is an event. It is a failure to meet a contractual obligation such as a payment, or a breach of a covenant (a technical default). Bankruptcy is a legal status. It is a formal, court-supervised process, such as liquidation or reorganisation, that deals with the debtor's obligations to its creditors. A firm can be insolvent without being in default, for example when creditors forbear or a parent keeps funding payments. It can default while solvent, because of a temporary liquidity squeeze. A bankruptcy filing is usually itself an event of default under loan and bond contracts. Remember: condition, event, legal process.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description best fits bankruptcy?

  1. A failure to make a scheduled payment of principal or interest when it is due.Why not: This describes a payment default, which is an event under a contract, not a legal status.
  2. A legal status, resolved through a formal court-supervised process, in which a debtor's obligations to its creditors are dealt with. - correct
  3. A condition in which the debtor's liabilities exceed the value of its assets.Why not: This describes balance-sheet insolvency, which is a financial condition rather than a legal process.
  4. A breach of a financial covenant in a loan agreement while all payments are still being made.Why not: This describes a technical default, a contractual event that is not a court proceeding.

Bankruptcy is a legal process or status. Insolvency is a financial condition and default is a failure to meet an obligation, so the other options describe those instead.

A harder one

A property company's liabilities exceed the fair value of its assets. Its parent injects cash each quarter so that every interest and principal payment is made on time, and no creditor has filed a petition. The company's status is best described as:

  1. In default and bankrupt, because negative net worth leads to both.Why not: Negative net worth does not by itself cause default or bankruptcy; payments are being made and nothing has been filed.
  2. Bankrupt but not insolvent, because the parent's support shows the company is solvent.Why not: Bankruptcy needs a legal proceeding, and the support does not change the fact that liabilities exceed assets.
  3. In default but not insolvent, because the payments depend on the parent's cash.Why not: Every payment is made on time, so there is no default, and liabilities exceed assets, so the company is insolvent.
  4. Insolvent on the balance-sheet test, but neither in default nor bankrupt. - correct

Insolvency is a condition (liabilities exceed assets). Default needs a failure to perform and bankruptcy needs a legal process; neither has happened because the parent funds the payments.

The hardest tier

A company reports book assets of USD 500 million and liabilities of USD 460 million. Assets include USD 40 million of goodwill that has no realisable value and a property carried at USD 200 million that would fetch only USD 150 million. Using realisable values, its balance-sheet net worth and status are best described as:

  1. Positive USD 40 million: solvent, because book assets exceed liabilities.Why not: Uses book values (500 - 460) without adjusting for goodwill or the property's lower realisable value.
  2. Zero: at break-even after removing the goodwill, so not insolvent.Why not: Removes the goodwill (500 - 40 - 460 = 0) but does not write the property down to 150 million.
  3. Negative USD 50 million: insolvent on the balance-sheet test, not necessarily in default. - correct
  4. Negative USD 10 million: insolvent because the property is written down.Why not: Writes down the property (500 - 50 - 460 = -10) but leaves the worthless goodwill in assets.

Realisable assets = 500 - 40 - (200 - 150) = 410 million. Net worth = 410 - 460 = -50 million, so it fails the balance-sheet test. Insolvency alone does not mean default or bankruptcy has happened.

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