If a borrower defaults, their account is flagged and their Ether collateral is eligible to be auctioned off to pay off their debt. The mechanism is designed so that a loan is closed at a point where auctioning the collateral will cover the debt.
In the event that the value of their collateral doesn't cover the debt, the Maker system has a surplus account that would cover the difference. In the event that the surplus can't cover the remainder of the debt, MKR token is created and auctioned off to to cover it.
Since this devalues MKR, holders of MKR token are incentivized to ensure that the system always runs at a sufficient surplus to cover these events and that loans are liquidated early enough to prevent having to dip into the surplus.
In addition to this, interest on loans are paid in MKR token and destroyed when the loan is closed, which also incentivizes holding MKR.
A default is not possible. The loans are fully secured by Ethereum. If collateral dips below an acceptable threshold, the collateral is liquidated and the debt is payed back to the system in full
> If you sell the Ether, you no longer have the Ether. If while you're holding the loan the price of Ether goes up, you benefit from that. Of course, if the price of Ether goes down, you're at risk of having your loan liquidated, but that's a requirement imposed by the system to maintain the Dai peg.
In the event that the value of their collateral doesn't cover the debt, the Maker system has a surplus account that would cover the difference. In the event that the surplus can't cover the remainder of the debt, MKR token is created and auctioned off to to cover it.
Since this devalues MKR, holders of MKR token are incentivized to ensure that the system always runs at a sufficient surplus to cover these events and that loans are liquidated early enough to prevent having to dip into the surplus.
In addition to this, interest on loans are paid in MKR token and destroyed when the loan is closed, which also incentivizes holding MKR.