The Basics of Loss Given Default for Investors

Loss given default is a crucial concept for investors to understand, especially in the context of lending and borrowing. It's a measure of the amount of money that a lender can expect to lose if a borrower defaults on a loan.

A loan's loss given default is typically expressed as a percentage of the loan's outstanding balance. For example, if a loan has a loss given default of 50%, that means the lender can expect to lose half of the loan's outstanding balance if the borrower defaults.

Understanding loss given default is essential for investors to assess the risk of a loan and make informed decisions. It's a key factor in determining the overall credit quality of a loan.

On a similar theme: Muni Bond Defaults

Loss Given Default (LGD) is a lender's projected loss in the event that a borrower triggers an event of default.

It's a measure used by financial institutions and other private lenders to calculate the projected profitability of a loan. LGD is most commonly expressed as a percentage, but it can also be expressed as an absolute dollar figure.

LGD is facility-specific, meaning it's influenced by key transaction characteristics such as the presence of collateral and the degree of subordination.

Loss Given Default, or LGD, is a lender's projected loss in the event that a borrower triggers an event of default.

LGD is a measure used by financial institutions and other private, non-bank lenders to help calculate the projected profitability of a loan.

The recovery rate is defined as 1 minus the LGD, which means it's the share of an asset that is recovered when a borrower defaults.

LGD is facility-specific, meaning it's influenced by key transaction characteristics such as the presence of collateral and the degree of subordination.

LGD is most commonly expressed as a percentage, but it can also be expressed as an absolute dollar figure.

In its most literal sense, LGD is the inverse of an asset's recovery rate.

You might like: Risk Weighted Asset Meaning

Comparing LGD estimates from different time periods can be tricky, especially when default definitions have changed. This is because different definitions can lead to varying results.

One problem facing practitioners is the comparison of LGD estimates from one time period to another. The formula to compare LGD estimates from time period x to time period y is LGDy = LGDx * (1 - Cure Ratey) / (1 - Cure Ratex).

Explore further: Capital One Deposit Slip

The Cure Rate is an important factor in this calculation, as it affects the overall LGD estimate. It's a measure of the proportion of defaulted loans that are recovered.

To get an accurate comparison, you need to use the correct Cure Rate for each time period. This ensures that your calculation is based on the actual recovery rates for each period.

Calculating LGD is a crucial step in determining the potential loss of a loan or investment in the event of default. You can calculate LGD by dividing total losses by exposure at default (EAD), which is the most popular method known as 'gross' LGD.

The LGD calculation is easily understood with the help of an example: If the client defaults with an outstanding debt of $200,000 and the bank or insurance is able to sell the security for a net price of $160,000, then the LGD is 20% (= $40,000 / $200,000). This is a simple way to understand how LGD works.

There are different types of statistical methods that can be used to calculate LGD, but 'gross' LGD is most popular amongst academics due to its simplicity. Blanco LGD, which divides losses by the unsecured portion of a credit line, is popular amongst some practitioners (banks) because they often have secured facilities.

The LGD is the percentage of total exposure that is not expected to be recovered in the event of a default. To calculate LGD, you can use the formula: Loss Given Default (LGD) = Exposure at Default (EAD) * (1 - Recovery Rate). For instance, if the recovery rate is 90%, then the LGD would be 10% of the EAD.

Here's a breakdown of how to calculate LGD using the formula:

A higher anticipated recovery rate equals a lower LGD. This means that if you expect to recover a larger portion of the loan, the potential loss will be lower.

There are two main methods for calculating LGD: gross LGD and Blanco LGD.

Gross LGD is the most popular method amongst academics because of its simplicity and because academics only have access to bond market data, where collateral values often are unknown, uncalculated or irrelevant.

Gross LGD is calculated by dividing total losses by exposure at default (EAD).

Theoretically, there are different ways to calculate LGD, but gross LGD is the most widely used method.

Blanco LGD, on the other hand, is popular amongst some practitioners because banks often have many secured facilities.

Blanco LGD is calculated by dividing losses by the unsecured portion of a credit line, where security covers a portion of EAD.

If collateral value is zero in the case of Blanco LGD, then it is equivalent to gross LGD.

Banks using the advanced approach (A-IRB) and retail-portfolio under the foundation approach (F-IRB) have to determine their own LGD values.

Take a look at this: Internal Ratings-based Approach (credit Risk)

These values are expected to represent a conservative view of long-run averages.

A bank wishing to use its own estimates of LGD needs to demonstrate to its supervisor that it can meet additional minimum requirements.

Repurchase value estimators (RVEs) have proven to be the best kind of tools for LGD estimates.

The repurchase value ratio provides the percentage of the value of the house/apartment or machinery at a given time compared to its purchase price.

This ratio is a key factor in calculating LGD values.

LGD models assess the value and/or the quality of a security the bank holds for providing the loan.

The higher the value of the security, the lower the LGD and thus the potential loss the bank or insurance faces in the case of a default.

A fresh viewpoint: How Much Is a Safe Deposit Box

Calculating LGD for corporate, sovereign, and bank exposures requires considering specific factors.

The foundation approach for deriving LGD estimates is used for corporate, sovereign, and bank exposures.

Factors affecting LGD include the type of exposure, such as corporate, sovereign, or bank.

The LGD for corporate exposures is typically lower than for sovereign exposures.

In the context of bank exposures, LGD is an important consideration for calculating risk-weighted assets under Basel II.

The LGD estimate is crucial for determining required capital for a bank or financial institution.

A downturn in the business cycle is characterized by at least two consecutive quarters of negative growth in real GDP.

The economy often experiences a negative output gap during a downturn, where potential production exceeds actual demand.

Downturn LGD (loss given default) is recommended to be calculated for regulatory purposes under Basel II.

The calculation of LGD poses significant challenges to modelers and practitioners due to the length of time it takes to resolve defaults and determine final losses.

Practitioners lack data on downturn LGD since Basel II implementation is relatively new.

Financial institutions may only have recently started collecting necessary information for calculating LGD elements like EAD, direct and indirect losses, security values, and potential recoveries.

A different take: Basel Accords

Different default definitions between institutions can result in varying cure-rates or percentage of defaults without losses.

This can make LGD parameters non-comparable between institutions.

Institutions may resort to 'mapping' to estimate downturn LGD due to a lack of downturn data.

Mapping involves adding a supplement or buffer to existing LGD to represent a potential increase in LGD during a downturn.

LGD often decreases for some segments during a downturn due to a relatively larger increase of defaults with higher cure-rates.

These defaults often result from temporary credit deterioration that disappears after the downturn period is over.

Governments and central banks often rescue defaulting financial institutions during economic downturns to maintain financial stability, which can decrease LGD values.

Take a look at this: How Does Insurance Protect a Policyholder against Financial Loss

In Australia, the prudential regulator APRA has set an interim minimum downturn LGD of 20 per cent on residential mortgages for all applicants for the advanced Basel II approaches. This 20 per cent floor is designed to encourage authorized deposit-taking institutions (ADIs) to undertake further work.

APRA believes that this floor is not risk sensitive, but rather an average that ADIs' original estimates fell short of.

LGD warrants more attention than it has been given in the past decade, where credit risk models often assumed that LGD was time-invariant. Movements in LGD often result in proportional movements in required economic capital.

Institutions implementing Advanced-IRB instead of Foundation-IRB will experience larger decreases in Tier 1 capital, and the internal calculation of LGD is a factor separating the two Methods.

A lender's returns are calculated as income less expenses and less expected (credit) losses. This includes interest income, closing or origination fees, and the lender's interest expense.

The expected loss is calculated as the credit exposure (at default), multiplied by the borrower's probability of default, multiplied by the loss given default (LGD). For example, a $1,000,000 loan exposure with a 2.00% probability of default and an LGD of 25.00% would result in an expected loss of $5,000.

This $5,000 represents the potential loss the lender could face if the borrower defaults. It's a crucial calculation that lenders need to get right to ensure they're accurately pricing their loans and managing their risk.

Discover more: 5 3 Bank Routing Number Illinois

The LGD calculation is a crucial step in understanding the potential losses in the event of a default. It's calculated by dividing total losses by exposure at default (EAD). Theoretically, there are different ways to calculate LGD, but the most popular is 'gross' LGD.

Gross LGD is the most popular method amongst academics due to its simplicity and because bond market data often doesn't provide collateral values. This method is also known as 'gross' LGD, where total losses are divided by exposure at default (EAD).

LGD can be calculated using the following three steps:

To illustrate this, let's consider an example. If a bank has lent $2 million to a corporate borrower and the recovery rate is 90%, the LGD can be calculated as follows: LGD = $2 million * (1 – 90%) = $200,000.

The LGD formula is a simple yet effective way to estimate potential losses in the event of a default. It's essential for lenders to constantly monitor their LGD to project out their expected losses and determine how much capital is at risk.

In a liquidation event, the lender's ability to recover its loan is largely tied to the value of the borrower's collateral and the recovery rates of the assets.

The value of the collateral and recovery rates are critical factors that lenders must pay attention to. Collateral refers to items with monetary value after liquidation that borrowers can pledge as part of a lending agreement.

The recovery rates of a company's assets impact the lender's Loss Given Default (LGD), which is the percentage of the loan that the lender is likely to lose in the event of default. In the event of a liquidation, the higher-ranking debt holders are more likely to receive full recovery because they must be paid first.

The following factors tend to reduce potential losses for lenders: liens on the borrower's collateral, higher priority claims in the capital structure, and large asset bases with high liquidity. These factors can help lenders recover a significant portion of their loan in the event of default.

Here are the key factors that impact recovery rates:

Unsecured exposures don't have collateral backing them up, making them riskier for lenders.

Fixed LGD ratios are prescribed by the foundation approach for certain classes of unsecured exposures.

Senior claims on corporates, sovereigns, and banks not secured by recognized collateral attract a 45% LGD.

All subordinated claims on corporates, sovereigns, and banks attract a 75% LGD.

This means that if a borrower defaults on a senior claim, the lender can expect to recover only 55% of the loan amount (100% - 45%).

Recovery Rate is a crucial factor in determining the potential loss for lenders in the event of a borrower's default. It's the approximated range of recoveries that an asset would sell for in the market if sold now, depicted as a percentage of the book value.

The value of a borrower's collateral and the recovery rates of the assets are critical factors that lenders must pay attention to. The existing liens and contractual provisions can impact the expected loss, which is why lenders use historical default/liquidation data to calculate an expected recovery rate.

A fresh viewpoint: Large Value Transfer System

The recovery rate can vary greatly depending on the type of collateral and the priority of the lender's claim in the capital structure. For example, higher-ranking debt holders are more likely to receive full recovery because they must be paid first.

Lenders use various methods to determine the recovery rate, including using risk rating or risk management organizations that aggregate data from reputable sources like Moody's or Fitch.

Here are some key factors that can impact the recovery rate:

In a simple LGD example, if the client defaults with an outstanding debt of 200,000 and the bank is able to sell the security for a net price of 160,000, then 40,000, or 20%, of the EAD are lost.

Liquidity Ratios are a way to measure a company's ability to pay its short-term debts. They focus on the company's current assets versus its current liabilities.

The current ratio and quick ratio are two common liquidity ratios. These ratios show how easily a company can convert its assets into cash to pay its debts.

A fresh viewpoint: Low Ltv Ratio

High liquidity ratios indicate a company has sufficient liquid assets to cover its short-term debts. On the other hand, low liquidity ratios suggest a company may struggle to meet its short-term obligations.

Liquidity ratios do not depict how likely a borrower is to default on an obligation. This is different from Loss Given Default (LGD), which focuses on quantifying the potential negative impact to lenders in the event of default.

For another approach, see: Cyber Insurance Loss Ratios

Probability analysis for expected values is a crucial step in calculating loss given default.

In a normal distribution, about 68% of the data points fall within one standard deviation of the mean, which is essential for understanding the probability of default.

The expected value of a loss given default is the average amount of loss that will be incurred when a borrower defaults.

This can be calculated using the formula: E(LGD) = ∑ (x * P(x)), where x is the loss amount and P(x) is the probability of that loss amount.

According to the data, the expected loss given default for a specific loan portfolio is 15%.

A unique perspective: Current Expected Credit Losses