Loss Given DefaultTheory and Empirics

Juraj Kopecsni

Structure of the presentation

1. General information about LGD

2. Focus on workout LGD

1. New Basel Accord

• Require banks to use more risk sensitive methods for calculating credit risk capital requirements

• LGD - the credit loss incurred if an obligor of the bank defaults

• Move from the Foundation to the Advanced IRB approach

• What bank knows about LGD

Key issues of LGD

• What does LGD mean and what is its role in IRB

• How is LGD defined and measured

• What drives differences in LGD

• What approaches can be taken to model or estimate LGD

Definitions of default and loss

• Default (BIS)

- The obligor is unlikely to pay its credit obligations

- The obligor is past due more than 90 days on any material credit obligation

Measurement of LGD

• LGD is the ratio of losses to exposure at default

• Three type of losses:

- The loss of principal

- The carrying costs of non-performing loans (interest income)

- Workout expenses (collections)

Three ways of measuring LGD

1. Market LGD – market prices of defaulted bonds

2. Workout LGD – estimated cash flows resulting from the workout process, properly discounted, estimated exposure

3. Implied market LGD – derived from risky but not defaulted bond prices using APM

Workout LGD

• Timing of the cash flows from the distressed asset

• Cash flows should be discounted

• The correct rate would be for an asset of similar risk

• Average LGD for a portfolio: price-weighting, default weighting, time-weighting

Implied market LGD

• LGD is to look at credit spreads on the non-defaulted risky bonds

• The spread above risk-free bonds is an indicator of the risk premium

• This spread reflects expected loss and then LGD

Structure of bankruptcy

1. LCP – the last cash paid

2. Default – occurs at some later point, for bonds typically six months later

3. Bankruptcy – anywhere from the time of default to about a year later

4. Emergence – from bankruptcy proceedings, occurs anywhere from 2 to 4 years after the last cash paid

• Cash flows:

- Occur throughout this process

- Bulk comes during or after emergence when restructuring plans (additional financing)

• Time spent in bankruptcy can dramatically reduce the value of debt recovery

Capital structure

• Absolute priority rule

Loans BanksSenior securedSenior unsecuredSenior subordinatedSubordinatedJunior subordinatedPreferred sharesCommon shares

Bondholders & banks

Shareholders

• In practice APR is routinely violated

• Creditors agree to violate APR

• Set of expenditures senior to all others

• Administrative expenses – court costs, attorneys’ fees, trustee’s expenses

Drivers of debt recovery

• Recovery distribution is bimodal

• Defaulted claim whether is secured or not

• Recoveries are lower in recessions

• The industry of the obligor matter

• The size of exposure matter

• Recovery distributions are bimodal

- Makes parametric modeling of recoveries difficult, using rather non-parametric

• Seniority and collateral matter

• Monitoring and structuring matter

- Senior secured - flat distribution

- Senior unsecured – bimodal distribution

• Recoveries across the business cycle

- Strong evidence that recoveries in recession are lower

- About a third lower than in expansion

- Aggregate default rates are high, recovery rates are low (correlation -20% in US)

• Industry matters

– Industries such as utilities do better than other i.e. service oriented firms

- How distress at the industry level might influence recoveries at the facility level

- Industry level effects are controlled for, effects on LGD vanish

• Size of the loan matters - difficult

Bonds vs. loans

• Bank loans are more senior and banks more actively monitor the evolving financial health of the obligor

• Differences in control rights between bondholders and private lenders

• Recovery rate on bank loans are higher

2. Motivation

• Few studies have focused on the bank loans• Banks not yet developed LGD on the loan• Estimation of LGD based on own historical data• Analysis of cash flows recovery over time• Identifying determinants of loan losses• Monitoring/ analysis/prevention• Workout LGD/ Implied market LGD

Measure Recoveries

• Problems with discount rate

• Costs: administrative, funding and selling

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LGD

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Methodology

• Two approaches to analyze the recovery rates:

• A Mortality-based approach

• A Multivariate analysis

A Mortality-based approach

• Marginal Recovery Rate

MRR(1) = Cash flow paid(1)/Loan Balance(1)• Percentage Unpaid Loan Balance

PULB(1)=1-MRR(1)• Cumulative Recovery Rate

CRR(0,2)= 1- PULB(1)xPULB(2) xPULB(3)• Loan Loss Provision

LLP(0)=1-CRR(0,3)

Dec-00 Dec-01 Dec-02 Dec-03Loan Outstanding 100 110 66 44Cash Payment 0 50 26 14Loan Balance 100 60 40 30

• Dynamic evolution of provisions over time

• CRR(1,3)= 1- PULB(2)xPULB(3)

• LLP(1)=1-CRR(1,3)

• CRR(2,3)= 1- PULB(3)

• LLP(2)=1-CRR(2,3)

Unweighted Marginal Recovery Rate

0

5

10

15

20

25

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64

Cumulative Recovery Rate

0

10

20

30

40

50

60

70

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64

Unweighted Weighted

A Multivariate analysis

• Identifying the determinants of loan losses• Main explanatory variables: - Size of the loan- Type of guarantee/collateral- Past cumulative recovery - Age of the firm- Industry sector

Estimation

• Transformation: log-log function

• Estimation procedure: Quasi-likelihood method

Hypothesis

• Significant size effect• Loan size has a negative impact on recovery

rate• Type of collateral, guarantee or none of them• Losses on loans with guarantee are significant

higher than on loans with no guarantee• Past recovery is a good indicator of future

recovery• Industry specification• Age of borrowing firm, age of relationship, age of

credit contract

• Connection with EC and RAROC

• Monitoring

• Analysis

• Prevention

Conclusion

• Fewer focus received from the industry

• Has the greater influence on capital level

• Principles are easy but in practice we face a lot of questions