Loss given default and recovery

When a borrower defaults, the bank does not lose the whole loan. It sells collateral, negotiates, sometimes takes control of the business, and over a year or three gets part of its money back, after paying lawyers and administrators. In RiskAtoms Bank's last twenty corporate defaults, the share lost ran from 26% to 93%. That share, the loss given default, is the second number in PD × LGD × EAD, and the one banks know least well.

Loss given defaultLoss given default: the share of the exposure at default that is lost, after recoveries and costs, valued at the default date. (LGD) is the share of the exposure at default that is lost; the recovery rateRecovery rate: the share of the exposure that comes back, so LGD = 1 − recovery rate. is the rest (L2.2.03: Credit and counterparty risk). Both are measured at the default date. So a bank needs three things: how much comes back, when it comes back, and what it cost to get it.

Workout LGD: the twenty cases

A workout LGDLGD measured from the cash a bank actually recovers after default, minus its costs, discounted back to the default date. discounts every recovery and every workout costLegal, administrator, valuation and staff costs of collecting a defaulted loan. back to the default date. RiskAtoms Bank uses 8% a year:

Discounting is not a detail. The same cash flows give very different LGDs at different rates. A bank must choose a rate that reflects both the time value of money and the risk that the recoveries do not come in:

Seniority

Who gets paid first matters more than anything else. Under absolute priorityThe rule that a more senior class is repaid in full before a junior class gets anything. In practice it is often bent in restructurings., secured lenders are paid from their collateral, then senior unsecured creditors, then subordinated ones, and shareholders last. The book's averages, from 34.5% to 79.7%, follow that order. Published recoveries do too. Moody's measured average recoveries from 1982 to 2006 from trading prices about 30 days after default (each issuer counted once):

Market LGDLGD read from the price of the defaulted debt shortly after default: 1 − price / par. is read straight from such prices: a defaulted senior unsecured bond at 38 per 100 implies an LGD of 62%. It is quick and objective but exists only for traded debt, and the price reflects what distressed-debt investors will pay, discounted at their own, high, required return. Discount the bank's senior unsecured workouts at 15% and their average rises from 52.2% to 56.8%. A third route, LGDs implied by the spreads of bonds that have not defaulted, comes in L3.3.16: Market-implied default risk.

Collateral

For a secured loan the book splits the exposure in two. Collateral is valued after a haircut for the fall in its price before it can be sold (L3.3.12: Collateral, guarantees and credit risk mitigation), and that covered part loses only 10% (selling costs and delay). The rest loses the unsecured LGD. Six of the twelve corporates are secured:

Pellcourt Properties Ltd is lent £120m against property worth £180m: after the 35% haircut £117m is covered and the LGD is only 10.88%. But collateral values move. If the machinery behind Thornvale Engineering Ltd's loan fell 20% in value, its covered part would drop from £21.0m to £16.8m and its LGD would rise from 31.0% to 33.8%.

Downturn LGD

Defaults bunch in recessions, and so do low recoveries: collateral and defaulted debt are sold into a market full of sellers. Research on US corporate bonds from 1982 to 2002 found recovery rates driven by the supply of and demand for defaulted debt, with the default rate playing a central role. In the book, the 5 downturn cases average 61.0% against 47.2% for the rest; within the senior secured group the gap is 9.8% points. Five cases are too few to estimate a gap with any precision, so the bank's credit committee set a downturn LGDThe LGD expected when defaults are high and asset prices low, used so that losses are not understated in a bad year. add-on of 8% points for every borrower. It lifts the corporate book's expected loss from £2.81m to £3.34m.

Workout LGD. With recoveries $R_t$ and costs $C_t$ at times $t$ years after default and a discount rate $r$:

Collateral. With collateral value $V$, haircut $H$, covered amount $C^{*} = \min\bigl(\text{EAD},\ V(1-H)\bigr)$, unsecured LGD $\text{LGD}_U$ and the covered part's LGD $\text{LGD}_C$:

Averages. A default-weighted average counts each case once; an exposure-weighted average weights by EAD. For the senior unsecured cases they are 52.2% and 51.8%. A bank states which it uses. Downturn LGD here is $\min(1,\ \text{LGD} + 0.08)$.

Pick a case. Raise the discount rate, delay the recoveries, or double the costs, and watch the LGD. Then set the rate to 15% and look at the seniority averages.

W01 was a £5.2m senior secured loan that defaulted in a downturn year. The bank recovered £1.891m at the end of each of the next two years and spent £0.123m on the workout, paid in two equal parts.

Under the Basel internal ratings-based approach, banks on the foundation approach use supervisory LGDs (45% for senior unsecured corporate claims under Basel II; the current Basel framework sets 40% for most corporates and keeps 45% for banks and other financial institutions), while advanced-approach banks estimate their own. Own estimates must reflect downturn conditions and use a discount rate that reflects the time value of money and the risk in the recoveries. The detail, and the floors that now apply, are in M4.2: Credit risk capital. Statistical LGD models (beta regressions, cure models) are in M6.4: Credit risk modelling.

• LGD = 1 − recovery rate, with recoveries net of costs and discounted to the default date.
• Discounting matters: the bank's senior unsecured average is 45.7% undiscounted, 52.2% at 8% and 56.8% at 15%.
• Market LGD comes from defaulted debt prices; it is quick but reflects distressed investors' high required return.
• Seniority and collateral drive LGD: the book's averages run from 34.5% (secured) to 79.7% (subordinated).
• Recoveries fall when defaults rise; a downturn add-on of 8% points lifts the corporate EL from £2.81m to £3.34m.

Loss given default (LGD)

Loss given default: the share of the exposure at default that is lost, after recoveries and costs, valued at the default date.

Recovery rate

Recovery rate: the share of the exposure that comes back, so LGD = 1 − recovery rate.

Workout LGD

LGD measured from the cash a bank actually recovers after default, minus its costs, discounted back to the default date.

Market LGD

LGD read from the price of the defaulted debt shortly after default: 1 − price / par.

Downturn LGD

The LGD expected when defaults are high and asset prices low, used so that losses are not understated in a bad year.

Seniority

A claim's rank in being repaid: secured lenders first from their collateral, then senior unsecured, then subordinated.

Absolute priority

The rule that a more senior class is repaid in full before a junior class gets anything. In practice it is often bent in restructurings.

Workout costs

Legal, administrator, valuation and staff costs of collecting a defaulted loan.