Definition of Loss Given Default (LGD)

LGD or Loss given default is a very common parameter used for the purpose of calculating economic capital, regulatory capital or expected loss and it is the net amount lost by a financial institution when a borrower fails to pay EMIs on loans and ultimately becomes a defaulter.

In recent times, the instances of defaults have grown exponentially. The sluggish oil and commodity marketsThe commodity market is a place where people buy and sell positions in commodities such as oil, gold, copper, silver, barley, wheat, and so on. Started with agricultural commodities, there are now fifty main commodity markets throughout the world, dealing with over a hundred commodities.read more in the last couple of years have led to the downfall of several companies across sectors. Hence, loss given default (or “LGD”) analysis has become imperative for analyzing any credit. In simple terms, Loss Given Default Definition is the amount of loss incurred by a lender when a borrower defaults, expressed in percentage.

Loss

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For eg:
Source: Loss Given Default (LGD) (wallstreetmojo.com)

Simple Basic LGD Example

Let us take a simple example of a bank, say HDFC, which lends $1 million to Mr. Sharma to buy an apartment worth $1.2 million. The apartment is mortgaged or provided as collateral to the bank. Of course, prior to the actual disbursement and approval of the loan, HDFC performs due diligence on Mr. Sharma’s credit profile, which would include the following:

Practical Industry LGD Example – Kingfisher Airline

The extreme scenario that comes on top of our minds when we think of default is the infamous Kingfisher Airlines story.

  • The 17 banks that have a total loan outstanding of INR9,000 Cr (SBI being the biggest lender – lending ~25% of the total outstanding), which includes INR7,000 Cr principal and the rest penal interest with Kingfisher Airlines, have been facing a hard time.
  • We recall how the company was regarded as a wilful defaulter by several banks in 2015.
  • As per the RBI guidelines, a wilful defaulter is the one who has defaulted in meeting certain repayment obligations (even when it has the capacity to repay) or has utilized the money from the lender for purposes other than what the finance was availed for.
  • Have you ever thought what could be the number of losses that the banks could incur on its loans to Kingfisher?
  • In Aug 2016, the Airlines’ assets worth INR700 Cr were put on auction, including assets such as the erstwhile Kingfisher house headquarters, cars, Mr. Mallya’s personal jet, Kingfisher Villa in Goa (famous for hosting parties by Mr. Mallya), as well as several brands and trademarks.
  • Assuming that Kingfisher Airlines, which stopped operating after 2012, had only these assets for disposal, the banks would be able to recover only INR700 Cr, i.e., only ~8% on their outstanding loan of INR9000 Cr.
  • In layman terms, the average LGD for the banks on Kingfisher loans can be considered as 92% in this scenario! On a separate note, Mr. Mallya personally owns INR7,000 Cr worth assets, which includes several investments, land, and properties.
  • If Mr. Mallya willfully comes to rescue its lenders, he could actually repay most of the debt outstanding, in which case the average LGD for these banks could be lower.

Collateral and LGD

Subordination and LGD calculation

During the actual liquidation scenario, one important aspect that we also need to look closely at is the subordination debt. The SBI and UCO banks could have lent to Kingfisher airlines in several tranches. The secured loans (or loans secured by collateral) would be paid at a priority over the unsecured loans.

Let us understand what these tranches and priorities mean with the help of a simpler example. A UK based company XYZ has the following liabilities on its balance sheet:

Liability (GBP million)AmountCollateral value at the time of default
Administration claims70
Underfunded pension obligations80
Senior Secured loan – 1st lien100120
Senior Secured loan – 2nd lien50
Senior Unsecured loan60None
Subordinated loan50None
Total410

Let us assume a scenario where the company XYZ is left with assets worth GBP300 million and has filed for bankruptcy. Of course, the assets do not completely cover the liabilities, which total GBP410 million. The creditors would need to settle the claims in court. In such a case, the liabilities would be repaid according to a priority order. Let us see how the recovery waterfall works for XYZ’s creditors:

  • 1) The administration claims: The priority claim in case of any bankruptcy is usually of the administration expenses, unpaid taxes, or suppliers. Let us assume that GBP60 million is under priority claims, while the remaining GBP10 million have lesser priority and could be repaid a few steps later in the payment waterfall. The claim on the remaining GBP10 million would be pari passu with the unsecured loans. We note that “pari passu” is the term that indicates an equal priority of two obligations.
  • 2) Underfunded pension obligations: One of the priority claims for a bankrupt company is also towards its pension obligations. Typically, a company needs to match its future pension payments to its retired employees with equivalent assets (mostly long term investments). The underfunded portion represents the amount that is not covered by assets, and the shortfall is usually taken care of during the bankruptcy situation.
  • 3) Secured 1st lien loan: Senior secured loans rank typically higher than unsecured loans. Within senior secured loans, the 1st lien loans have a higher priority order than the 2nd lien loans. In this example, the senior secured loans (both 1st lien and 2nd lien) totaling GBP150 million had claim over certain assets (could be land or machinery), which are now worth GBP120 million. The secured 1st lien loan would have a higher priority of claims on these assets and is able to recover completely.
  • 4) Secured 2nd lien loan: The second claim on the collateralized assets of GBP120 million would be of the 2nd lien creditor. However, now that only GBP20 million is available, the 2nd lien creditor would be able to initially cover GBP20 million (40% of the GBP50 million loan), while the remaining GBP30 million loan would be ranked pari passu with the unsecured loans.
  • 5) Unsecured loans: The assets that remain available for disposal is now worth GBP40 million (i.e., 300-60-80-120), which would be distributed among the pari passu unsecured creditors: GBP10 million of trade payables, GBP30 million of the 2nd lien loan, and GBP60 million of the unsecured loans. Let us assume that the court came up with a decision to distribute the GBP40 million amount on a pro-rata basis to the three kinds of creditors. This means that the distribution would be in the ratio of 10:30:60, which would be GBP4 million, GBP12 million, and GBP24 million for the three creditors, respectively.
  • 6) Subordinated loans: Unfortunately, as all the assets were already used up to repay the other liabilities, the subordinated loans and shareholders would not receive any proceeds from the liquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more. Of course, with the high risk involved, these loans are priced much higher than the senior loans. However, we also note that as they turn out to be quite expensive for XYZ, in a normal scenario, it would try and repay these loans first.

Summarizing the above discussion, the below table shows the recovery amount and the LGD for each of the creditors. We do notice that the LGD is different for different creditors and could vary as per the credit termsCredit Terms are the payment terms and conditions established by the lending party in exchange for the credit benefit. Examples include credit extended by suppliers to buyers of products with terms such as 3/15, net 60, which essentially implies that although the amount is due in 60 days, the customer can avail a 3% discount if they pay within 15 days.read more and priority claims on particular assets.

LiabilityAmountRecoverable amountThe recoverable amount of an asset is the present value of the expected cash flows that will result from the assets sale or use, and is determined as the greater of two amounts: the assets fair value as reduced by related selling costs, and the assets value in use.read moreRecovery rate (RR)LGD
Trade payables706491%9%
Underfunded pension obligations8080100%0%
Senior Secured loan – 1st lien100100100%0%
Senior Secured loan – 2nd lien503264%36%
Senior Unsecured loan602440%60%
Subordinated5000%100%
Total410300

LGD estimate:

  • In the above examples, we calculated LGDs in default scenarios, for which we already knew values under stressed cases. However, for a creditor to a well functioning company, it could be difficult for the credit team to come up with LGDs of each type of its liabilities under a default scenario.
  • In such cases, historical empirical results (based on past defaults) could help estimate the LGD for a loan facility.
  • It is also imperative for the creditors to apply distressing scenarios on its borrowers while determining the LGD, which could involve applying haircuts to its assets such as inventories, receivables, and machinery.
  • The credit team must look at the materiality of senior debt above the priority order of the loan that they would be lending.

Let us see how to analyze the materiality of senior debt.

Loan provisioning and Loss Given Default

Conclusion

In conclusion, it is imperative that the credit teams across various banks detect the probable defaults such as Kingfisher Airlines well in advance and save itself from a significant hit on its balance sheet. A Conservative approach and well thought out stress cases could immensely help the banks cut down on the NPA levels going forward.

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