Loss Given Default (LGD)

LGD or Loss given default is a common parameter used to calculate economic capital, regulatory capital, or expected loss. A financial institution loses the net amount 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 markets 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.

• LGD, or Loss Given Default, is a typical metric to determine whether economic capital, regulatory capital, or projected loss is the default. The financial institution loses the net amount if a borrower fails to make their loan EMIs and eventually defaults.
• Creditors use distressing scenarios on borrowers to determine LGD, including haircuts on assets like inventories, receivables, and machinery. It is crucial for creditors.
• Banks follow Basel regulations and use the Expected Loss formula to set aside funds for potential loan losses. It includes Loss Given Default, Probability of Default, and Exposure at Default.

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, before the actual disbursement and approval of the loan, HDFC performs due diligence on Mr. Sharma's credit profile, which would include the following:

• Looking up his past credit history and whether he has repaid his earlier obligations promptly, ensuring that his salary sufficiently covers the interest and principal payments on the loan, and determining the fair market value of the property, which, let's say, was valued at $1.2 million by external valuation experts hired by the bank.
• Suppose just six months after the lending, Mr. Sharma is fired by his employer. Since the loss of his job led to the end of his revenue stream, Mr. Sharma defaults on his EMIs. In the absence of a new job and inadequate funds, Mr. Sharma decides to get rid of the loan and give up the ownership of his house. Now that Mr. Sharma has defaulted, HDFC would then need to auction the apartment and use the proceeds to recover its loan amount.
• Suppose in the meanwhile, property prices in that area have declined significantly as a few new constructions are announced in other areas.
• Consequently, HDFC can recover only $900,000 from the apartment sale. In this case, the bank would be able to recover 90% of its loan amount, "also termed as recovery rate (or RR)." Loss Given Default formula would be 1- RR, i.e., 10%.

The extreme scenario that comes to the 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 can repay) or has utilized the money from the lender for purposes other than what the finance was availed for.
• Have you ever thought about the number of losses the banks could incur on their 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 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's terms, the average LGD for the banks on Kingfisher loans can be considered 92% in this scenario! On a separate note, Mr. Mallya owns INR7,000 Cr worth of assets, including several investments, land, and properties.
• If Mr. Mallya willfully comes to rescue its lenders, he could repay most of the debt outstanding, in which case the average LGD for these banks could be lower.

• One might wonder why would the 17 banks lend such a humongous amount to Kingfisher Airlines.
• Do you know that during the actual “good times” of Kingfisher Airlines, the brand itself was valued at INR4,000 Cr by Grant Thornton (a leading US-based consulting and advisory firm) in 2011? The brand is now valued at INR160 Cr by the banks.
• With such high valuations of the Kingfisher airline entity in the past, such an amount of lending seemed quite reasonable to the then-credit team of the banks.
• One important lesson that every bank in India must have gathered from this incident is to be mindful of the quality of underlying loans provided by the company.
• A bank needs to ensure that the security offered as collateral is more tangible, i.e., contains more fixed assets such as land and machinery (which could also depreciate). For working capital loans, the collateral offered could be inventories and receivables.
• The banks ought to be cautious if the underlying collateral of the loans is intangibles, i.e., brands or trademarks (whose values have high reputation risk) or stocks of certain investments (the equity value of which are at the mercy of financial markets and macroeconomic conditions).

During the 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 as 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:

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 not covered by assets, and the shortfall is usually taken care of during a bankruptcy situation.
• 3) Secured 1^st lien loan: Senior secured loans rank typically higher than unsecured loans. Within senior secured loans, the 1^st lien loans have a higher priority order than the 2^nd lien loans. In this example, the senior secured loans (both 1^st lien and 2^nd lien) totaling GBP150 million had a claim over certain assets (could be land or machinery), which are now worth GBP120 million. The secured 1^st lien loan would have a higher priority of claims on these assets and can recover completely.
• 4) Secured 2^nd lien loan: The second claim on the collateralized assets of GBP120 million would be of the 2^nd lien creditor. However, now that only GBP20 million is available, the 2^nd lien creditor could initially cover GBP20 million (40% of the GBP50 million loan). In contrast, the remaining GBP30 million loan would be ranked pari passu with the unsecured loans.
• 5) Unsecured loans: The assets that remain available for disposal are 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 2^nd lien loan, and GBP60 million of the unsecured loans. Let us assume that the court decided 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 liquidation. Of course, with the high risk involved, these loans are priced much higher than senior loans. However, we also note that as they turn out to be quite expensive for XYZ, in a normal scenario, it would try to repay these loans first.
• Summarizing the above discussion, the below table shows the recovery amount and the LGD for each of the creditors. We notice that the LGD is different for different creditors and could vary per the credit terms and priority claims on particular assets.

• 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 to 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 they would be lending.

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

• Suppose JPMorgan wants to lend an unsecured loan to a company ABC. ABC has a debt worth $200 million on its balance sheet and a senior secured revolving credit facility worth $100 million, which remains drawn.
• Out of the $200 million debt outstanding, $150 million is secured, and ABC’s total assets are worth $300 million.
•  JPMorgan should be aware that the drawn senior secured debt represents 50% of the total assets. If the company entirely draws down on the revolving credit facility, the senior secured debt could reach $250 million (~83% of the total assets).
• In a default scenario, the assets could be valued even lower and may be insufficient to cover even the secured debt.
• This means that for JPMorgan, lending an unsecured loan to ABC could be risky, and hence it may price the loan at a very high-interest rate or even reject ABC's loan application.
• Alternatively, JPMorgan could go ahead with the deal and may hedge the risk using CDS (Credit Default Swap).
• A CDS is a form of insurance that the bank typically buys for its stressed credits, for which it pays a premium. In return, the CDS buyer receives protection from the CDS seller, where the latter repays the entire loan in case the borrower defaults.

• As per the Basel norms, the banks need to make adequate provisions for their loans based on the Expected Loss on their loans (calculated as LGD X Probability of default X Exposure at default).
• The probability of default would depend on the credit rating of the company.
•  An investment-grade company (rated BBB- or above) has a lower probability of default (again estimated from the historical empirical results). See the credit rating process.
• So for an LGD of 40%, a Probability of default of 5%, and Exposure at a default of $80 million, the expected loss for a bank would be $1.6 million.
• The bank may need to provide $1.6 million or above for such a loan. This is to ensure an adequate cushion for the impact of NPA on the bank’s balance sheet.

In conclusion, the credit teams across various banks must detect potential 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 help the banks cut down on the NPA levels.

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