What is Loss Given Default?
The Loss Given Default (LGD) is the estimated loss incurred by a lender if a borrower defaults on a financial obligation, expressed as a percentage of the total capital at risk.
How to Calculate Loss Given Default (Step-by-Step)
LGD, which stands for “loss given default”, measures the loss potential in the event of default, taking into consideration the borrower’s asset base and existing liens – i.e. collateral pledged as part of the lending agreement.
The loss given default (LGD) is the percentage of total exposure that is not expected to be recovered in the event of a default.
In other words, the LGD calculates the approximate loss on an outstanding loan, expressed as a percentage of the exposure at default (EAD).
In such a situation, the borrower is incapable of meeting interest expense or principal amortization payment requirements, which places the company in technical default.
Anytime that a lender agrees to provide financing to a company, there is a possibility that the borrower will default on the financial obligation, especially during economic downturns.
However, quantifying the potential losses is not as straightforward as assuming it is equal to the total value of the loan – i.e. the exposure at default (EAD) – because of variables such as collateral value and recovery rates.
For lenders projecting out their expected losses and how much capital is at risk, the LGD of their portfolio must be constantly monitored, especially if their borrowers are at risk of default.
Liquidation Analysis: Collateral and Recovery Rates
The value of a borrower’s collateral and the recovery rates of the assets are critical factors that lenders such as financial institutions and banks must pay attention to.
- Collateral: Items with monetary value after liquidation (i.e. sold in the market for cash proceeds) that borrowers can pledge as part of a lending agreement to obtain a loan or a line of credit (LOC)
- Recovery Rates: An approximated range of recoveries that an asset would sell for in the market if sold now, depicted as a percentage of the book value
While the total capital provided as part of the loan agreement must be taken into account, the existing liens and contractual provisions are factors that can impact the expected loss.
As for the recovery rates of a company’s assets, the impact on a lender’s LGD is largely tied to where the debt tranche is in the capital structure (i.e. the priority of their claim – senior or subordinated).
In the event of a liquidation, the higher-ranking debt holders are more likely to receive full recovery because they must be paid first (and vice versa).
Putting the above together, the following rules tend to be true for lenders and their LGD:
- Liens on Borrower’s Collateral ➝ Reduced Potential Losses
- Higher Priority Claim in Capital Structure ➝ Reduced Potential Losses
- Large Asset Base with High Liquidity ➝ Reduced Potential Losses