Loss Given Default Risk

What is “Loss Given Default Risk?”

When lenders lend to companies or individuals, there is a possibility that the borrower may default. The risk of default or financial losses, due to a borrower being unable to pay back the loan is termed as credit risk. The same can be broken down into two categories – default risk (likelihood of a borrower being unable to pay interest and principal) and loss-given default (LGD) risk. The latter type of risk is the severity of loss the lender is likely to incur in the event of a default. It is based on things such as collateral, covenants in term sheet and seniority of the debt issuance.  

LGD and Debt (Ranking and Credit Rating)

LGD risk is reflected in the ranking of the debt within the capital structure (there is a legal/contractual ranking of stakeholders (creditors debt holders) in a company) – i.e. lower (higher) the ranking, the higher (lower) the loss-given default (%). Further, debt issuance ratings drive LGD analysis. This is explained below. 

Basically, issuers have the ability to issue several types of debt under a variety of capital structures. Further, not all debt is equal, as some have the right to be paid back before others are paid (there is a ranking structure used by issuers to prioritize payout of debt). 

Individual debt issue or issuance, just as in the case of a company or an issuer, have a credit rating. Essentially, to quantify the LGD, an issuer rating is used. Such rating is rather a starting point to then examine the debt instrument. For each issue, a rating is given and recovery rating is given.

In the event of a liquidation of a company, holders of highest (lowest) ranking debt will be paid first (last). For example, if a creditor holds secured debt, which is also typical senior, they are more likely to be paid first in the event of a liquidation.

However, it might be noted that in terms of the ranking of stakeholders (creditors) in a company, there is a legal precedent i.e. first, the taxes are paid, followed by the liquidator’s expenses. Next in line for payment are the senior secured debt holders, followed by senior unsecured debt holders. Subordinated debt comes next, followed by junior debt. Next comes preference equity followed by common equity. 

Having stated the above, it’s important to note that debt issue ratings drive LGD analysis. The more senior and secured a debt issuance is, which is often the bank debt in a capital structure (top of the capital structure or the one with the senior most ranking), the lower the LGD risk is and higher is the rating of the debt issue. Vice versa, for riskier debt i.e. as we go down the capital structure from bank loan, to senior secured bond, senior unsecured bond, senior subordinated bond, subordinated bond and junior subordinated bond (this is the debt at the bottom of the capital structure), the higher is the LGD risk and lower is the rating of the debt issue.  

Next, the loan and capital structure matters for the LGD. A properly structured loan and capital structure can mitigate the bank’s risk. Structures that have lots of senior and/or secured debt competing for the payouts have lower recovery rates. Well-structured capitalizations that have used more junior and unsecured debt have higher recovery rates.

Loss Given Default – Example

Assume that a company wants to purchase some commercial real estate worth $3 million and it borrows $ 2.8 million from a bank in return for collateral. As part of the loan agreement, if the company is unable to honor its debt repayment obligations and defaults, the bank can take over the ownership of this piece of land.

Now suppose, after six months, the economy goes into a recession and the sales of the company plummet and losses mount. Consequently, the company defaults on its debt repayment obligations. Thus, the bank takes up ownership of this commercial real estate and attempts to sell the same. However, it is able to sell this land for only $ 2.5 million which results in a total loss of $0.3 million. 

As per the calculation below, given a total loss of $0.3 million on an initial loan of $2.8 million, the LGD is 10.7%.