LGD Examples

9/21/2018 Loss Given Default - LGD | Examples, Formula, Calculation
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Loss Given Default – LGD | Examples, Formula,

Calculation
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Loss Given Default –

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Loan
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 Loss Given Default – LGD | Examples, Formula, Calculation – In the recent times, the instances
Promissory Note
of defaults have grown exponentially. The sluggish oil and commodity markets in the last couple
of years have led to downfall of several companies across sectors. Hence, loss given default (or
 Bonds vs Debentures
“LGD”) analysis has become imperative for analysing any credit. In simple terms, Loss Given
About of loss
Default De nition is the amount Resources
incurredby a Free Courses
lender Certi cation
when a borrower Courses
defaults, expressed

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in percentage.
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Loss Given Default or LGD Example

Loss Given Default – King sher Airline Example
Collateral and LGD

Subordination and LGD calculation
LGD estimate
Loan provisioning and Loss Given Default
Conclusion
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LOSS GIVEN DEFAULT OR LGD EXAMPLE
Let us take a simple example of a bank, say HDFC, which lends $1 million to Mr. Sharma to buy a
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 pro le, which would include the following:
Looking up his past credit history and whether he has repaid his earlier obligations in a
timely manner, ensuring that his salary su ciently 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 red by his employer. Since the
loss of his job led to 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 signi cantly as a few
new constructions are announced in other areas.
Consequently, HDFC is able to recover only $900,000 from the sale of the apartment. 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 simply be 1- RR i.e 10%.
LOSS GIVEN DEFAULT – KINGFISHER AIRLINE EXAMPLE
The extreme scenario that comes on top of our minds when we think of a default is the infamous
King sher 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 King sher Airlines have been facing hard time.
We recall how the company was regarded as 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 utilised the money
from the lender for purposes other than what the nance was availed for.
Have you ever thought what could be the amount of losses that the banks could incur on its
loans to King sher?
In Aug 2016, the Airlines’ assets worth INR700 Cr were put on auction including assets such
as the erstwhile King sher house headquarters, cars, Mr. Mallya’s personal jet, King sher
Villa in Goa (famous for hosting parties by Mr. Mallya), as well as several brands and
trademarks. 200+ Courses All in One Bundle 

Assuming that King sher 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 King sher 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 wilfully 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
One might wonder why would the 17 banks really lend such humongous amount to
King sher Airlines?

Do you know that during the actual “good times” of King sher Airlines, the brand itself was
valued at INR4,000 Cr by Grant Thornton (a leading US-based consulting and advisory rm)
in 2011. The brand is now valued at INR160 Cr by the banks.

With such high valuations of the King sher airlines entity in the past, such 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 of the loans provided by the company.

It is important for a bank to ensure that the security o ered as collateral is more tangible in
nature, i.e contains more of xed assets such as200+
landCourses
and machinery
All in One(which
Bundlecould also

depreciate in value by the way). For working capital loans, the collateral o ered could be the
inventories and receivables.

The banks ought to be cautious if the underlying collateral of the loans are intangibles i.e
brands or trademarks (whose values have high reputation risk), or stocks of certain
investments (the equity value of which are on the mercy of nancial markets and
macroeconomic conditions).
SUBORDINATION AND LGD CALCULATION
During the actual liquidation scenario, one important aspect that we also need to look closely at is
the subordination debts. The SBI and UCO banks could have lent to King sher 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) Amount Collateral value at the time of default
Administration claims 70
Underfunded pension obligations 80
Senior Secured loan – 1st lien 100

120
Senior Secured loan – 2nd lien 50
Senior Unsecured loan 60 None
Subordinated loan 50 None
Total 410
Let us assume a scenario where the company XYZ is left with assets worth GBP300 million,
and has led 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 a court. In such a case, the
liabilities would be repaid according to a priority order. LetCourses

200+ us see how
All inthe
Onerecovery
Bundle waterfall

works for XYZ’s creditors:
1) 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
which indicates 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 which 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 the higher priority order than the 2nd lien
loans. In this example, the senior secured loans (both 1st lien and 2nd lien) totalling 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 higher priority of claims on these
assets and is able to recover completely.
4) Secured 2nd lien loan: The second claim on the collateralised 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

200+ pariAll
Courses passu with
in One the unsecured
Bundle 
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 liquidation. 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 rst.
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 di erent for di erent creditors, and could vary
as per the credit terms and priority claims on particular assets.
Liability Amount Recoverable amount Recovery rate (RR) LGD
Trade payables 70 64 91% 9%
Underfunded pension obligations 80 80 100% 0%
Senior Secured loan – 1st lien 100 100 100% 0%
Senior Secured loan – 2nd lien 50 32 64% 36%
Senior Unsecured loan 60 24 40% 60%
Subordinated 50 0 0% 100%
Total 410 300
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 di cult for the credit team to come up with LGDs of each type of its liabilities under a
default scenario. 200+ Courses All in One Bundle 
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 distressed 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 analyse the materiality of senior debt.
Suppose JPMorgan wants to lend an unsecured loan to a company ABC. ABC has a total debt
worth $200 million on its balance sheet and also 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 of the fact that the drawn senior secured debt represents a
signi cant 50% of the total assets, and 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 insu cient to cover
even the secured debt.
This means that for JPMorgan, lending an unsecured loan to ABC could be very risky, and
hence it may price the loan at a very high interest rate or may even reject ABC’s loan
application.
Alternatively, JPMorgan could go ahead with the200+

deal Courses
and mayAllhedge
in Onethe risk using CDS
Bundle 
(Credit Default Swap).
A CDS is a form of insurance that the bank buys typically 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.
LOAN PROVISIONING AND LOSS GIVEN DEFAULT
As per the Basel norms, the banks need to make adequate provisions for its loans based on
the Expected Loss on its 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 lower probability of default (again
estimated from the historical empirical results). See the credit rating process
So for an LGD of 40%, Probability of default of 5% and Exposure at default of $80 million, the
expected loss for a bank would be $1.6 million
This means that the bank may need to make a provision of $1.6 million or above for such a
loan. This is to ensure adequate cushion for the impact of non-performing assets (NPAs) on
the bank’s balance sheet.
CONCLUSION
In conclusion, it is imperative that the credit teams across various banks detect the probable
defaults such as King sher Airlines well in advance and save itself from signi cant hit on its
balance sheet. Conservative approach and well thought out stress cases could immensely help the
banks cut down on the NPA levels going forward.
o 36 SHARES j f
s h
‫ﻛﯾف ﯾﻣﻛﻧﻧﻲ أنْ اﺟد ﷲ؟‬
.ً‫اﺑدأ ﻋﻼﻗﺗك ﺣﺎﻻ‬
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DHEERAJ VAIDYA
    
worked as JPMorgan Equity Analyst, ex-CLSA India Analyst ; edu quali cation - engg (IIT Delhi), MBA (IIML);
This is my personal blog that aims to help students and professionals become awesome in Financial
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9/21/2018 Loss Given Default - LGD | Examples, Formula, Calculation

About  Resources  Free Courses Certi cation Courses 

200+ Courses All in One Bundle 

Loss Given Default – LGD | Examples, Formula,

Fixed Income Tutorials  

 Credit Rating Process

 ABS and MBS Index

Loss Given Default –

 Payment in Kind Bond

 Books on Bonds Market

 Fixed Income Books

 Credit Research Books

Loss Given Default or LGD Example

Collateral and LGD

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Online Training on Financial Analyst 200+ Courses All in One Bundle 

LOSS GIVEN DEFAULT OR LGD EXAMPLE

LOSS GIVEN DEFAULT – KINGFISHER AIRLINE EXAMPLE

King sher Airlines story.

loans to King sher?

trademarks. 200+ Courses All in One Bundle 

outstanding loan of INR9000 Cr.

assets, which includes several investments, land and properties.

COLLATERAL AND LGD

King sher Airlines?

in 2011. The brand is now valued at INR160 Cr by the banks.

be mindful of the quality of underlying of the loans provided by the company.

inventories and receivables.

SUBORDINATION AND LGD CALCULATION

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Liability (GBP million) Amount Collateral value at the time of default

Underfunded pension obligations 80

Senior Secured loan – 1st lien 100

Senior Unsecured loan 60 None

Subordinated loan 50 None

liabilities would be repaid according to a priority order. LetCourses

which indicates equal priority of two obligations.

shortfall is usually taken care of during the bankruptcy situation.

assets and is able to recover completely.

while the remaining GBP30 million loan would be ranked

as per the credit terms and priority claims on particular assets.

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Liability Amount Recoverable amount Recovery rate (RR) LGD

Trade payables 70 64 91% 9%

Underfunded pension obligations 80 80 100% 0%

Senior Secured loan – 1st lien 100 100 100% 0%

Senior Secured loan – 2nd lien 50 32 64% 36%

Senior Unsecured loan 60 24 40% 60%

Total 410 300

LGD for a loan facility.

receivables and machinery.

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

worth $100 million, which remains drawn.

worth $300 million.

even the secured debt.

Alternatively, JPMorgan could go ahead with the200+

latter repays the entire loan in case the borrower defaults.

LOAN PROVISIONING AND LOSS GIVEN DEFAULT

expected loss for a bank would be $1.6 million

banks cut down on the NPA levels going forward.

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