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- Relative Risk Reduction Formula
In this article we discuss Loss Given Default or LGD in detail –
- Loss Given Default or LGD Example
- Loss Given Default – Kingfisher Airline Example
- Collateral and LGD
- Subordination and LGD calculation
- LGD estimate
- Loan provisioning and Loss Given Default
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 profile, 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 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 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 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 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 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 finance was availed for.
- Have you ever thought what could be the amount 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 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 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 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 offered as collateral is more tangible in nature, i.e contains more of fixed assets such as land and machinery (which could also depreciate in value by the way). For working capital loans, the collateral offered 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 financial 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 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)||Amount||Collateral value at the time of default|
|Underfunded pension obligations||80|
|Senior Secured loan – 1st lien||100||120|
|Senior Secured loan – 2nd lien||50|
|Senior Unsecured loan||60||None|
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 a 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) 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 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 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 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 terms and priority claims on particular assets.
|Liability||Amount||Recoverable amount||Recovery rate (RR)||LGD|
|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%|
- 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 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 significant 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 insufficient 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 the deal and may hedge the risk using CDS (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.
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 significant 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.