What is Loss Given Default (LGD)?
The loss incurred by a bank or lender when a borrower defaults (does not pay back) on the loan is called loss given default. The LGD value is often expressed as a percentage.
During an economic downturn, individuals and companies suffer the consequences of a sluggish economy. It leads to the downfall of numerous companies across various sectors, and very often, they are unable to pay back loans borrowed from the bank.
Illustrative Example of Loss Given Default
John wants to buy a piece of land worth $1.9 million. To finance the purchase, he borrows $1 million from a local bank. He uses a parcel of land as collateral for the loan. Before lending the money to John, the bank looks at his credit history and performs due diligence before approving the loan. They make sure that John has not defaulted on prior loans and earns a sufficient income to repay the loan.
However, five months after the bank lends John the money, he loses his job and is unable to repay the loan as there is no income stream. As a result, he must default on the loan. As stated in the loan agreement, the bank takes ownership of John’s land and attempts to sell it to recover the amount of the loan.
Afterward, due to property restrictions and a lack of infrastructure in the area, the property’s value goes below the market value. The bank is unable to sell the land for the total amount of the loan, and the land is sold for $800,000 only. The loss given default is the total amount of loss the bank incurs as a result of John’s default on the loan. It is calculated as:
Total Loss = 1,000,000 – 800,000 = $200,000
Loss Given Default = (200,000 / 1,000,000) * 100 = 20%
When a company defaults on a loan, one of two things can happen:
- The company recovers on its own, with no intervention by the bank; or
- The assets of the company need to be sold in order to recover the money
There are two extremes that can occur when a company defaults on the loan. In addition, there is an in-between scenario that can occur as well.
1. Full recovery
When a company defaults, they are given 90 days to recover from their financial situation and pay back the loan. Sometimes, the companies can recover with no intervention by the bank.
2. Sale of assets
Such a scenario does not occur unless the company is facing bankruptcy and is left with no choice but to sell their assets to settle the loan. It is done after the overdue period of 90 days is complete. Two types of assets can be sold to recover the loan amount. They include collateral assets and unpledged assets.
- Collateral assets refer to assets that the company previously pledged to the bank when the money was initially borrowed. Banks ask the customer for collateral as the assets or securities can be sold in the event that the company (borrower) defaults on their loan. The assets pledged can be sold to recover the money lent by the bank.
- Unpledged assets are assets that the company owns but did not put up as collateral to the bank when taking out the loan. The proceeds from the sale of such assets will be given to creditors in order of how long the payment remained outstanding.
3. In-between scenarios
In most cases, the bank will identify the credit risk of the company before it defaults on a loan. At this time, the bank will contact the company to make arrangements and ensure that the amount outstanding on the loan is paid. If it is not possible, the bank will consider other alternatives, such as exempting the company from interest payments or restructuring the existing loan agreement so that the company pays lower interest rates.
Alternatively, the bank can sell the loan to another entity. This in-between scenario occurs when the bank believes that the company can recover from its current financial position. The scenario is usually implemented along with the sale of the company’s assets. A portion of the loan is repaid through the sale of assets, while the other portion is repaid with the restructuring of the loan agreement.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: