What determines loss given default (LGD), and how do workout LGD and market LGD differ?

Loss Given Default (LGD) is the percentage of exposure lost when a borrower defaults: LGD = 1 - Recovery Rate. Understanding its determinants and estimation is critical for credit risk management.

Key Determinants of LGD:

1. Seniority and Security:

The most important factor. Secured senior debt typically has LGD of 30-40%, while unsecured subordinated debt can reach 70-80%.

2. Industry:

Asset-heavy industries (utilities, real estate) have lower LGD because tangible assets can be liquidated. Asset-light industries (technology, services) have higher LGD.

3. Economic Conditions:

LGD is countercyclical — recovery rates are LOWER during recessions because:

• More firms default simultaneously, flooding the market with distressed assets
• Buyers have less capital to purchase distressed assets
• Collateral values decline (especially real estate)

Brightwater Bank found that its corporate loan LGD averaged 42% during expansions but 58% during recessions.

4. Jurisdiction:

Bankruptcy regimes vary. US Chapter 11 tends to produce higher recoveries (debtor-friendly reorganization) vs. UK administration.

Workout LGD vs. Market LGD:

Workout LGD (internal bank approach):

• Tracks actual cash flows recovered over the entire workout period
• LGD = 1 - [PV(all recoveries) - PV(workout costs)] / EAD
• Requires discounting all cash flows back to the default date
• Can take 2-5 years to resolve
• More accurate but slow and resource-intensive

Market LGD (trading approach):

• Uses the market price of defaulted bonds/loans shortly after default (30-60 days)
• LGD = 1 - (Post-default market price / Par)
• If Crossfield Corp bonds trade at $0.35 on the dollar 30 days post-default, market LGD = 65%
• Fast but reflects market sentiment (which may overshoot)

FRM Key Points:

• Basel requires 'downturn LGD' — estimates calibrated to stressed economic conditions
• LGD and PD are positively correlated (both worsen in recessions), which the Basel formula partially captures through the maturity adjustment
• For retail exposures, banks can estimate their own LGD under Advanced IRB
• Collateral valuation is critical — overvalued collateral leads to LGD underestimation

Deepen your LGD modeling skills in our FRM Part II course.