Maheen Mahmood

FIN 9854
Study Note #3

• Exposure at default (EAD) is the total value a bank is exposed to when a loan defaults.
o For on balance sheet exposures, such as term loans and mortgages, the EAD ExpIrae
o For off-balance-sheet exposures, such as credit guarantee and credit commitment,
the EAD depends on portion of the undrawn amount is likely to be converted into
credit.
• Exposure at default (EAD)= EAD from on-balance sheet + EAD from off-balance sheet
exposure
 Off-balance sheet (OBS) items is a term for assets or liabilities that do not appear on a
company's balance sheet.
 A credit guarantee scheme provides third-party credit risk mitigation to lenders through the
absorption of a portion of the lender's losses on the loans in case of default.
 EAD = Drawn + CCF*(Limit-Drawn)
 Factors affecting Exposure at Default:
o Facility-specific: Covenant protection, utilization, or loan-to-value (LTV)
o Borrower-specific: industry, geographical region, PD, credit rating, recent new
o loans/payoff, change in frequency of payment, or prepayment
o Time density: time to default, time since origination
o Macroeconomic variables
 LGD: Loss Given Default: The loss given default is as the ratio of the loss on an exposure due
to the default of an obligor to the amount outstanding at default
o 1- recovery rate
o Default is the failure to repay a debt including interest or principal on a loan or
security.
o LGD focuses on economic loss
 Market approach
o To look at prices for debt securities for firms that went bankrupt, such as bonds or
loans.
o Only for debt securities that trade in the market and is not applicable for retail
exposures.
 Implied historical approach
o EL= PD*LGD*EAD. Using the PD estimates and the observed losses to derive the
implied LGD.
 Implied market approach
o It analyzes the market price of risky but not defaulted bonds using asset pricing
models, and then finds the spread above the risk-free rate, which reflects the EL.
 Moody’s Analytics LossCalc: is a model of loss given default (LGD) that incorporates both
static and forward-looking dynamic drivers of recovery, ranging from firm-specific variables
to broader geography and industry factors including:
 1. Debt Type (Absolute Seniority):
o Absolute Seniority rule states that different types of debt have different recovery
levels.
o Debt type provides the most explanatory power for predicting recovery
 2. Relative Seniority
o Relative Seniority rule states that, in liquidation, certain creditors are satisfied in full
before any other creditors receive any payments.
 3. Industry Difference
o Recovery varies by industry for many reasons, including differences in the cyclicality,
differences in regulation, and differences in asset hardness. The following figure
presents the recovery of Senior Unsecured Bonds for Utilities for the whole sample,
as well as for the pre-2000 and post-2000 time periods.
 4. Issuer Credit Risk: Distance-to-default
o Moody believes that recovery is positively related to a firms DtD and negatively
related to the PD.
o If both firm A and firm B default but firm A is measured to have a much lower
default risk than firm B a fixed time prior to default, the value of firm A’s assets
relative to its liabilities is likely to be higher than that of B. Therefore, Firm A’s
recovery is likely to be higher than that of firm B.
 5. Geography:
o Different regions have different bankruptcy regimes and cultures. Some regions have
been characterized as creditor friendly, while others are considered more creditor
unfriendly.
o The following figure shows the average post-default price of Senior Unsecured Bond
for the UK, Europe, and for the whole sample from 1987-2007
 6. Industry Distress:
o If the industry in suffering distress, investors are less likely to buy distressed assets
from the industry and a firm from this industry is less likely to have higher recovery
rate.
o Industry distress is measured as median firm DD of a specific industry.
 7. Aggregate Default Rate:
o When the overall default rate is high, recovery tends to be low. The following plot
shows the average recovery rate against the speculative grade corporate default
rate as published by Moody’s Investors Service.
 The Model’s Functional Form:
o Recovery: is the post-default price.
o MSD: is a dummy variable that indicates whether the debt is the most senior debt in
the corporate family. DD is the distance-to-default. indDD is the median industry
distance-to- default of the firm industry.
o Utilities: is a dummy variable that indicates if the firm belongs to the utility industry.
o Defrate: is the aggregate default rate for corporate firms as published by Moody’s
Investors Service.
o F : is the final transform that ensures the predicted recovery is bounded between 0
and 1.