For instance, let’s say a borrower wants to purchase a home for $250,000 and takes out a mortgage from a local bank. The home that the borrower purchases is used as collateral for the loan. Before the bank approves the mortgage, it checks the borrower’s credit score and performs its due diligence. It finds the borrower has no history of default, so the bank approves the mortgage. But a year after purchasing the home, the borrower loses their job and defaults on their mortgage. This doesn’t mean the bank has lost exactly $250,000, as there are other factors that have to be considered. The bank still has an asset it can use as collateral and the borrower had already made a year’s worth of mortgage payments. LGD can help the bank determine how much money was actually lost from the default.
How Loss Given Default Works
LGD is a part of the Basel Framework, which sets standards for international banking. So using the above example, how can a bank calculate the LGD? There are a number of different calculations that can be used, but most accountants prefer gross calculation because of its simplicity. Gross calculation compares the total amount of money with the exposure at time of default. Using the example above, the borrower defaulted on a $250,000 mortgage, but after making $20,000 in mortgage payments over the course of a year. So the exposure at the time of default is $230,000. The bank forecloses on the home and is able to sell it for $150,000. The bank’s net loss is $80,000, and the LGD is 35%.
Loss Given Default (LGD) vs. Exposure at Default (EAD)
However, EAD measures the total loss exposure when a borrower defaults on the loan. For instance, if a borrower takes out a $250,000 mortgage and pays $20,000 before defaulting, the EAD is $230,000. The EAD is constantly changing as the borrower makes additional payments toward a loan. In addition, this figure doesn’t account for the money the bank could recoup by selling off the collateral toward the loan.
