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Stress Tests with Loss Given Default

Jon Frye

Charlotte Economics Club


Tuesday May 19, 2015
Jon.Frye@chi.frb.org
http://www.chicagofed.org/webpages/people/frye_jon.cfm
(or, Google Jon Frye LGD)

The views expressed are the authors and do not necessarily represent the views of the management of the Federal
Reserve Bank of Chicago or the Federal Reserve System.

Please read the fine print


Today I discuss a model of loss given default (LGD).
This is the fraction of the loan that is lost, rather than recovered.

A bank might use this model in several ways.


One way is in supervisory stress test compliance.

Only a banks management and supervisors determine that


a particular model is appropriate.
Neither the Fed nor any other agency has endorsed the
model that I will present. What you hear are my views
The views expressed are the authors and do not necessarily represent the views of the management of the Federal
Reserve Bank of Chicago or the Federal Reserve System.

Outline of this presentation


The problem:
Banks need to project credit loss in stress tests.
Loss given default (LGD) has proved difficult to model.

The LGD function can help.

It tells the value of LGD as conditions change.


It is easy to apply without doing statistics.
It matches some broad behavioral patterns of LGD.
It is an almost perfect match for LGD risk in loan data.

Because of these qualities, the LGD function may


become a standard in the credit risk toolkit.
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Stress tests
Dodd-Frank requires big banks to stress test loans.
The Fed specifies several economic scenarios.
In a typical scenario the economy deteriorates, bottoms out,
and begins to improve within a nine-quarter horizon.

A bank must project its credit loss for each quarter.

When conditions get worse


A loans probability of default (PD) gets worse.
I assume that the bank has a model of this behavior.

The loans loss given default (LGD) also gets worse.


But the behavior of LGD is hard to model,
because LGD data has poor quality for this purpose

LGD data have poor quality


Most bank data sets reflect only one cycle.
One observation is not enough to do good statistical analysis.
And, the recent cycle is not typical.
Policy was intended to distort the usual connection of loss to conditions.
The connection of LGD to conditions was probably affected.

LGD is noisy.
Seemingly similar loans can have very different LGDs.
The remedy for noisy data is to have lots of cases.

In years like 2014 there arent many large corporate defaults.


We didnt get enough LGDs to take a reliable average.

Banks can face a statistical nightmare:


Noisy data, few cases, a short sample, an atypical period...
Regression lines can point anywhere, and they arent reliable.

Three broad LGD behaviors


There are three cycles of bond data. They reveal:
1. LGD is elevated when the default rate is elevated.
2. The elevation is moderate.
3. The elevation is similar across debt types.

Positive, moderate response


16%

80%

Bad years

12%

60%
Average LGD in

good years

= 52%

LGD Rate

Default Rate

Similar response

8%

40%

4%

20%

0%

0%

1978 1982 1986 1990 1994 1998 2002 2006 2010

Altmans junk bonds

Moodys loans and bonds, 1983-2001


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The LGD function


The LGD function expresses these three behaviors.
You will soon see this.

To calibrate the LGD function for a loan:


Estimate loan PD and LGD without looking at scenarios.
Call these values PD0 and LGD0.
The LGD function does not provide any help with this step.

Locate the point (PD0, LGD0) on a chart.


Draw the LGD function through this point.
Only one LGD function passes through any point.

This fully calibrates the LGD function.

For example, suppose that PD0 = 2%, LGD0 = 25%...


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Calibrate the LGD function


40%

30%
LGD0 = 25%
20%

PD0 = 2%

LGD

10%

0%
0%

PD

2%

4%

6%

8%

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From snapshot to movie


The user supplies a snapshot of a loan,
by estimating PD0 and LGD0.
These estimates do not depend on the scenario that is to come.

The LGD function converts the snapshot to a movie.


During the scenario, the loan moves along the function.
The PD model tells PD as conditions change.
The LGD function tells LGD under the same conditions.

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Stress test with the LGD function


40%
Quarter t LGD = 31.5%

30%
LGD0 = 25%
20%
Quarter t PD = 6%

PD0 = 2%

LGD

10%

0%
0%

PD

2%

4%

6%

8%

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Moderate, similar LGD response


80%
Each loan moves along its line.

60%
The effect of a change in PD is
nearly the same

40%

whether the loan has high LGD


(red or gold line)

20%

LGD

or low LGD (blue or purple line).

0%
0%

PD

5%

10%

15%
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Does this work?


With Mike Jacobs, I analyze Moodys loans 1996-2009.

40%

cLGD

Parameter a lets the LGD function take different slopes.


50%

Fit to Moody's loans (a = 0.01)


LGD function (a = 0)

30%
20%

cDR

10%

0%

5%

10%

15%

20%

25%

30%

Studies cited in the last slide provide further support.

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Summary
The LGD function is easy to apply in a stress test.
If you know a loans current PD and current LGD, you know its
LGD function.

The LGD function is hard to beat.

It captures the stylized behaviors of LGD.


It is a nearly perfect match for Moodys-rated loans.
Simulation studies provide further support.
No model has been shown to be significantly better.

I hope that the LGD function becomes a standard against


which other models of LGD behavior will be compared.
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Questions?

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References
Jon.Frye@chi.frb.org

Frye, Modest Means, Risk, January 2010.


A two-parameter credit loss distribution is adequate, given
current data. The LGD function is later inferred from this idea.

Frye and Jacobs, Journal of Credit Risk, Spring 2012


The calibrated sensitivity of cLGD to cDR is nearly equal to the
sensitivity built into the LGD function.

Frye, The link from default to LGD, Risk, March 2014


Tail LGD is better predicted by the LGD function than by linear
regression using simulated data.

Frye, Stress tests with LGD, under development


Macro data do not significantly improve the LGD function.
The paper on my website is still very preliminary.

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