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Explain how Loss Given Default (LG) can be higher than the face value of the loan.

Explain how Loss Given Default (LG) can be higher than the face value of the loan.

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Answer #1

In case of default the banks can recover certain percentage of loan by selling of the collateral, securities, mortgage, etc. However in following cases the LGD can be higher than the face value of loan
1. During downturn: The value of the security can go down severely in case of downturn which might affect the value of recovery of loan.
2. Recovery and Administration Cost: To recover the loan banks have to expend recovery and administrative cost for recovery of loan.
3. Time Value Of money: Since the actual recovery of loan will take a long time the present value of recovery will be very less due to discounting with WACC.

Hence if Present value of recovery minus the present value of recovery and administrative cost is less than 0 then LGD can be higher than face value of loan

Best of Luck. God Bless
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