UL & EL, ong chapter 6

[ibrahim-1987]

hi david,

regarding the calculation of UL & EL, i noticed that LGD was 35% for rating " B ", while it is 50% for rating " BBB",
the q is: is it reasonable to be like this way? i mean "BBB" is better than "B" and it will be safer, so the recovery rate must be higher for it, in this example it was 50% for "BBB" and 65% for "B" ?!!

 

[David Harper CFA FRM]

Hi ibrahim,

That's observant! Later in an unassigned chapter the author (Ong) characterizes LGD in two criteria: by credit rating/risk code (RC) and by secured/unsecured status. So, with respect to recovery (1- LGD) both seniority and collateral status (secured vs. unsecured). In this way, for modeling, a secured lower quality credit (e.g., BBB, RC = 5) can have a higher LGD than a higher quality credit (e.g., B, RC = 3). I think there are maybe two points:

• For LGD, collateral (secured/unsecured) is maybe the most important issue; but at the same time:
• Just like with UGD, where Ong shares data that is sometimes anomalous, both are viewed as "very hard to parametrize" such that point estimates are not really up to the task. Hence the use of a beta distribution, rather than a point estimate for LGD

I hope that helps, thanks!

 

[ibrahim-1987]

okay, lets assume the following:
1. there are two bonds or CDOs or any other securitized debts that have the same characteristics, ( BBB - 50% LGD, B - 35% LGD).
2. lets assume that these data are correct:
if we look to them like investors, we will find that Bond "B" will give me a higher yield while it is more safer than "BBB", even though that PD is higher for bond "B", but it doesn't matter, because if the bonds defaulted, bondholder of "B" will recover more, so PD become implicitly negligible. i my opnion what gives a bond or a debt in general, a higher rating is the collateral, i think investors's first Q is: is it safe? or how much is it safe?, and we saw many cases where the yield is high but there in no buyers.

in this case the fundemental rule in finance is broken: higher risk, higher return.

3. now lets see another perspective:
some investors may think that this can never be happened, and there is two possible explanations for this:
first, rating agency has mistakenly rate these two bonds like this way, OR
rating agency didn't do it's job in apporpriate way, Friction # 7.