September 17, 2004 -- Sound portfolio management requires accurate estimates of loss given default (LGD). LGD drives pricing, valuation, provisioning, and risk capital. In addition, validated LGD estimates are required by Basel II.

The challenge is that most organizations do not have sufficient loss data to estimate or validate their own LGD estimates, much less to estimate the variation of LGD across exposures or over the credit cycle. The traditional solution of using long-run historical studies on rated firms to estimate LGD gives static and backward-looking estimates. Moreover, the issues associated with using long-run averages are exacerbated in today’s credit environment and at other turning points in the economic cycle.

LOSSCALC™: A POWERFUL LGD PREDICTOR TO ASSESS AND MANAGE RISK

Moody’s KMV™ LossCalc provides accurate LGD estimates. With LossCalc, historical LGD studies are merely a starting point. The model’s increased accuracy comes from inclusion of dynamic, forward-looking indices, including regularly updated industry recovery rates and median default probabilities. While lenders and investors intuitively know that recovery rates vary over the credit cycle, LossCalc is the only model that captures the correlation between default risk and recoveries. Our validation work demonstrates that LossCalc’s estimates outperform those from traditional historical studies. LossCalc was built from two decades of detailed market, fundamental, and security level data on recoveries for over 1,800 defaulted instruments, both rated and unrated. It is the first LGD model designed to calculate LGD for bonds, bank loans, and preferred stock.

KEY PRODUCT FEATURES

INCREASED ACCURACY AND TRANSPARENCY

• More accurate and dynamic predictions of LGD than traditional look-up tables or historical averages
• Model developed on over 1,800 recovery observations spanning two decades
• Extensive public documentation of the model, validation techniques, and performance results, including out-of-sample testing periods

• Obligation-specific LGD estimates at default and for one-year time horizons
• Explicit LGD confidence bounds that measure uncertainty around the predictions; much tighter bounds than those produced using traditional look-up tables
• One-off calculations for individual transactions or as an input into portfolio analytics
• Graphing and simulations of LGD distributions in Moody’s KMV Portfolio Manager™

LossCalc estimates are sensitive to changing credit cycles through the incorporation of market indices and credit cycle factors that are updated automatically, as well as dynamic company-level information:

• Moving average of normalized industry recoveries
• One year, forward-looking median default rates
• Other factors, including Moody’s Bankrupt Bond Index, trailing 12 month speculative grade average default rate, and changes in Leading Economic Indicators
• Debt type and seniority for the transaction
• Firm leverage and the relative seniority of this transaction in the firm’s capital structure

• Web-based access for one-off analysis or batch submission of groups of transactions
• Indices updated automatically by Moody’s KMV
• Automated loading by Portfolio Manager

LGD estimates generated by LossCalc can be used as inputs for each transaction in Portfolio Manager and CreditMark. In addition, LGD distributions are generated for each transaction in Portfolio Manager.