Modeling Ultimate Loss Given Default on Corporate Debt

Jacobs, Michael; Karagozoglu, Ahmet K.

doi:10.3905/jfi.2011.2011.1.008

“…Credit risk depends on probability of default, exposure at default, and loss given default (Jacobs and Karagozoglu, 2011). 5 Operating lease commitments could affect lender assessments of both probability of default and loss given default.…”

Section: Hypotheses Developmentmentioning

confidence: 99%

Operating Leases and Credit Assessments

Altamuro

¹

,

Johnston²,

Pandit

³

et al. 2012

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Operating leases have grown significantly as a source of corporate financing over the last 30 years. Their offbalance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial ratios better explain loan spreads, especially for larger lenders. Our results also suggest that retailer leases that are closer in substance to rental agreements than financed asset purchases are less relevant for credit risk assessments. Thus we conclude that banks not only price operating leases, on average, but also make distinctions about which leases should be priced. Second, we explore the role of credit rating agencies and confirm that credit ratings also reflect capitalized operating leases, and find support for an informational role for others' credit assessments. However, unlike banks, rating agencies appear to capitalize all operating leases mechanically. Overall, our results suggest that banks and rating agencies adjust for the off-balance sheet presentation of operating leases and, at least in the case of banks, attempt to do so to reflect the underlying economics of the leases. This evidence lessens concern over the potential negative consequences of existing operating lease accounting and raises concern over proposed accounting that capitalizes all leases regardless of their economic characteristics. Electronic copy available at: http://ssrn.com/abstract=1115924 1 AbstractOperating leases have grown significantly as a source of corporate financing over the last 30 years. Their off-balance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial...

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“…Carey and Gordy (2007) examine whether there is systematic variation in ultimate recoveries at the obligor (firm-level default incidence) level, and find only weak evidence of systematic variation in recoveries. Recently, building upon these two studies, Jacobs and Karagozoglu (2011) empirically investigate the determinants of LGD and build alternative predictive econometric models for LGD on bonds and loans using an extensive sample of most major US defaults in the period 1985-2008. They build a simultaneous equation model in the Beta-Link Generalized Linear Model (BLGLM) class, identifying several that perform well in terms of the quality of estimated parameters as well as overall model performance metrics.…”

Section: Review Of the Related Literaturementioning

confidence: 99%

“…In this context, since we are dealing with a random variable in a bounded region, this is most conveniently modelled through employing a beta distribution. Consequently, we follow Mallick and Gelfand (1994), in which the GLM link function 13 is taken as a mixture of cumulative beta distributions, which we term as the BLGLM (see Jacobs and Karagozoglu (2011) for an application of the GLM model in estimating the ultimate LGD). The coefficient estimates and diagnostic statistics for our 'leading' three models are shown in Table 6.…”

Section: Multivariate Regression Analysis Of Defaulted Debt Returnsmentioning

confidence: 99%

“…Thus far, most research studying systematic variation in defaulted debt recoveries has focused on the influence of either macroeconomic factors (Frye, 2000a(Frye, , b, c, 2003Hu and Perraudin, 2002;Carey and Gordy, 2007;Jacobs, 2011), supply/demand conditions in the defaulted debt markets , or some combination thereof (Jacobs and Karagozoglu, 2011). Probably the reason for this focus is the conventional wisdom that determinants of recoveries (i.e.…”

Section: Introductionmentioning

confidence: 97%

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An empirical study of the returns on defaulted debt

Jacobs

¹

2011

Applied Financial Economics

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This study empirically analyses the historical performance of defaulted debt from Moody's Ultimate Recovery Database (1987Database ( -2010. Motivated by a stylized structural model of credit risk with systematic recovery risk, we argue and find evidence that returns on defaulted debt co-vary with determinants of the market risk premium, firm specific and structural factors. Defaulted debt returns in our sample are observed to be increasing in collateral quality or debt cushion of the issue. Returns are also increasing for issuers having superior ratings at origination, more leverage at default, higher cumulative abnormal returns on equity prior to default, or greater market implied loss severity at default. Considering systematic factors, returns on defaulted debt are positively related to equity market indices and industry default rates. On the other hand, defaulted debt returns decrease with short-term interest rates. In a rolling out-of-time and out-of-sample re-sampling experiment we show that our leading model exhibits superior performance. We also document the economic significance of these results through excess abnormal returns, implementing a hypothetical trading strategy, of around 5%-6% (2%-3%) assuming zero (1 bp per month) round-trip transaction costs. These results are of practical relevance to investors and risk managers in this segment of the fixed income market.

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“…Credit risk depends on probability of default, exposure at default, and loss given default (Jacobs and Karagozoglu ) . Operating lease commitments could affect lender assessments of both probability of default and loss given default.…”

Section: Hypotheses Developmentmentioning

confidence: 99%

Operating Leases and Credit Assessments

Altamuro

¹

,

Johnston

²

,

Pandit

³

et al. 2014

Contemporary Accting Res

View full text Add to dashboard Cite

Operating leases have grown significantly as a source of corporate financing over the last 30 years. Their offbalance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial ratios better explain loan spreads, especially for larger lenders. Our results also suggest that retailer leases that are closer in substance to rental agreements than financed asset purchases are less relevant for credit risk assessments. Thus we conclude that banks not only price operating leases, on average, but also make distinctions about which leases should be priced. Second, we explore the role of credit rating agencies and confirm that credit ratings also reflect capitalized operating leases, and find support for an informational role for others' credit assessments. However, unlike banks, rating agencies appear to capitalize all operating leases mechanically. Overall, our results suggest that banks and rating agencies adjust for the off-balance sheet presentation of operating leases and, at least in the case of banks, attempt to do so to reflect the underlying economics of the leases. This evidence lessens concern over the potential negative consequences of existing operating lease accounting and raises concern over proposed accounting that capitalizes all leases regardless of their economic characteristics. Electronic copy available at: http://ssrn.com/abstract=1115924 1 AbstractOperating leases have grown significantly as a source of corporate financing over the last 30 years. Their off-balance sheet treatment, which may in part explain their popularity, raises concern that financial risk may be misjudged and capital misallocated. Prior research evidence on the above issue is mixed. To improve reporting transparency, regulators propose a new accounting concept, right of use, which will add the present value of most leases to the balance sheet. We examine the effect of operating leases on loan pricing by banks, a sophisticated financial statement user. Since leases are a potential debt substitute, we expect them to be important in our setting. With loan spreads as the dependent variable, we test the differential explanatory power and model fit of as-reported financial ratios versus financial ratios adjusted for the capitalization of operating leases. We find that lease-adjusted financial...

show abstract

Modeling Ultimate Loss Given Default on Corporate Debt

Cited by 10 publications

References 19 publications

Operating Leases and Credit Assessments

Operating Leases and Credit Assessments

An empirical study of the returns on defaulted debt

Operating Leases and Credit Assessments

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