Resolved: What is the meaning of the EL value after the lender loses 5%?
When we calculate that
EL = PD * LGD * EAD,
EL = 25% * 5% * 360000
EL = 4500$
We calculated the expected loss (EL), but already the lender lost 18000$ (5%)
My questions are:
1- Why do need to EL value after the lender lost 18000$ (5%), do you mean EL for the next borrower?
2- Why did the bank sell a house that was valued 500000$ in 360000 it is not the real value of the house, is it?
Hi Zeid,
Good to hear from you! I'm be happy to answer these questions.
1) I think you got the intuition right. We're talking about 'expected' loss. This is the loss a financial institution can expect before all events happen. We make this calculation preemptively in order to quantify the risk. The EL calculation would be useless once we know what actually happened.
2) This is a very good representation of what happens in real-life. Lenders pledge assets that are worth more, but then banks end up selling them at a discount and also deduct any expenses related to the sales process (organizing bidding, posting ads, hiring brokers, legal fees, etc.). Therefore we can't ever expect that the bank will be able to use the same amount of money as the market value of the pledged assets.
Hope these make sense!
Best,
Ned
