Category
May 28, 2024

Behind the Scenes: How Default Rates are Calculated

Author:
Kyle Meade
Behind the Scenes: How Default Rates are Calculated

Default rates are one of the most important metrics in loan analysis, and it's important to understand the various methods used to calculate default rates. At Cascade, we use four different primary methodologies to measure default: Rolling DPD, Strict DPD, Number of Installments, and Percent of Payment in the last [x] days. The standard methodology is Rolling DPD, but new methodologies can be computed to provide more accurate results. Loan analysis is a complex process, but understanding the way default rates are calculated is an essential part of the process. By understanding the different methodologies used to calculate default rates, you can make more informed decisions when analyzing loans.

Overview of Methodologies

Strict DPD measures the number of days a client has a negative outstanding balance, starting from the missed payment date until they fully repay the negative balance. Rolling DPD, on the other hand, takes into account the client's ongoing payments, reducing the negative balance as they make payments and resetting the default date to the last missed payment. The Number of Installments method calculates the count of missed installments based on the average scheduled installment over negative outstanding balance. Lastly, Percent of Payment in the last [x] days calculates the ratio of actual payments received to expected payments within a specified time frame.

Different methodologies for different use cases

Different methodologies are used to calculate default rates in loan analysis for a variety of reasons. One important factor is regulation. Central banks often require lenders to report default rates using specific methodologies, ensuring consistency and transparency in the industry. For example, Basel II, a global regulatory framework for banks, provides guidelines for calculating default rates. Additionally, loan products with different payment frequencies may require different methodologies. Institutional Debt investors also have specific ways of looking at portfolio companies through a standard methodology.

An Example

Walking through an example is the best way to understand the different methodologies - let’s assume the following scenario:

  • A client received a loan of $1,100 with the first payment due on 1/1/2023.
  • Each installment the client pays $100 in principal and $1 in interest.
  • The real schedule below is as of 3/12/2023 - meaning the client didn’t make payments between 2/26 and 3/12.

Schedule Payments Real Payment
Date Principal Interest Date Principal Interest
1/1/2023 100
1 1/1/2023  100 1
1/8/2023 100 1 1/8/2023 100 1
1/15/2023  100 1 1/15/2023  100 1
1/22/2023  100 1 1/22/2023  100 1
1/29/2023  100 1 2/19/2023  100 1
2/5/2023 100 1 2/26/2023 100 1
2/12/2023 100 1
2/19/2023  100 1
2/26/2023  100 1
3/5/2023 100 1
3/12/2023  100 1

To help view the Real Payment Schedule - we align the payments

Schedule Payments Real Payment
Date Principal Interest Date Principal Interest
1/1/2023 100
1 1/1/2023  100 1
1/8/2023 100 1 1/8/2023 100 1
1/15/2023  100 1 1/15/2023  100 1
1/22/2023  100 1 1/22/2023  100 1
1/29/2023  100 1
2/5/2023 100 1
2/12/2023 100 1
2/19/2023  100 1 2/19/2023  100 1
2/26/2023  100 1 2/26/2023 100 1
3/5/2023 100 1
3/12/2023  100 1

How Default is Calculated


Calculation Date 2/18/2023 2/19/2023 2/26/2023 3/5/2023 3/12/2023
Strict DPD 
20
21 35 42 49
Description DPD started on 1/29/23 when they missed the payment
DPD started on 1/29 - with the payment on 2/19 the client still has a outstanding overdue balance DPD started on 1/29 - with payment on 2/26 the client still has an outstanding overdue balance DPD started on 1/29 - client still has a negative outstanding balance DPD started on 1/29 - client still has a negative outstanding balance
Rolling DPD 20 14 14 21 28
Description DPD started on 1/29/23 when they missed the payment With payment on 19th the 1/29/2023 installment is paid and last missed payment date is 2/5/23 With payment on 26th the 2/5 installment is marked as paid and last installment missed date is 2/12 With missed payment on 3/5 client hasn't had a marked payment since 2/12 With missed payment on 3/12 client hasn't had a marked payment since 2/12
Count of Installment 3 3 3 4 5
Description Defaulted Outstanding Balance is 303 the avg installment is 101 Defaulted Outstanding Balance is 303 the avg installment is 101 Defaulted Outstanding Balance is 303 the avg installment is 101  Defaulted Outstanding Balance is 404 the avg installment is 101  Defaulted Outstanding Balance is 505 the avg installment is 101
% Paid Last [30] 50% 60% 60% 40% 40%
Last 30 Days 1/19/2023 1/20/2023 1/27/2023  2/3/2023  2/10/2023 
Expected Payment 404 505 505 505 505
Paid 202 303 303 202 202

By comparing and contrasting the methodologies, loan analysts can determine which method suits their needs and objectives best. It's important to remember that the choice of methodology can impact the accuracy of default rates and the overall risk assessment of the loan. Ultimately, understanding the nuances of these methodologies allows for better decision-making in loan analysis and mitigates potential risks in Asset Backed Lending, Loan Tape Analysis, and computing Borrowing Bases.

Want to explore how Cascade can help you better monitor your portfolio? Book a strategy call with our team.