Default Recovery Rates and LGD in Credit Risk Modeling and Practice

Evidence from many countries in recent years suggests that collateral values and recovery rates on corporate defaults can be volatile and, moreover, that they tend to go down just when the number of defaults goes up in economic downturns. This link between recovery rates and default rates has traditionally been neglected by credit risk models, as most of them focused on default risk and adopted static loss assumptions, treating the recovery rate either as a constant parameter or as a stochastic variable independent from the probability of default. This traditional focus on default analysis has been partly reversed by the recent significant increase in the number of studies dedicated to the subject of recovery rate estimation and the relationship between default and recovery rates. This paper presents a detailed review of the way credit risk models, developed during the last thirty years, treat the recovery rate and, more specifically, its relationship with the probability of default of an obligor. We also review the efforts by rating agencies to formally incorporate recovery ratings into their assessment of corporate loan and bond credit risk and the recent efforts by the Basel Committee on Banking Supervision to consider “downturn LGD” in their suggested requirements under Basel II. Recent empirical evidence concerning these issues and the latest data on high-yield bond and leverage loan defaults is also presented and discussed.