Understanding Recovery Rates
The recovery rates are a crucial element for calculating credit risk.
The loss given default of an asset or a portfolio is calculated as 1 minus the recovery rate.
LGD = 1 - R
The problem with recovery rates is that they are not easy to estimate and the data available for recovery rate is very fragmented and inconsistent.
The recovery rates are closely linked to the bankruptcy procedures which happens after an obligor has defaulted. Based on the procedures, all the creditors of the defaulter are paid a part of their claims based on the priority. For example, the secured creditors will have first claim on the collateral and other assets of the defaulting firm. The unsecured creditors will come after them, and the shareholders will get the last preference.
Another important issue is whether the payment received as recovery should be discounted to the time of default or not. In case of large obligors the payments will generally be discounted back.
The recovery rates can be generally defined in two ways:
- Market Value Recovery: This is the market value per unit of legal claim amount, short time (1 to 3m) after the default
- Settlement Value Recovery: This refers to the value of the default settlement per unit of legal claim amount, discounted back to the default date and after subtracting legal costs