Modeling the loss distribution

In this paper, we focus on modeling and predicting the loss distribution for credit risky assets such as bonds and loans. We model the probability of default and the recovery rate given default based on shared covariates. We develop a new class of default models that explicitly accounts for sector specific and regime dependent unobservable heterogeneity in firm characteristics. Based on the analysis of a large default and recovery data set over the horizon 1980-2008, we document that the specification of the default model has a major impact on the predicted loss distribution, whereas the specification of the recovery model is less important. In particular, we find evidence that industry factors and regime dynamics affect the performance of default models, implying that the appropriate choice of default models for loss prediction will depend on the credit cycle and on portfolio characteristics. Finally, we show that default probabilities and recovery rates predicted out of sample are negatively correlated and that the magnitude of the correlation varies with seniority class, industry, and credit cycle. Key words: loss distribution; default prediction; recovery rates; Basel II History: Received May 11, 2009; accepted February 10, 2011, by Wei Xiong, finance. Published online in Articles in Advance May 17, 2011.
1. Introduction The predicted loss distribution is a basic input for calculating the loan loss reserves and the economic capital and for computing portfolio risk metrics such as value-at-risk and [...]