Recovery rates, default probabilities, and the credit cycle

In recessions, the number of defaulting firms rises. On top of this, the av-erage amount recovered on the bonds of defaulting firms tends to decrease, amplifying the systematic component of credit risk. This paper proposes an econometric model which allows for time-variation in default rates and recov-ery rate distributions via an unobserved Markov chain, which we interpret as the “credit cycle”. The model allows measuring the quantitative importance of the amplification of losses via time-variation in recovery rate distributions. Our estimates indicate that it does amplify losses, but to a smaller extent than previously suggested