Although a defaulted asset generates a loss, there is often an opportunity to recover cash. Repossessing the asset and selling it is the primary method to achieve this recovery. The cash received from the sale flows into the structured transaction from which the asset came and is available for liabilities. While this process is very straightforward, a number of details need to be understood in order to model recoveries accurately.
The best approach to explain the nuances of recoveries is to first understand the relevant terminology. In Chapter 4, a gross loss was defined as an asset that is defaulted and assumed not to pay. Once that asset is repossessed and sold, the cash recovered can be subtracted from the original loss amount. The gross loss minus recovery is known as a net loss.
Net loss = Gross loss amount-Recovery amount
Related to net loss are two terms that are often confused: loss severity and recovery rate. These are actually inverse concepts. The recovery rate is the amount recovered divided by the gross loss amount. Loss severity is the ratio between net loss and gross loss amount. For instance, assume that an asset defaulted and created a $100 loss. If $80 is recovered from the sale of the asset then there is an 80 percent recovery rate or a 20 percent loss severity.
Recovery rate = Recovery amount/Gross loss amount Loss severity = Net loss/Gross loss amount
A final term to define is recovery lag. A recovery does not take place immediately ...