June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 57 of 92 5.7. Recovery Rate and Recovery Rate Volatility The recovery rate measures the fraction of each dollar of exposure that can be recovered in the event of a default. Like the default rate, there is significant amount of variability around what is actually recovered in the event of a default. When calculating recovery rates and volatilities, it is important to consider the seniority of the debt and any security or collateral held. The reason for this is that even within seniority levels of debt, there is a fair degree of variability of the recovery rate. Careful consideration should be given to the assumptions used in determining the recovery rate due to the high degree of volatility. Table 5.3 demonstrates how significant the variability of recovery rates can be within differing seniority levels. Table 5.3 Recovery Rates by Seniority and Security26 Seniority and Security Average Recovery Rate Standard Deviation Senior Secured Bank Notes 71.18 21.09 Senior Secured Public Debt 63.45 26.21 Senior Unsecured Public Debt 47.54 26.29 Senior Subordinated Public Debt 38.28 24.74 Subordinated Public Debt 28.29 20.09 Junior Subordinated Public Debt 14.66 8.67 An important distinction to make here is that this data is reflecting recovery on debt loaned. What it does not address is the recovery of open positions on commodities contracts, which will be the primary focus for energy companies assessing capital adequacy. Energy companies should make an assessment as to where on the priority level the commodities exposures reside, relative to other stakeholders, in the event of default. Also, the recovery rate relative to the assessed priority level should be analyzed. Table 4.3 demonstrates that recovery rates should be assessed at a confidence interval, as well as stress tested to ascertain the impact of various recovery scenarios. 5.8. Rating Migration Some credit risk models use this to measure mark-to-market (MTM) change with regard to the change of credit quality from one notch to another within a given time period. In addition to assessing the default probability, credit analysis should extend to analyzing changes in credit quality. This is done because changes in credit quality will affect margining and collateral requirements related to open commodities contracts. Table 5.4 demonstrates the migration probabilities for various credit ratings over a one year period. 26 Historical Default Rates of Corporate Issuers, 1920-1996 (January 1997) Moody’s Investors Service Global Credit Research