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The paper describes a theoretical approach to determine the downturn LGD for residential mortgages, which is compliant with the regulatory requirement and thus suited to be used for validation, at least as it can give benchmark results. The link between default rates and recovery rates is in fact acknowledged by the regulatory framework as the driver of the downturn LGD, but data constraints do not usually allow for direct estimation of such a dependency. Both default rates and LGD parameters can anyway be related to macroeconomic variables: in the case of mortgages, real estate prices are the common driver. Household default rates are modelled inside a Vector Autoregressive Model incorporating a few other macroeconomic variables, which is estimated on Italian data.
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