Abstract
Using a regime switching framework we investigate the determinants of default clustering. We find that a common credit cycle, modeled as a two-state Markov chain, can account for a large portion of default correlations, with the residual clustering being captured by a factor structure. During credit crunches default rates increase, and so does the conditional residual correlation. Using data for the period 2000-2006 we find that this common cycle is robust in explaining a large part of the default behavior of individual industries and recovery rates. We also find that structured products that depend on the distribution tail are the first to respond to a deterioration of the credit environment.
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