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Correlated defaults and risk retention: Can prices be increasing in risk

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  • Echeverry, David

Abstract

Pooling is the core diversification technology in securitization, but default correlation limits diversification and shifts the optimal mix of credit enhancement. This note combines a correlated Bernoulli default process with a simple securitization design problem in which the sponsor chooses subordination and (optionally) private mortgage insurance. The technical contribution is an aggregation result for insured correlated Bernoulli cash flows: insuring each loan induces a linear "floor" that scales down its variance by the square of the uninsured loss given default. This tractability makes it immediate to characterize how correlation alters equilibrium credit enhancement. Higher correlation raises the value of loss-given-default insurance relative to pure subordination, providing a clean mechanism through which senior-tranche prices need not fall monotonically with correlation once credit enhancement is chosen endogenously.

Suggested Citation

  • Echeverry, David, 2026. "Correlated defaults and risk retention: Can prices be increasing in risk," Finance Research Letters, Elsevier, vol. 102(C).
    • Handle: RePEc:eee:finlet:v:102:y:2026:i:c:s1544612326005994
    DOI: 10.1016/j.frl.2026.110070
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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