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Mortgages: estimating default correlation and forecasting default risk

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  • Neumann, Tobias

    (Bank of England)

Abstract

Default correlation is a key driver of credit risk. In the Basel regulatory framework it is measured by the asset value correlation parameter. Though past studies suggest that the parameter is over-calibrated for mortgages — generally the largest asset class on banks’ balance sheets — they do not take into account bias arising from small samples or non-Gaussian risk factors. Adjusting for these biases using a non-Gaussian, non-linear state space model I find that the Basel calibration is appropriate for UK and US mortgages. This model also forecasts mortgage default rates accurately and parsimoniously. The model generates value-at-risk estimates for future mortgage default rates, which can be used to inform stress-testing and macroprudential policy.

Suggested Citation

  • Neumann, Tobias, 2018. "Mortgages: estimating default correlation and forecasting default risk," Bank of England working papers 708, Bank of England.
  • Handle: RePEc:boe:boeewp:0708
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Mortgages; bank regulation; credit risk; default correlation; state space model; Basel Committee; stress testing; macroprudential policy;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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