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Effects of unobserved defaults on correlation between probability of default and loss given default on mortgage loans

  • Palmroos, Peter

    ()

    (Bank of Finland Research)

Registered author(s):

    This paper demonstrates how the observed correlation between probability of default and loss given default depends on the fact that defaults in which collateral provides 100% recovery are not observed. Creditors see only the defaults of mortgagors who suffer from a fall in collateral value to less than the remaining loan principal. Consequently, the default data available to creditors amounts to a mere truncated sample from the underlying population of defaults. Correlation estimates based on such truncated samples are biased and differ substantially from estimates derived from representative non-truncated samples. Moreover, the observed correlation between default probability and loss given default is sensitive to the truncation point, which may explain the differences in correlation estimates found in the literature. This may also explain why correlation estimates seem to be specific to cycle phase.

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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0903netti.pdf
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    Paper provided by Bank of Finland in its series Research Discussion Papers with number 3/2009.

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    Length: 28 pages
    Date of creation: 21 Jan 2009
    Date of revision:
    Handle: RePEc:hhs:bofrdp:2009_003
    Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/

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    1. Sanjiv Das, 2007. "Basel II: Correlation Related Issues," Journal of Financial Services Research, Springer, vol. 32(1), pages 17-38, October.
    2. Jon Frye, 2000. "Depressing recoveries," Emerging Issues, Federal Reserve Bank of Chicago, issue Oct.
    3. David B. Gross & Nicholas S. Souleles, 2001. "An Empirical Analysis of Personal Bankruptcy and Delinquency," NBER Working Papers 8409, National Bureau of Economic Research, Inc.
    4. Campbell, Rachel A.J. & Forbes, Catherine S. & Koedijk, Kees G. & Kofman, Paul, 2008. "Increasing correlations or just fat tails?," Journal of Empirical Finance, Elsevier, vol. 15(2), pages 287-309, March.
    5. Jon Frye, 2000. "Collateral damage detected," Emerging Issues, Federal Reserve Bank of Chicago, issue Sep.
    6. Edward I. Altman & Andrea Resti & Andrea Sironi, 2002. "The link between default and recovery rates: effects on the procyclicality of regulatory capital ratios," BIS Working Papers 113, Bank for International Settlements.
    7. Cairns, Hollie & Pryce, Gwilym, 2005. "An Analysis of Mortgage Arrears Using the British Household Panel Survey," ERES eres2005_134, European Real Estate Society (ERES).
    8. Kau, James B, et al, 1992. "A Generalized Valuation Model for Fixed-Rate Residential Mortgages," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(3), pages 279-99, August.
    9. Ambrose, Brent W & Buttimer, Richard J, Jr & Capone, Charles A, 1997. "Pricing Mortgage Default and Foreclosure Delay," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 314-25, August.
    10. Erlenmaier, Ulrich & Gersbach, Hans, 2001. "Default probabilities and default correlations," Research Notes 01-5, Deutsche Bank Research.
    11. Paraskevi Dimou & Colin Lawrence & Alistair Milne, 2005. "Skewness of Returns, Capital Adequacy, and Mortgage Lending," Journal of Financial Services Research, Springer, vol. 28(1), pages 135-161, October.
    12. Linda Allen & Anthony Saunders, 2003. "A survey of cyclical effects in credit risk measurement model," BIS Working Papers 126, Bank for International Settlements.
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