Credit Risk Rating Migration and Unobserved Borrower Heterogeneity

Abstract:     
Some past studies of credit risk ratings migration have found trend reversals and evidence that the data generating process is non-stationary. Using a sample of FCS mortgages, we find no compelling statistical evidence of either phenomenon. We do find evidence that our sample of loans may be characterized by two types of borrowers, namely, movers and stayers. This type of borrower heterogeneity is unobserved because movers that do not migrate are indistinguishable from stayers who never migrate. We report on the development of a flexible nonparametric model for estimating transition probabilities. The model can also be used to estimate non-stationary transition probabilities and an example is provided.

Number of Pages in PDF File: 27

Keywords: Credit risk, Markov chain, maximum entropy, migration, mover, risk ratings, stayer

JEL Classification: C14, C61, G21

working papers series