Macro, Industry, and Frailty Effects in Defaults: The 2008 Credit Crisis in Perspective

Abstract:     
We determine the magnitude and nature of systematic default risk using 1971-2009 default data from Moody’s. We disentangle systematic risk factors due to business cycle effects (macro), common default dynamics (frailty), and industry-specific dynamics (including contagion). To quantify the contribution of each of these factors to default rate volatility we adopt a flexible class of factor models that can treat continuous and discrete variables simultaneously. In our study we show that macro, frailty, and industry factors are of key importance to default risk. These systematic risk factors account for roughly one third of observed default risk variation. About one half of systematic default risk is captured by observed macro and financial market factors. The other half is captured by frailty and industry effects in roughly equal proportions. The frailty components are particularly relevant in times of stress. Models based only on macro variables may both under-estimate and over-estimate default activity during and before such times. This indicates that frailty factors do not simply capture missed non-linear responses of defaults to business cycle dynamics. We also find significant differences in the impact of crises on defaults at the sectoral level, implying frailty as well as contagion may play a role in systematic default clustering. Finally, we show that the contribution of frailty and industry factors on top of macro factors is economically significant for assessing portfolio risk.

Keywords: Systematic Default Risk, Credit Portfolio Models, Frailty-Correlated Defaults, State Space Methods, Credit Risk Management

JEL Classification: G21, C33

working papers series