Deriving Credit Portfolio Diversification Properties from Large Asset-Backed Security Pools

Abstract:     
The present analysis estimates Markowitz portfolio correlations for retail loan portfolios. The correlations are derived from almost $1 trillion of asset backed security pools originated by more than five hundred issuers between January 2000 and September 2003. Such a broad sample, comprised of several hundred thousand pool-month observations, provides a unique opportunity to infer asset correlation structures of commercial bank assets. Since the types of loans analyzed are rarely traded, Markowitz correlations are estimated from five different loan performance measures. The analysis demonstrates that the performance of many different loan credit types is weakly correlated, and is sometimes even negatively correlated. Hence, there is the potential to eliminate a significant amount of risk in diversified credit portfolios.

Working Paper Series