Model Stability and the Subprime Mortgage Crisis

43 Pages Posted: 14 Sep 2010

See all articles by Xudong An

Xudong An

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Yongheng Deng

Wisconsin School of Business, University of Wisconsin-Madison

Eric Rosenblatt

Federal National Mortgage Association (Fannie Mae) - Research

Vincent W. Yao

Georgia State University - J. Mack Robinson College of Business

Date Written: September 12, 2010

Abstract

We study the potential model instability problem with respect to mortgage default risk and examine to what extent it helps explain the default shock during the recent crisis. We find that econometric default risk models based on historical data can be unstable over time. Due to temporal shifts in the parameters, default prediction of the 2006 vintage subprime loans based on hazard and Logit models estimated with 2003 vintage loan data can generate over 40 percent fewer defaults than the actual number, assuming perfect forecast of house price change. We also find that the combined impact of parameter instability and bad forecast of HPI growth enlarges the under-prediction of default rate but the marginal impact of parameter instability is larger than that of bad HPI forecast. Our findings have important implications regarding model limitations and risk, model improvements, economic capital, and regulatory reform.

Keywords: Subprime Mortgage, Default Risk, Model Stability, Hazard Model, Logit Model

JEL Classification: G21, G12, C52, C41

Suggested Citation

An, Xudong and Deng, Yongheng and Rosenblatt, Eric and Yao, Vincent W., Model Stability and the Subprime Mortgage Crisis (September 12, 2010). Journal of Real Estate Finance and Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1676724

Xudong An

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Yongheng Deng (Contact Author)

Wisconsin School of Business, University of Wisconsin-Madison ( email )

4110 Grainger Hall
975 University Avenue
Madison, WI 53706
United States
+1 (608) 262-4865 (Phone)

HOME PAGE: http://https://bus.wisc.edu/faculty/yongheng-deng

Eric Rosenblatt

Federal National Mortgage Association (Fannie Mae) - Research ( email )

16517 Keats Terrace
Derwood, MD 20855
United States

Vincent W. Yao

Georgia State University - J. Mack Robinson College of Business ( email )

35 Broad Street
Atlanta, GA 30303-3083
United States

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