Collateral Risk in Residential Mortgage Defaults

Posted: 30 Sep 2010

See all articles by Tyler T. Yang

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management

Che-Chun Lin

National Tsing Hua University

Man Cho

KDI School of Public Policy and Management

Date Written: September 29, 2010

Abstract

This paper presents a systematic framework for capturing the collateral-driven mortgage default risk. A forward-looking home price distribution model is developed that explicitly incorporates different sources of volatility in the market value of collateral houses. A consistent and computationally-efficient top-down approach of home price simulation is also introduced. We show that with the proper inclusion of all relevant sources of volatilities, the top-down approach provides close approximation to the results generated by a theoretically sound but computationally demanding bottom-up simulation approach. Using a numerical simulation, we demonstrate that a geographically-diversified mortgage pool entails a substantially lower level of systematic collateral driven mortgage default risk compared to a spatially-concentrated pool. However, the expected default risk is shown to remain unaffected, indicating that the benefit from geographic diversification is only realized through lower risk-based capital requirements, not in lower mortgage insurance premiums. Based on the US state level house price indices, the systematic risk of a state-concentrated mortgage pool is estimated to be about four times higher than that of a nationally-diversified mortgage pool. Our results also show that, among the different volatility components, omitting the cross-sectional dispersion of individual home prices would produce the largest bias in assessing home-price-based mortgage default risk.

Keywords: Mortgage Default Risk, House Price Volatility, Diversification Benefit, Default Options, House Price Index, Systematic Risk, Geographic Concentration

Suggested Citation

Yang, Tyler T. and Lin, Che-Chun and Cho, Man, Collateral Risk in Residential Mortgage Defaults (September 29, 2010). Journal of Real Estate Finance and Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1684611

Tyler T. Yang (Contact Author)

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management ( email )

McLean, VA 22101
United States

Che-Chun Lin

National Tsing Hua University ( email )

Hsin Chu 3
China

Man Cho

KDI School of Public Policy and Management ( email )

87 Hoegiro
Dongdaemun
Seoul, 130-868
Korea

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