Forecasting Mortgage Securitization Risk under Systematic Risk and Parameter Uncertainty

Abstract

The Global Financial Crisis exposed financial institutions to severe unexpected losses in relation to mortgage securitizations and derivatives. This paper analyzes a unique and extensive ratings and impairment events database for securitizations. The paperfinds that risk models such as ratings are exposed to a large degree of systematic risk and parameter uncertainty. An out-of-sample forecasting exercise of the financial crisis shows that a simple approach addressing both issues is able to produce ranges for risk measures consistent with realized losses. This explains how financial markets were taken by surprise in relation to realized losses.

Keywords: Economic Capital, Global Financial Crisis, Home Equity Loan Security, Mortgage-backed Security, Parameter Uncertainty, Rating, Securitization, Systematic Risk, Value-at-Risk

JEL Classification: G20, G28, C51