Decomposing the Smile: Systematic Credit Risk in Mortgage Portfolios

48 Pages Posted: 24 May 2014 Last revised: 29 May 2014

See all articles by Yongwoong Lee

Yongwoong Lee

Department of International Finance, Hankuk University of Foreign Studies

Daniel Roesch

University of Regensburg

Harald (Harry) Scheule

University of Technology Sydney (UTS) - School of Finance and Economics; Financial Research Network

Date Written: March 7, 2014

Abstract

This study analyzes systematic and non-systematic credit risk in mortgage portfolios given US loan-level information by controlling for time-varying observable information in relation to the borrower, the collateral and the macro economy. The total risk in relation to rating class default rates is decomposed into systematic and class-specific non-systematic risk by a state space model. The paper finds that the total risk relates to credit quality in a smile-shaped pattern: systematic risk is negatively related and non systematic risk is positively related to average default rate levels. In addition, total risk increases during and after the Global Financial Crisis. The impact of the crisis on systematic risk is persistent whereas the impact on non-systematic risk appears to be temporary. The analysis of regulatory capital suggests that mortgage risk models in conjunction with periodic updating warrant a sufficient level of regulatory capital given the current regime. These findings are relevant to prudential regulators who are currently discussing the implementation of a monotone relationship between default probabilities and asset correlations under Basel III.

Keywords: Asset correlation, Basel capital, Loss given default, Mortgage portfolio, Probability of default, State space model, Systematic risk.

JEL Classification: G20, G28, C51

Suggested Citation

Lee, Yongwoong and Roesch, Daniel and Scheule, Harald, Decomposing the Smile: Systematic Credit Risk in Mortgage Portfolios (March 7, 2014). CIFR Paper No. 012/2014, Available at SSRN: https://ssrn.com/abstract=2440961 or http://dx.doi.org/10.2139/ssrn.2440961

Yongwoong Lee (Contact Author)

Department of International Finance, Hankuk University of Foreign Studies ( email )

81 Oedae-ro, Mohyeon-myeon, Cheoin-gu
Yongin-si, Gyeonggi-do
Korea, Republic of (South Korea)

Daniel Roesch

University of Regensburg ( email )

Chair of Statistics and Risk Management
Faculty of Business, Economics and BIS
Regensburg, 93040
Germany

HOME PAGE: http://www-risk.ur.de/

Harald Scheule

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

P.O. Box 123
Broadway, NSW 2007
Australia

HOME PAGE: http://https://www.uts.edu.au/staff/harald.scheule

Financial Research Network ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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