Mortgages: estimating default correlation and forecasting default risk

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 09 February 2018

Working paper No. 708
By Tobias Neumann

Default correlation is a key driver of credit risk. In the Basel regulatory framework it is measured by the asset value correlation parameter. Though past studies suggest that the parameter is over-calibrated for mortgages — generally the largest asset class on banks’ balance sheets — they do not take into account bias arising from small samples or non-Gaussian risk factors. Adjusting for these biases using a non-Gaussian, non-linear state space model I find that the Basel calibration is appropriate for UK and US mortgages. This model also forecasts mortgage default rates accurately and parsimoniously. The model generates value-at-risk estimates for future mortgage default rates, which can be used to inform stress-testing and macroprudential policy.

PDFWorking paper No. 708

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