Eric Hillebrand (Department of Economics, Louisiana State University)

Tittle: TEMPORAL CORRELATION OF DEFAULTS IN SUBPRIME SECURITIZATION 

Abstract: The securitization of subprime mortgages in instruments like mortgage-backed securities and collateralized debt obligations is one of the key ingredients to the current financial crisis. During 2007 and 2008, subprime defaults increased sharply, displaying high serial correlation in their arrival. Subprime default events depend on house price changes. We establish a link between the dynamics of house price changes and the dynamics of default rates in the Gaussian copula framework by specifying a time series model for a common risk factor. We show analytically and in simulations that serial correlation translates from the common risk factor to correlation of default rates across vintages of mortgage pools. We simulate prices of mortgage-backed securities, which are securitized from pools of mortgages using a waterfall structure. We find that subsequent vintages of these securities inherit default correlation from the common risk factor. The findings in this paper imply that one can model correlated default arrivals by introducing serial correlation to the common risk factor.

Joint work with Ambar N. Sengupta and Pierre Xu.