Research Discussion Papers, Bank of Finland
Effects of unobserved defaults on correlation between probability of default and loss given default on mortgage loans
Abstract: This paper demonstrates how the observed correlation
between probability of default and loss given default depends on the fact
that defaults in which collateral provides 100% recovery are not observed.
Creditors see only the defaults of mortgagors who suffer from a fall in
collateral value to less than the remaining loan principal. Consequently,
the default data available to creditors amounts to a mere truncated sample
from the underlying population of defaults. Correlation estimates based on
such truncated samples are biased and differ substantially from estimates
derived from representative non-truncated samples. Moreover, the observed
correlation between default probability and loss given default is sensitive
to the truncation point, which may explain the differences in correlation
estimates found in the literature. This may also explain why correlation
estimates seem to be specific to cycle phase.
Keywords: credit risks; mortgage loans; truncated distributions; sample selection; log-normal distribution; (follow links to similar papers)
JEL-Codes: C46; E32; G21; G28; (follow links to similar papers)
28 pages, January 21, 2009
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