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A transitions-based framework for estimating expected credit losses

Author

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  • Gaffney, Edward

    (Central Bank of Ireland)

  • Kelly, Robert

    (Central Bank of Ireland)

  • McCann, Fergal

    (Central Bank of Ireland)

Abstract

This paper presents a framework for estimating losses for residential mortgage loans.At the core is a transitions-based probability of default model which yields directly observ- able cash-fl ows at the loan level. The estimated model includes coefficients on unemployment, Loan to Value ratio and interest rates, all of which allow a macroeconomic scenario to be fed through the model and impact loans' probability of default and cure. Other loan-level covariates such as bank, Buy-to-Let status, and vintage also impact loans' transition probabilities. Loss Given Default is also modelled over a three-year horizon combining loan-level collateral information with macroeconomic house price forecasts. The breakout of ows from the stock of defaults allows the impact of loan modi cations on recovery rates to be modelled. Unlike other models of mortgage credit risk, this framework allows a hysteresis e ect of the time spent in default on the probability of loan cure to be modelled explicitly. In Ireland, an increase in the time spent in default from three months to one year leads to a decrease in the probability of loan cure from 30 to 12 per cent.

Suggested Citation

  • Gaffney, Edward & Kelly, Robert & McCann, Fergal, 2014. "A transitions-based framework for estimating expected credit losses," Research Technical Papers 16/RT/14, Central Bank of Ireland.
    • Handle: RePEc:cbi:wpaper:16/rt/14
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    References listed on IDEAS

    as
    1. Betancourt, Luis, 1999. "Using Markov Chains to Estimate Losses from a Portfolio of Mortgages," Review of Quantitative Finance and Accounting, Springer, vol. 12(3), pages 303-317, May.
    2. Kelly, Robert & O’Malley, Terence, 2016. "The good, the bad and the impaired: A credit risk model of the Irish mortgage market," Journal of Financial Stability, Elsevier, vol. 22(C), pages 1-9.
    3. Robert A. Jarrow & David Lando & Stuart M. Turnbull, 2008. "A Markov Model for the Term Structure of Credit Risk Spreads," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 18, pages 411-453, World Scientific Publishing Co. Pte. Ltd..
    4. Jackson, Christopher, 2011. "Multi-State Models for Panel Data: The msm Package for R," Journal of Statistical Software, Foundation for Open Access Statistics, vol. 38(i08).
    5. McCann, Fergal, 2014. "Modelling default transitions in the UK mortgage market," Research Technical Papers 18/RT/14, Central Bank of Ireland.
    6. Scott D. Grimshaw & William P. Alexander, 2011. "Markov chain models for delinquency: Transition matrix estimation and forecasting," Applied Stochastic Models in Business and Industry, John Wiley & Sons, vol. 27(3), pages 267-279, May.
    7. Lando, David & Skodeberg, Torben M., 2002. "Analyzing rating transitions and rating drift with continuous observations," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 423-444, March.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Vilislav Boutchaktchiev, 2018. "A Markov Chain Model for the Cure Rate of Non-Performing Loans," Papers 1805.11804, arXiv.org, revised Jun 2018.
    2. Kelly, Robert & O'Malley, Terence & O'Toole, Conor, 2015. "Designing Macro-prudential Policy in Mortgage Lending: Do First Time Buyers Default Less?," Research Technical Papers 02/RT/15, Central Bank of Ireland.
    3. Kelly, Robert & O'Toole, Conor, 2016. "Lending Conditions and Loan Default: What Can We Learn From UK Buy-to-Let Loans?," Research Technical Papers 04/RT/16, Central Bank of Ireland.
    4. Gaffney, Edward & Kelly, Robert & McCann, Fergal & Lyons, Paul, 2014. "Loan loss forecasting: a methodological overview," Economic Letters 13/EL/14, Central Bank of Ireland.
    5. Viral V. Acharya & Katharina Bergant & Matteo Crosignani & Tim Eisert & Fergal Mccann, 2022. "The Anatomy of the Transmission of Macroprudential Policies," Journal of Finance, American Finance Association, vol. 77(5), pages 2533-2575, October.
    6. International Monetary Fund, 2016. "Ireland: Financial Sector Assessment Program: Technical Note-Macroprudential Policy Framework," IMF Staff Country Reports 2016/316, International Monetary Fund.
    7. Slaymaker, Rachel & O'Toole, Conor & McQuinn, Kieran & Fahy, Mike, 2018. "Monetary policy normalisation and mortgage arrears in a recovering economy: The case of the Irish residential market," Papers WP613, Economic and Social Research Institute (ESRI).
    8. Morell, Joe & Rice, Jonathan & Shaw, Frances, 2022. "A Framework for Macroprudential Stress Testing," Research Technical Papers 7/RT/22, Central Bank of Ireland.
    9. Gaffney, Edward & McCann, Fergal, 2019. "The cyclicality in SICR: mortgage modelling under IFRS 9," ESRB Working Paper Series 92, European Systemic Risk Board.
    10. Barasinska, Nataliya & Haenle, Philipp & Koban, Anne & Schmidt, Alexander, 2019. "Stress testing the German mortgage market," Discussion Papers 17/2019, Deutsche Bundesbank.
    11. Siemsen, Thomas & Vilsmeier, Johannes, 2017. "A stress test framework for the German residential mortgage market: Methodology and application," Discussion Papers 37/2017, Deutsche Bundesbank.
    12. McCann, Fergal, 2014. "Modelling default transitions in the UK mortgage market," Research Technical Papers 18/RT/14, Central Bank of Ireland.
    13. Gaffney, Edward & McCann, Fergal, 2018. "The cyclicality in SICR: mortgage modelling under IFRS 9," Research Technical Papers 16/RT/18, Central Bank of Ireland.
    14. Joyce, John & McCann, Fergal, 2016. "Model-based estimates of the resilience of mortgages at origination," Economic Letters 09/EL/16, Central Bank of Ireland.
    15. Kelly, Robert & O’Toole, Conor, 2018. "Mortgage default, lending conditions and macroprudential policy: Loan-level evidence from UK buy-to-lets," Journal of Financial Stability, Elsevier, vol. 36(C), pages 322-335.
    16. International Monetary Fund, 2016. "Ireland: Financial Sector Assessment Program: Technical Note-Nonbank Sector Stability Analyses," IMF Staff Country Reports 2016/317, International Monetary Fund.
    17. Kelly, Jane & Mazza, Elena, 2019. "Mortgage servicing burdens and LTI caps," Financial Stability Notes 13/FS/19, Central Bank of Ireland.

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    Keywords

    Mortgages; default; credit risk; Markov multi-state model.;
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