Collateral Risk in Residential Mortgage Defaults |
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Authors: | Tyler T Yang Che-Chun Lin Man Cho |
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Institution: | (1) IFE Group, 51 Monroe Street, Suite 801, Rockville, MD 20850, USA;(2) National Tsing Hua University, 101, Sec. 2, Kuang-Fu Road, Hsin-Chu, 30013, Taiwan, Republic of China;(3) The KDI School of Public Policy and Management, P.O.Box 184, Cheong-Nyang, Seoul, 130-868, Korea |
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Abstract: | This paper presents a systematic framework for capturing the collateral-driven mortgage default risk. A forward-looking home
price distribution model is developed that explicitly incorporates different sources of volatility in the market value of
collateral houses. A consistent and computationally-efficient top-down approach of home price simulation is also introduced.
We show that with the proper inclusion of all relevant sources of volatilities, the top-down approach provides close approximation
to the results generated by a theoretically sound but computationally demanding bottom-up simulation approach. Using a numerical
simulation, we demonstrate that a geographically-diversified mortgage pool entails a substantially lower level of systematic
collateral driven mortgage default risk compared to a spatially-concentrated pool. However, the expected default risk is shown
to remain unaffected, indicating that the benefit from geographic diversification is only realized through lower risk-based
capital requirements, not in lower mortgage insurance premiums. Based on the US state level house price indices, the systematic
risk of a state-concentrated mortgage pool is estimated to be about four times higher than that of a nationally-diversified
mortgage pool. Our results also show that, among the different volatility components, omitting the cross-sectional dispersion
of individual home prices would produce the largest bias in assessing home-price-based mortgage default risk. |
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