Stress testing retial loan portfolios with dual-time dynamics

Breeden, J.L., Thomas, L. and McDonald III, J. (2007) Stress testing retial loan portfolios with dual-time dynamics (Discussion Papers in Centre for Risk Research, CRR-07-15) Southampton. University of Southampton 19pp.

Abstract

Stress testing has become an important topic in retail lending since
the introduction of the new Basel II guidelines. The present work uses a
scenario-based forecasting approach developed explicitly for retail lending
in order to provide a suitable stress testing approach. We first decompose
the historical vintage performance data into a maturation function
of months-on-books, a quality function of vintage origination date, and
an exogenous function of calendar date. In a second step, the exogenous
function is modeled with macroeconomic data or factors representing portfolio
management impacts. Stress tests are performed by extrapolating
the exogenous function using externally provided scenarios for extreme
macroeconomic events. The resulting scenario is combined with the known
maturation and quality functions. This process is repeated for each of a
key set of rates, such as default rate, exposure at default, and loss given
default in the context of Basel II. These key rate forecasts are combined
to create total portfolio forecasts and stress tests.
This approach is demonstrated in an analysis of the US Mortgage
markets.

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