Differential default risk among traditional and non-traditional mortgage products and capital adequacy standards

Che-Chun Lin, Larry J. Prather, Ting-Heng Chu and Jing-Tang Tsay

International Review of Financial Analysis, 2013, vol. 27, issue C, 115-122

Abstract: We develop a framework to quantify credit risks of non-traditional mortgage products (NMPs). Ex ante probabilities of default are caused by willingness-to-pay and ability-to-pay problems and the high default rates for NMPs confirm that payment shock is a critical default risk indicator. Monte Carlo simulations are conducted using three correlated stochastic variables (mortgage interest rate, home price, and household income) under normal and stressed economies. Results confirm that the default risk of 2/28 and option ARM contracts requiring a minimum monthly interest payment have a greater probability of default than other mortgage products in all economic scenarios. Additionally, the credit risk of NMPs is primarily systematic risk, suggesting that these products should require higher risk-based capital. Due to the non-linear distribution of credit risk, even the advanced internal-based rating approach of the Basle II framework can understate the risk involved in these NMPs.

Keywords: Payment shock; Credit risk; Default option; Systematic risk; Risk-based capital (search for similar items in EconPapers)
JEL-codes: G17 G21 G32 (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:27:y:2013:i:c:p:115-122

DOI: 10.1016/j.irfa.2012.11.005

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