Business cycle fluctuations and macro economic information have been given second order importance
Future house prices should be a key driver in a PD model
Falling prices and unemployment have dramatic impact
Traditional credit risk models are good at comparing clients, but not so good at determining the likelihood that either or both will defaults
Including aggregate data in individual regression leafs to biased and inconsistent estimates of the impact of the macro factors
Unemployment will not touch all individuals and you need a way to spread the pain
Just sticking macro factors in PD models is the wrong approach to modelling and forecasting their likely future impact
Best way to account for external macro factors is to model the future path of aggregate default statistics by tying them to macroeconomic and portfolio level information of a matching level off aggregation. Then benchmark to forecast aggregates.
A model that assumes constant elasticities of slopes across the business cycle is likely to incorrectly determine the PD for certain groups under changing economic conditions
Assuming participants manage their operations competently, management action should be incorporated into the models used to conduct stress testing
Strong incentive to outsource stress testing activities of a lender and that incentive is negatively associated with the size of the institution
Source of errors:
Naïve purely statistical or historical view of what constitutes stress
Non economist view with taking into account the interrelationship between variables
Simply replicate past events. Past superlatives like the oil crash of 1973 are not realistic anymore. he external shock needed to generate theses types of outcomes today will have to be of comet strike severity
Greatest current threat (2007) for mortgages is the outbreak of inflation.
