Consulting Corner

Modeling Mortgage Risk: Definitional Issues
by Kyle G. Lundstedt, Ph.D.

1. Introduction

In the February issue of The Pipeline, we provided a general overview of the issues involved in loan level modeling of both major components of mortgage risk – prepayment and default. We discussed the non-agency mortgage market and outlined a brief history of the analytical frameworks used to capture these risks, including competing risks hazard models.

In this issue of The Pipeline, we begin our discussion of the AD&Co methodology for loan level modeling of mortgage risk by starting with some important definitional issues. In order to successfully build models of mortgage risk that capture prepayment, delinquency and default behavior, we must decide upon common, generally accepted definitions for each of these behaviors. This article discusses the two standards for measuring mortgage delinquency. We then offer up two definitions of default, based upon various levels of delinquency. Finally, we discuss the implications that our default definitions have for a loan-level definition of prepayment.

2. Definitions of Delinquency

Delinquency is a mandatory precursor to an event of default and plays an important role in the definition of default. From the primary market perspective, for example, delinquency status on previous mortgages helps shape the “paper grade” of subprime mortgages. For secondary market investors, delinquency status determines “trigger” values that determine cash flows to subordinate bonds. Also, a prepayment event occurring while in a delinquency state obviously may have different motivations than prepayment on a current loan. Therefore, our first task is to clearly understand the standards for measuring delinquency.

 

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