Extreme portfolio loss correlations in credit risk

• Published in: Risks (Basel) Vol. 6; no. 3; pp. 1 - 25
• Main Authors: Mühlbacher, Andreas, Guhr, Thomas
• Format: Journal Article
• Language: English
• Published: Basel MDPI 01.09.2018; MDPI AG
• Subjects: collateralized debt obligations; Corporate debt; Credit risk; Diversification; Economic models; non-stationarity; portfolio credit risk; portfolio loss correlation; Portfolio management; Probability distribution; State court decisions; Stock exchanges; systemic risk; Germany
• ISSN: 2227-9091; 2227-9091
• DOI: 10.3390/risks6030072

The stability of the financial system is associated with systemic risk factors such as the concurrent default of numerous small obligors. Hence, it is of utmost importance to study the mutual dependence of losses for different creditors in the case of large, overlapping credit portfolios. We analytically calculate the multivariate joint loss distribution of several credit portfolios on a non-stationary market. To take fluctuating asset correlations into account, we use an random matrix approach which preserves, as a much appreciated side effect, analytical tractability and drastically reduces the number of parameters. We show that, for two disjoint credit portfolios, diversification does not work in a correlated market. Additionally, we find large concurrent portfolio losses to be rather likely. We show that significant correlations of the losses emerge not only for large portfolios with thousands of credit contracts, but also for small portfolios consisting of a few credit contracts only. Furthermore, we include subordination levels, which were established in collateralized debt obligations to protect the more senior tranches from high losses. We analytically corroborate the observation that an extreme loss of the subordinated creditor is likely to also yield a large loss of the senior creditor.