Using Markov Chains to Estimate Losses from a Portfolio of Mortgages

Using Markov Chains to Estimate Losses from a Portfolio of Mortgages Under Statement of Financial Accounting Standards Number Five, Accounting for Contingencies (SFAS 5), financial institutions record a provision for loan losses and establish loan loss reserves when impairment of a loan is probable and the loss can be reasonably estimated. Increasingly, Markov chain models are being used to estimate these losses. This paper develops and test the suitability and forecast accuracy of alternate Markov chain models of mortgage payment behavior using transition data from the Federal Home Loan Mortgage Corporation (Freddie Mac). In developing the models, the Freddie Mac transition data is examined to see if it satisfies the Markovian assumptions of stationary transition probabilities and homogenous payment behavior. The data examined in this paper did not satisfy these assumptions. With respect to accuracy in forecasting loan losses, the Markov chain approach, when incorporating recent information on transition probabilities, performed better than a random-walk model of loan losses. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Using Markov Chains to Estimate Losses from a Portfolio of Mortgages

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Publisher
Kluwer Academic Publishers
Copyright
Copyright © 1999 by 1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Subject
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1023/A:1008331016892
Publisher site
See Article on Publisher Site

Abstract

Under Statement of Financial Accounting Standards Number Five, Accounting for Contingencies (SFAS 5), financial institutions record a provision for loan losses and establish loan loss reserves when impairment of a loan is probable and the loss can be reasonably estimated. Increasingly, Markov chain models are being used to estimate these losses. This paper develops and test the suitability and forecast accuracy of alternate Markov chain models of mortgage payment behavior using transition data from the Federal Home Loan Mortgage Corporation (Freddie Mac). In developing the models, the Freddie Mac transition data is examined to see if it satisfies the Markovian assumptions of stationary transition probabilities and homogenous payment behavior. The data examined in this paper did not satisfy these assumptions. With respect to accuracy in forecasting loan losses, the Markov chain approach, when incorporating recent information on transition probabilities, performed better than a random-walk model of loan losses.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Oct 15, 2004

References

  • A Simple Check for the Time Homogeneity of Markov Chains
    Mattsson, A.; Thorburn, D.
  • Small Sample Properties of Quarterly Forecast Errors
    Sankaran, S.

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