TY - CHAP
T1 - Mortgage Portfolio Diversification in the Presence of Cross-Sectional and Spatial Dependence
AU - Dombrowski, Timothy
AU - Pace, R. Kelley
AU - Narayanan, Rajesh P.
N1 - To read the full version of this content please select one of the options below: a Department of Finance, Louisiana State University, USA b Endowed Chair of Real Estate Department of Finance, Louisiana State University, USA c E.
PY - 2020/4/15
Y1 - 2020/4/15
N2 - Portfolios of mortgage loans played an important role in the Great Recession and continue to compose a material part of bank assets. This chapter investigates how cross-sectional dependence in the underlying properties flows through to the loan returns, and thus, the risk of the portfolio. At one extreme, a portfolio of foreclosed mortgage loans becomes a portfolio of real estate whose returns exhibit substantial cross-sectional and spatial dependence. Near the other extreme, almost all loans perform and yield constant returns, which do not correlate with other performing loan returns. This suggests that loan performance effectively censors the random returns of the underlying properties. Following the statistical properties of the correlations among censored variables, the authors build off this foundation and show how the loan return correlations will rise as economic conditions deteriorate and the defaulting loans reveal the underlying housing correlations. In this chapter, the authors (1) adapt tools from spatial statistics to document substantial cross-sectional dependence across house price returns and examine the spatial structure of this dependence, (2) investigate the nonlinear nature of correlations among loan returns as a function of the default rate and the underlying house price correlations, and (3) conduct a simulation exercise using parameters from the empirical data to show the implications for holding a portfolio of mortgages.
AB - Portfolios of mortgage loans played an important role in the Great Recession and continue to compose a material part of bank assets. This chapter investigates how cross-sectional dependence in the underlying properties flows through to the loan returns, and thus, the risk of the portfolio. At one extreme, a portfolio of foreclosed mortgage loans becomes a portfolio of real estate whose returns exhibit substantial cross-sectional and spatial dependence. Near the other extreme, almost all loans perform and yield constant returns, which do not correlate with other performing loan returns. This suggests that loan performance effectively censors the random returns of the underlying properties. Following the statistical properties of the correlations among censored variables, the authors build off this foundation and show how the loan return correlations will rise as economic conditions deteriorate and the defaulting loans reveal the underlying housing correlations. In this chapter, the authors (1) adapt tools from spatial statistics to document substantial cross-sectional dependence across house price returns and examine the spatial structure of this dependence, (2) investigate the nonlinear nature of correlations among loan returns as a function of the default rate and the underlying house price correlations, and (3) conduct a simulation exercise using parameters from the empirical data to show the implications for holding a portfolio of mortgages.
KW - Censored variables
KW - Cross-sectional dependence
KW - Mortgage markets
KW - Portfolio diversification
KW - Spatial dependence
KW - Variogram
UR - https://www.emerald.com/insight/content/doi/10.1108/S0731-905320200000041014/full/html
U2 - 10.1108/S0731-905320200000041014
DO - 10.1108/S0731-905320200000041014
M3 - Chapter
BT - Essays in Honor of Cheng Hsiao (Advances in Econometrics, Vol. 41),
ER -