Extreme portfolio loss correlations in credit risk

TL;DR

This paper analytically investigates the joint loss distribution of multiple credit portfolios under correlated market conditions, revealing that diversification fails in correlated markets and large concurrent losses are likely, especially with subordination effects.

Contribution

It introduces an analytical framework using a random matrix approach to model non-stationary, correlated credit portfolio losses, including subordination levels, with reduced parameters and high tractability.

Findings

Diversification fails in correlated markets leading to large concurrent losses.

Large portfolios and small portfolios both exhibit significant loss correlations.

Subordination levels influence the likelihood of simultaneous losses across different creditor tiers.

Abstract

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.