Technical Note - Introducing the Loan Pool Specific Factor in CreditManager - March 2014

Mar 7, 2014

In the CreditMetrics framework, the value of a pool of loans at the risk horizon is determined by the state of its driving market factors and the idiosyncratic factors of the individual loans.  However, if the loan pool consists of hundreds of loans, most of the risk from idiosyncratic factors is diversified away, leaving the horizon values driven mostly by market factors.  While this behavior is intuitive for standalone pools, it has an undesirable side effect for portfolios containing multiple large loan pools, which differ in some systematic dimension, but remain mapped to the same market factor. In this Technical Note, we present an enhancement to the Loan Pool and Mortgage Pool models in CreditManager that allows users to decorrelate the horizon values of distinct pools driven by the same market factor. We also introduce a Loan Pool Specific Factor that applies only to a single pool of assets and is not correlated to any market factor.