Credit Risk Modelling Under Recessionary and Financial Distressed Conditions

Abstract

This paper provides clear cut evidence that recessionary and financial distressed conditions, as well as banning foreclosure laws, often introduced by governments to mitigate the effects of the economic and/or financial distressed conditions on mortgage loans, have adverse effects on the loan default probability. We argue that this may be attributed to long-term persistency of the above conditions, which can cause abrupt shifts in the probability of default of a loan. Our estimates indicate that these policies may also raise moral hazard incentives that borrowers will not maintain their payments in long run, even for loans with low LTV. Under these conditions, efforts of banks to restructure (or refinance) mortgage loans may not successfully affect future default probabilities. Our evidence is based on an extension of the discrete-time survival analysis model which allows for a structural break in its hazard rate function due to abrupt changes to exogenous events, like changes in political conditions. It is also robust to alternative specifications of the binary link function between default events and covariates. Asymmetric link functions are found to be more appropriate under financial distressed conditions. ABSTRACT FROM AUTHOR]

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