Frailty Correlated Default

by Darrell Duffie of Stanford University,
Andreas Eckner of the Bank of America,
Guillaume Horel of the Bank of America, and
Leandro Saita of Barclays Capital

October 2009

Abstract: The probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and collateralized debt obligation (CDO) default losses are typically measured for economic capital and rating purposes, conventionally based loss estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms between 1979 and 2004.We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm-by-firm default probabilities.

JEL Classification: C11, C15, C41, E44, G33.

Keywords: correlated default, doubly stochastic, frailty, latent factor, default clustering.

Published in: Journal of Finance, Vol. 64, No. 5, (October 2009), pp. 2089-2123.

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