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| Frailty Correlated Default by Darrell Duffie of Stanford University, February 18, 2008 Abstract: This paper shows that 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 CDO default losses are typically measured for economic-capital and rating purposes, our empirical results indicate that conventionally based estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public non-financial firms existing 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. Books Referenced in this Paper: (what is this?)
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