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T wo parameters determine a mortgage's credit risk: probability of default and loss severity given default. Although there is a growing body of research relevant to the modeling and estimation of mortgage default, there are few studies on loss severity (i.e., the percentage lost in the event of default) as a result of limited data. New data released by Freddie Mac, however, offer analysts the ability to assess mortgage loans made over 13 years for their loss severity. This robust database of more than 17 million loans, categorized by state, offers a range of new and useful insights into the ultimate financial losses associated with a loan after it experiences a credit event. The addition of loan performance information beyond the credit event is a new and welcome addition to the single-family loan level dataset.
In this article, we review loans experiencing four distinct credit events and, for the first time, track what happens to the loans. For loans that liquidate, we determine the loss severity as measured by the percentage of unpaid principal balance lost at the time of default. This analysis allows us to assess both the value of mortgage insurance (MI) and the accuracy of the preset severities used in Freddie Mac's risk-sharing deals. We find that MI significantly lowers the severities. We also find that the preset severity schedule is reasonable for loans with a loan-to-value (LTV) ratio of 60-80 but is too high for deals backed by higher-LTV loans.
We also analyze severity by loan size, state, and type of liquidation. We find that small loans have higher loss severity than larger ones, that real-estate-owned (REO) sales have higher severity than short sales, and that there is no stable relationship between the state of origination and severity. Finally, we review the components of loss--liquidation value and expenses--and find that the latter contributes significantly to the ultimate loss.
WHAT DO THE NEW DATA INCLUDE?
Historically, data allowed market participants to track loans only through the advent of a credit event. Government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae define a credit event as a loan being 180 days delinquent or being liquidated through a deed-in-lieu, short sale, foreclosure sale, or REO before the 180-day delinquency point. Once a loan experienced...