Co-Movement of State’s Mortgage Default Rates: A Dynamic Factor Analysis Approach

Abstract

Underestimated default correlations of the underlying assets of Collateralized Debt Obligation (CDO) products have been partially blamed for the initial inaccurate ratings. Given the increasingly reliant on mortgage related assets in CDO products, a way to test the underestimation default correlation theory is to estimate how mortgage loan defaults have co-moved across states over time. In this paper, we use a dynamic factor model to estimate the co-movement of mortgage loan default rates across states. The results show that with only one latent factor about 62% of the variation in the states mortgage default rates could be explained when the full sample, 1979 to 2010, is used. However, limiting the sample from 1979 to 2003, the factor explains only 28% of the default variation. There was not much co-movement until the beginning of the 1st quarter of 2007 to 2009. This implies that the initial assigned default correlations were perhaps not inaccurate. An examined relationship between the latent factor and some national variables show a positive correlation between the factor and the St. Louis Fed’s Financial Stress Index, and a negative correlation for percentage change in GDP, Retail and Food Services Sales and Consumer sentiments. The factor seems to be a leading indicator for Retail and Food Sales and the percentage change in the GDP.