The impact of macroeconomic scenarios on recurrent delinquency: A stress testing framework of multi-state models for mortgages

Abstract

Transition probabilities between delinquency states play a key role in determining the risk profile of a lending portfolio. Stress testing and IFRS9 are topics widely discussed by academics and practitioners. In this paper, we combine dynamic multi-state models and macroeconomic scenarios to estimate a stress testing model that forecasts delinquency states and transition probabilities at the borrower level for a mortgage portfolio. For the first time, a delinquency multi-state model is estimated for residential mortgages. We explicitly analyse and control for repeated events, an aspect previously not considered in credit risk multi-state models. Furthermore, we enhance the existing methodology by estimating scenario-specific forecasts beyond the lag of time-dependent covariates. We find that the number of previous transitions have a significant impact on the level of the transition probabilities, that severe economic conditions affect younger vintages the most, and that the relative impact of the stress scenario differs by attributes observed at origination.