Published by sunandoroy on Thu, 2008-09-18 16:26 (first published in http://www.prmia.org)
There is a huge loss of confidence in the financial marketplace. Who would otherwise think that despite the massive US $ 85 billion bailout of AIG by the FED, the markets will continue to slide. The intervention is real, not talking the market up. The faith in the market is completely destroyed, at least for the time being, and the faith is the central bank has dented. The impact of US $ 180 billion is yet to be seen and one hopes that the Central Banks together can overpower this crisis of monster proportion. ( Hooray, the Dow is in the green as I write, so it may be that we still believe our central banks)
One silent casualty has been the Credit portfolio Model that churned out default probabilities and expected loss numbers. Quite clearly, the present group of credit portfolio models will be reassessed and one is hopeful that the soul searching will lead to better modeling in future in arriving at the economic capital.
Once we come out of the current state of the market, and start thinking about the nightmare with some poise ( hopefully, sooner than later)Models that depend upon PD, LGD, EAD and Default correlations will undergo a post mortem. Let’s think of a few issues that may come up with credit portfolio modeling.
First, the class of models need to pay more attention to the derivatives snd off balance sheet items that goes in the bucket of the unknown and the risk information destroyed in the process.
Second, the correlations in the credit portfolio models suffer from the generic problems of subjectivity in time horizon, in many cases such correlations are based not on a global dataset, but only on US data, which is far from ideal.
The normality assumption acts as another constraint, that needs to be thoroughly examined, with the need for backtesting capabilities for model validation process.
these constraints are no reason to throw the model away, but to strengthen it for future.
As Rene descates once observed, our reason need not be clouded by blind faith in black box models. The search for better method is as relevant today as it was in the early seventeenth century, when Descartes observed, in his own flowing language:
” observing many things which, however extravagant and ridiculous to our apprehension, are yet by common consent received and approved by other great nations,I learned to entertain too decided a belief in regard to nothing of the truth of which I had been persuaded merely by example and custom; and thus I gradually extricated myself from many errors powerful enough to darken our natural intelligence, and incapacitate us in great measure from listening to reason.”
References
Rene Descartes, Discourse on Method, 1628.
Leave a Reply