An Analysis of the Limitations of Utilizing the Development Method for Projecting Mortgage Credit Losses and Recommended Enhancements

The rise and fall of subprime mortgage securitizations contributed in part to the ensuing credit crisis and financial crisis of 2008. Some participants in the subprime-mortgage-backed securities market relied at least in part on analyses grounded in the loss development factor (LDF) method, and many did not conduct their own credit analyses, relying instead on the work of others such as securities brokers and rating agencies. In some cases, the parties providing these analyses may have acked the independence, or at least the appearance of it, that would have likely better served the market.

A new appreciation for the value of independent analysis is clearly a silver lining and an important lesson to be taken from the crisis. Actuaries are well positioned to lend assistance to the endeavor.

Mortgages are long- duration assets and, similarly, mortgage credit losses are relatively long-tailed. As casualty actuaries are aware, the LDF method has inherent limitations associated with immature development. The authors in this paper will cite examples of parties relying on the LDF or similar methods for projecting subprime mortgage credit losses, highlight the limitations of relying exclusively on such methods for projecting subprime mortgage credit performance, and conclude by offering general enhancements for an improved approach that considers the underwriting characteristics of the underlying loans as well as economic factors.

Keywords: Mortgage, credit risk, cash flow modeling, credit crisis, cash flow modeling, independence