a portfolio view of consumer credit - finance department.pdf

* A Portfolio View of Consumer Credit David K. Musto Nicholas S. Souleles Finance Department Finance Department The Wharton School The Wharton School University of Pennsylvania University of Pennsylvania and NBER September, 2005 Abstract This paper takes a portfolio view of consumer credit. Default models (credit-risk scores) estimate the probability of default of individual loans. But to compute risk-adjusted returns, lenders also need to know the covariances of the returns on their loans with aggregate returns. Covariances are independently relevant for lenders who care directly about the volatility of their portfolios, e.g. because of Value-at-Risk considerations or the structure of the securitization market. Cross-sectional differences in these covariances also provide insight into the nature of the shocks hitting different types of consumers. We use a unique panel dataset of credit bureau records to measure the ‘covariance risk’ of individual consumers, i.e., the covariance of their default risk with aggregate consumer default rates, and more generally to analyze the cross-sectional distribution of credit, including the effects of credit scores. We obtain two key sets of results. First, there is significant systematic heterogeneity in covariance risk across consumers with different characteristics. Consumers with high covariance risk tend to also have low credit scores (high default probabilities). Second