Forecast Default Rates for

Real Estate Loans in a

Changing Environment
Presented by Chifei Juang, HSBC
For 2007 SAS Data Mining Conference

HSBC Overview
• Headquartered in London
• One of largest financial services
organizations in the world
• $215B market capitalization on 6/30/07
• Operates in 83 countries w/ 10,000+ offices
• Businesses in Europe, the Asia-Pacific
region, the Americas, the Middle East and
Africa

1
HSBC Finance Corp Consumer &
Mortgage Lending
• Headquartered in Prospect Heights, Illinois
• Serve subprime and near prime borrowers in
the U.S
• Over 1,300 consumer lending retail
branches in 46 states
• $90B+ mortgage loans on 6/30/07

Forecasting Challenge

Given one percent mortgage default can

have a significant impact on profit, how do
we accurately forecast the default in a
changing market environment?

2
Real Estate Market Overview
• Increase in non-conventional loans in last
two to three years (Interest only, ARM,
piggyback, etc.)
• Fed fund rates increased from 4.29% to
5.25% between Jan 06 to Jun 06
• Slow down in home price appreciation or
depreciation in many markets
• Default rate increased for publicly traded
companies

Factors to consider when forecasting

in a stable environment
• Customer’s credit or vintage quality
• loan size to property value
• Product mix (e.g., 1st vs. 2nd lien; fixed vs.
ARM, etc.)
• Month on book
• Liquidation
• Restructure
• Recovery

3
Additional factors to consider when
forecasting in a changing environment
• Home price appreciation/depreciation
• Geographical difference
• Historical volatility in home price
• ARM resets
• First time home buyers
• Investors
• Unemployment rate
• Interest rate

Hypothetical Example 1:
A company booked accounts only in Jan 04, 05
and 06. What is the default rate for each
vintage in 2007?
Default rates
2004 2005 2006 2007
Jan-04 2% 4% 6% ?
Jan-05 3% 6% ?
Jan-06 5% ?

4
 A forecast:
Default rates
2004 2005 2006 2007
Jan-04 2% 4% 6% 8%
Jan-05 3% 6% 9%
Jan-06 5% 10%
What are the assumptions?

Under what circumstances, are these

assumptions reasonable?

Hypothetical Example 2:
What is the default rate for each vintage in 2007?

Default rates
2004 2005 2006 2007
Jan-04 2% 4% 6% ?
Jan-05 4% 12% ?
Jan-06 5% ?

5
 Is this forecast reasonable:
Default rates
2004 2005 2006 2007
Jan-04 2% 4% 6% 8%
Jan-05 4% 12% 18%
Jan-06 5% 10%

How about this? 15%

Now, how about this?

Default rates
2004 2005 2006 2007
Jan-04 2% 4% 6% 6%
Jan-05 4% 12% 12%
Jan-06 5% 5%

What are the assumptions?

Under what circumstances, are these

assumptions reasonable?

6
 Hypothetical Example 3:
Similar to example 1, but Jan 04 and 05 vintages
paid off much faster than Jan 05

Default rates
2004 2005 2006 2007
Jan-04 2% 4% 6% ?
Jan-05 3% 6% ?
Jan-06 5% ?

A forecast:
Default rates
2004 2005 2006 2007
Jan-04 2% 4% 6% 8%
Jan-05 3% 6% 9%
Jan-06 5% 10%

How about this? 15%

7
 Changing two dimensions can
make forecasting complicated

What if you have 10-15 factors to

consider?

Hypothetical Example 4:
Similar to example 3, but Jan 04 and 06 vintages are
fixed rate product while that for Jan 05 is ARM that
will reset in Jan 2007

Default rates
2004 2005 2006 2007
Jan-04 2% 4% 6% ?
Jan-05 3% 6% ?
Jan-06 5% ?

8
 Validating future home price data

• geographical coverage
• # MSAs, existing or all homes
• forecasting horizon
• Monthly, quarterly, or yearly
• accuracy
• downturn and upside capture

Which data to choose?

A mock-up example:
Future 1 Future 2 Historical
Time Monthly for 2 years Monthly for last
horizon next 2 years from now 10 years
A validation Medium Low High accuracy
accuracy accuracy
Not capture Capture Not capture
down-turn down-turn down-turn
Price High Low Almost free

9
Incorporating home price impact
High level overlay
• National vs. geographical
Building models
• Portfolio vs. vintage
• Point in time vs. sequential
• Modeling default directly or through
drivers (delinquency, LTV, etc.)

Trade-offs in incorporating impact

Options depend on
• Accuracy
• modeling simplicity
• Ease of communication
• Ease of implementation
• Ease of update

10
Final thoughts
• All models are wrong; some are useful
• Forecasting and modeling are more arts
than science
• If a trend is impactful, any reasonable
method should give you reasonable
estimate
• Focus on goal and audience, don’t let the
intellectual curiosity derail your effort

11