What Is a Default Model?
Default model is constructed by financial institutions to determine the likelihood of a default on credit obligations by a corporation or sovereign entity. These statistical models often use regression analysis with certain market variables that are pertinent to a company's financial situation to identify the nature and scope of credit risk. Internally, a lender runs default models on loan exposure to their customers to determine risk limits, pricing, tenor and other terms. Credit agencies calculate probabilities of default with the models in order to assign credit ratings.
Understanding a Default Model
Before a bank or other lending institution extends substantial credit to a customer, it will set up a default model to run all the relevant numbers to calculate potential loss exposure. The relationships between dependent and independent variables will be established, and with the input of varying sets of assumptions into the model, an output of default probabilities (under sensitivity analysis) will be produced. Thus, a default model is essential for a standard loan, but it is also critical in quantifying risk for more sophisticated products like credit default swaps (CDS). For a CDS the buyer and seller would run their own default models on an underlying credit to determine the terms of the transaction.
The bread-and-butter business of credit agencies such as Moody's and Standard & Poor's is developing sophisticated default models. The goal of these models is to designate credit ratings that are standard in most cases for bond (or other credit-linked product) issuance into the public markets. The entities for which a default model is established can be corporations, municipalities, countries, government agencies and special purpose vehicles. In all cases, the model will estimate the probabilities of default under various scenarios. However, other types of default models are used to predict a creditor's exposure-at-default and loss-given-default. Theoretically, appropriate pricing of credit is made possible with default models, whether they are internally-generated or created by a credit agency.
CDO Default Models Prior to the Financial Crisis
The credit agencies were blamed for being partly responsible for the 2008 financial crisis because they gave triple-A ratings to hundreds of billions of dollars worth of collateralized debt obligations (CDO) packed with subprime loans. Their models predicted extremely low probabilities of default. With the stamp of approval of high credit ratings, CDOs were prostituted out around the markets by Wall Street. What happened to those CDOs is well known. One can only hope that credit agencies have made the necessary adjustments to their default models to avoid future mishaps.