hard · Asset-Backed Securities collateral

An ABS modeler projects defaults on an amortizing loan pool using a constant default rate (CDR) applied to the outstanding balance, with a fixed loss-given-default (LGD) and a 12-month recovery lag. A reviewer notes the model applies the CDR to the *gross* outstanding balance each month — i.e., the balance *before* removing that month's defaults — then separately amortizes the survivors on the original schedule. Relative to the standard convention (CDR applied to the performing balance net of cumulative prior defaults, with defaulted loans removed from the amortization schedule), the modeler's approach will:

1. Overstate cumulative defaults early but understate them later in the deal's remaining life, leaving lifetime gross defaults unchanged because the two timing errors offset exactly over the full pool life.
2. Understate cumulative defaults, because applying the CDR to a gross balance that still contains already-defaulted loans effectively double-counts survivors and suppresses the per-period default dollar amount.
3. Overstate cumulative defaults, because the gross balance is larger than the performing balance, so each month's CDR is applied to too large a base and defaulted loans wrongly keep amortizing and re-defaulting.
4. Leave cumulative defaults correct but overstate recoveries, because continuing to amortize already-defaulted loans inflates the balance to which the LGD-adjusted recovery percentage is applied after the 12-month lag.

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