hard · Asset-Backed Securities

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 late, leaving lifetime gross defaults unchanged because the two timing errors offset exactly over the pool's life.
2. Understate cumulative defaults, because applying the rate to a gross balance that still contains already-defaulted loans double-counts survivors and suppresses the per-period default dollars.
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 amortizing defaulted loans inflates the balance to which LGD-adjusted recovery is applied after the 12-month lag.

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