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Frailty Correlated Default






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    • Duffie is at the Graduate School of Business, Stanford University. Eckner and Horel are at Bank of America. Saita is at Barclays Capital. We are grateful for financial support from Moody's Corporation and Morgan Stanley; for data from Moody's and Ed Altman; for research assistance from Sabri Oncu and Vineet Bhagwat; for remarks from Torben Andersen, André Lucas, Richard Cantor, Stav Gaon, Tyler Shumway, Jun S. Liu, Xiao-Li Meng, and especially Michael Johannes; and for suggestions by a referee, an associate editor, and the editor, Campbell Harvey.


The probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and collateralized debt obligation (CDO) default losses are typically measured for economic capital and rating purposes, conventionally based loss estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm-by-firm default probabilities.