Large Bank Examination Workshop February 2026

Historical Evidence on Defaults • The historical evidence was that subprime mortgagers defaulted primarily for personal financial reasons, with little dependence on regional factors and even less on the national factor.

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• This suggested low default correlation among subprime borrowers.

• In addition, mortgage pools for most CDOs were diversified across states, which further reduced default correlation. Why?

• Finally, the national trend in house prices had been consistently positive, with downturns mainly regional in nature. This also suggested a low default risk and low correlation. Why?

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Reality Bites • In the event, as we know, a national downturn in house prices began in 2007, and this quickly undermined the assumption that subprime default risks were characterized by low correlation. • Default rates on mortgage loans increased, and clusters of default on subprime mortgages ate deeply into CDO structures. • Events exposed an element of unrealism in the model to which the market had not paid sufficient attention. • How could the ratings agencies and market participants have better protected themselves against this risk? • What, if anything, was wrong with their model?

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