Financial Simulation Modeling in Excel

TRANSITION MATRICES

The final subject we will cover in this chapter will be transition matrices. Transition matrices are representations of the likelihood that a credit will switch from one “state” to another. Transition matrices are useful when a large number of positions are held and there is little or no specific information about the fundamental drivers of performance. The major example of this is in consumer ABS assets like mortgage-backed securities (MBS) and auto loan securitizations, where there are potentially tens of thousands of individual loans that a noteholder may be exposed to. Due to privacy restrictions or just deficiencies with data, there may be limited information about the specific situation of most or all of the borrowers.

Another area where transition matrices can be used is with corporate credit pools such as CDOs. Typically, there is sufficient trading information about the assets in a widely syndicated deal that market information can be used to create default probabilities using a reduced form model for each asset. However, for small-business loans and other extensions of credit to small enterprises, market information may be impossible to obtain. As a result, for large pools, historical or projected transitions are likely to be a modeler's best bet to forecast the credit performance of the pool. And even for pools of larger credits, where ratings are available, many analysts use a rating transition matrix to include some differentiation between assets ...