Deriving Credit Portfolio Diversification Properties from Large Asset-backed Security Pools

Studies of bank diversification, as well as Basel II regulatory framework, use indirect methods of characterizing the sources of diversification in bank portfolios. The present paper more directly estimates the sources of diversification in thirteen retail credit categories from asset-backed security performance measures that are highly correlated with (unobservable) loan value. Classical Markowitz correlations are derived from almost $1 trillion of asset backed security pools originated by more than five hundred issuers between January 2000 and September 2003. The analysis demonstrates that the performance of many different loan types is weakly correlated, and is sometimes even negatively correlated. Hence, even narrowly focused bank portfolios consisting only of standard retail credits can be constructed to obtain a great deal of diversification. That potential, however, is still not acknowledged in the Basel II regulatory framework.