Credit Cycles: A Frailty Approach

We model aggregate loss rates on credit portfolios dynamically using a default intensity approach. The default intensity we employ is allowed to depend on both observable macroeconomic variables and unobserved frailties. We use the model to extract measures of the credit cycle from US bank charge-off rates and find that unemployment, industrial production (IP) and interest rates have significant and qualitatively plausible effects on aggregate defaults. Using smoothed estimates for the unobserved frailty factors, we characterize the credit cycles driving defaults in the corporate, real-estate and non-mortgage retail sectors.