Andrey Kamenov, Ph.D. Probability and Statistics
In recent posts, we have seen that both the Prosper and Lending Club loan grading systems do their job quite well, allowing you to assess your risks with each particular borrower.
What it doesn’t show us, however, is if there is any correlation in the loan charge-offs. As you may know, one of the reasons for the 2007 subprime mortgage crisis was the underestimation of the probability of a widespread wave of default events.
Now, we should probably provide an important disclaimer: there is no way to estimate the probability of so-called “black swan” events given the data we have. We can only manage systematic risk, and any smart investor should keep in mind that there will always be risks not present in his or her model.
So, with that in mind, let us assume that the individual default events are all independent. We’ll now see how well this assumption fits the data we can download from the Lending Club website.