Experiences with using

R in credit risk
Hong Ooi
Introduction

Not very sexy....

• LGD haircut modelling
• Through-the-cycle calibration
• Stress testing simulation app
• SAS and R
• Closing comments

Page 2
Mortgage haircut model

• When a mortgage defaults, the bank can take possession of the property
and sell it to recoup the loss1
• We have some idea of the market value of the property
• Actual sale price tends to be lower on average than the market value (the
haircut)2
• If sale price > exposure at default, we don’t make a loss (excess is passed
on to customer); otherwise, we make a loss

Expected loss = P(default) x EAD x P(possess) x exp.shortfall

Notes:
1. For ANZ, <10% of defaults actually result in possession
2. Meaning of “haircut” depends on context; very different when talking
about, say, US mortgages

Page 3
 Sale price distribution

Valuation

Expected shortfall

Haircut

Exposure
at default

Page 4
Stat modelling

• Modelling part is in finding parameters for the sale price distribution

• Assumed distributional shape, eg Gaussian
• Mean haircut relates average sale price to valuation
• Spread (volatility) of sale price around haircut
• Once model is found, calculating expected shortfall is just (complicated)
arithmetic

Page 5
 Valuation at origination Valuation at kerbside Valuation after possession
15

15

15
14

14

14
13

13

13
log sale price

log sale price

log sale price

12

12

12
11

11

11
10

10

10
9

9
11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15

log valuation log valuation log valuation

Page 6
Volatility

Volatility of haircut (=sale price/valuation) appears to vary systematically:

Property type SD(haircut)*

A 11.6%

B 9.3%

C 31.2%

State/territory SD(haircut)*
1 NA

2 13.3%

3 7.7%

4 9.2%

5 15.6%

6 18.4%

7 14.8%

* valued after possession

Page 7
Volatility modelling

• Use regression to estimate haircut as a function of loan characteristics

• Hierarchy of models, by complexity:
• Constant volatility
• Volatility varying by property type
• Volatility varying by property type and state
• Use log-linear structure for volatility to ensure +ve variance estimates

• Constant volatility model is ordinary linear regression

• Varying-volatility models can be fit by generalised least squares, using gls
in the nlme package
• Simpler and faster to directly maximise the Gaussian likelihood with
optim/nlminb (latter will reproduce gls fit)

Page 8
 Shortfall
140000 90000 40000 0 0 0 0

Estimated mean sale

price fairly stable
Expected shortfall with
volatility varying by
property type

Expected shortfall under

constant volatility

250000 300000 350000 400000 450000 500000 550000

Sale price

Page 9
Volatility: T-regression

• Still assumes Gaussian distribution for volatility

• Data can be more heavy-tailed than the Gaussian, even after deleting
outliers
• Inflates estimates of variance

• Solution: replace Gaussian distribution with t distribution on small df

• df acts as a shape parameter, controls how much influence outlying
observations have
• Coding this is a straightforward extension of the Gaussian: simply
change all *norm functions to *t
• Can still obtain Gaussian model by setting df=Inf
• cf Andrew Robinson’s previous MelbURN talk on robust regression and
ML fitting

Page 10
Example impact

Property type = C, state = 7, valuation $250k, EAD $240k

Gaussian model

Mean formula Volatility formula Expected

shortfall ($)
~1 ~1 7,610
~1 ~proptype 23,686
~1 ~proptype + state 29,931

t5 model

Mean formula Volatility formula Expected

shortfall ($)
~1 ~1 4,493
~1 ~proptype 10,190
~1 ~proptype + state 5,896

Page 11
Model fitting function (simplified)

tmod <- function(formula, formula.s, data, df, ...)

{
mf <- mf.s <- match.call(expand.dots = FALSE)
mf.s[["formula"]] <- mf.s$formula.s
mf$df <- mf$formula.s <- mf$... <- mf.s$df <- mf.s$formula.s <- mf.s$... <- NULL
mf[[1]] <- mf.s[[1]] <- as.name("model.frame")
mf <- eval(mf, parent.frame())
mf.s <- eval(mf.s, parent.frame())
mm <- model.matrix(attr(mf, "terms"), mf)
mm.s <- model.matrix(attr(mf.s, "terms"), mf.s)
y <- model.response(mf)
p <- ncol(mm)
p.s <- ncol(mm.s)
t.nll <- function(par, y, Xm, Xs)
{
m <- Xm %*% par[1:p]
logs <- Xs %*% par[-(1:p)]
-sum(dt((y - m)/exp(logs), df = df, log = TRUE) - logs)
}
lmf <- lm.fit(mm, y) # use ordinary least-squares fit as starting point
par <- c(lmf$coefficients, log(sd(lmf$residuals)), rep(0, p.s - 1))
names(par) <- c(colnames(mm), colnames(mm.s))
nlminb(par, t.nll, y = y, Xm = mm, Xs = mm.s, ...)
}

tmod(salepr/valuation ~ 1, ~ proptype + state, data = haircut, df = Inf)

tmod(salepr/valuation ~ proptype, ~ proptype, data = haircut, df = 5)

Page 12
 Shortfall
140000 90000 40000 0 0 0 0

Because it downweights
outliers, t distribution is more
concentrated in the center

Expected shortfall with

t-distributed volatility

250000 300000 350000 400000 450000 500000 550000

Sale price

Page 13
 Normal model residuals

0.7

6
0.6

4
0.5

Sample quantiles

2
0.4
Density

0.3

0
0.2

-2
0.1

-4
0.0

-4 -2 0 2 4 6 -3 -2 -1 0 1 2 3

Std residual Theoretical normal quantiles

t5-model residuals
0.4

10
0.3

Sample quantiles

5
Density

0.2

0
0.1

-5
0.0

-5 0 5 10 -6 -4 -2 0 2 4 6

Std residual Theoretical t-quantiles

Page 14
Notes on model behaviour

• Why does using a heavy-tailed error distribution reduce the expected

shortfall?
• With normal distrib, volatility is overestimated
→ Likelihood of low sale price is also inflated
• t distrib corrects this
• Extreme tails of the t less important
• At lower end, sale price cannot go below 0
• At higher end, sale price > EAD is gravy
• This is not a monotonic relationship! At low enough thresholds,
eventually heavier tail of the t will make itself felt

• In most regression situations, assuming sufficient data, distributional

assumptions (ie, normality, homoskedasticity) are not so critical: CLT comes
into play
• Here, they are important: changing the distributional assumptions can
change expected shortfall by big amounts

Page 15
In SAS

• SAS has PROC MIXED for modelling variances, but only allows one grouping
variable and assumes a normal distribution
• PROC NLIN does general nonlinear optimisation
• Also possible in PROC IML

• None of these are as flexible or powerful as R

• The R modelling function returns an object, which can be used to generate
predictions, compute summaries, etc
• SAS 9.2 now has PROC PLM that does something similar, but requires the
modelling proc to execute a STORE statement first
• Only a few procs support this currently
• If you’re fitting a custom model (like this one), you’re out of luck

Page 16
Through-the-cycle calibration

• For capital purposes, we would like an estimate of default probability that

doesn’t depend on the current state of the economy
• This is called a through-the-cycle or long-run PD
• Contrast with a point-in-time or spot PD, which is what most models will
give you (data is inherently point-in-time)
• Exactly what long-run means can be the subject of philosophical debate; I’ll
define it as a customer’s average risk, given their characteristics, across the
different economic conditions that might arise
• This is not a lifetime estimate: eg their age/time on books doesn’t
change
• Which variables are considered to be cyclical can be a tricky decision to
make (many behavioural variables eg credit card balance are probably
correlated with the economy)
• During bad economic times, the long-run PD will be below the spot, and
vice-versa during good times
• You don’t want to have to raise capital during a crisis

Page 17
TTC approach

• Start with the spot estimate:

PD(x, e) = f(x, e)

• x = individual customer’s characteristics

• e = economic variables (constant for all customers at any point in time)
• Average over the possible values of e to get a TTC estimate
PD

Economic cycle

Page 18
TTC approach

• This is complicated numerically, can be done in various ways eg Monte Carlo

• Use backcasting for simplicity: take historical values of e, substitute into
prediction equation, average the results
• As we are interested in means rather than quantiles, this shouldn’t affect
accuracy much (other practical issues will have much more impact)
• R used to handle backcasting, combining multiple spot PDs into one output
value

Page 19
TTC calculation

• Input from spot model is a prediction equation, along with sample of

historical economic data

spot_predict <- function(data)

{
# code copied from SAS; with preprocessing, can be arbitrarily complex
xb <- with(data, b0 + x1 * b1 + x2 * b2 + ... )
plogis(xb)
}

ttc_predict <- function(data, ecodata, from = "2000-01-01", to = "2010-12-01")

{
dates <- seq(as.Date(from), as.Date(to), by = "months")
evars <- names(ecodata)
pd <- matrix(nrow(data), length(dates))
for(i in seq_along(dates))
{
data[evars] <- subset(ecodata, date == dates[i], evars)
pd[, i] <- spot_predict(data)
}
apply(pd, 1, mean)
}

Page 20
Binning/cohorting

• Raw TTC estimate is a combination of many spot PDs, each of which is from
a logistic regression
→ TTC estimate is a complicated function of customer attributes
• Need to simplify for communication, implementation purposes

• Turn into bins or cohorts based on customer attributes: estimate for each
cohort is the average for customers within the cohort
• Take pragmatic approach to defining cohorts
• Create tiers based on small selection of variables that will split out
riskiest customers
• Within each tier, create contingency table using attributes deemed most
interesting/important to the business
• Number of cohorts limited by need for simplicity/manageability, <1000
desirable
• Not a data-driven approach, although selection of variables informed by
data exploration/analysis

Page 21
 Binning/cohorting

Example from nameless portfolio:

Raw TTC PD Cohorted TTC PD

Distribution of ILS long-run PD Distribution of cohorted ILS long-run PD
0.4

0.4
0.3

0.3
Density

Density
0.2

0.2
0.1

0.1
0.0

0.0

0.01% 0.1% 1% 10% 0.01% 0.1% 1% 10%

PD PD

Page 22
Binning input

varlist <- list(

low_doc2=list(name="low_doc",
breaks=c("N", "Y"),
midp=c("N", "Y"),
na.val="N"),
enq =list(name="wrst_nbr_enq",
breaks=c(-Inf, 0, 5, 15, Inf),
midp=c(0, 3, 10, 25),
na.val=0),
lvr =list(name="new_lvr_basel",
breaks=c(-Inf, 60, 70, 80, 90, Inf),
midp=c(50, 60, 70, 80, 95),
na.val=70),
...

low_doc wrst_nbr_enq new_lvr_basel ... tier1 tier2

by application of 1 N 0 50 ... 1 1
expand.grid()... 2 N 0 60 ... 1 2
3 N 0 70 ... 1 3
4 N 0 80 ... 1 4
5 N 0 95 ... 1 5
6 N 3 50 ... 1 6
7 N 3 60 ... 1 7
8 N 3 70 ... 1 8
9 N 3 80 ... 1 9
10 N 3 95 ... 1 10

Page 23
Binning output

if low_doc = ' ' then low_doc2 = 1;

else if low_doc = 'Y' then low_doc2 = 1;
else low_doc2 = 2;

if wrst_nbr_enq = . then enq = 0;

else if wrst_nbr_enq <= 0 then enq = 0;
else if wrst_nbr_enq <= 5 then enq = 3;
else if wrst_nbr_enq <= 15 then enq = 10;
else enq = 25;

if new_lvr_basel = . then lvr = 70;

else if new_lvr_basel <= 60 then lvr = 50;
else if new_lvr_basel <= 70 then lvr = 60;
else if new_lvr_basel <= 80 then lvr = 70;
else if new_lvr_basel <= 90 then lvr = 80;
else lvr = 95;
...

if lvr = 50 and enq = 0 and low_doc = 'N' then do; tier2 = 1; ttc_pd = ________; end;
else if lvr = 60 and enq = 0 and low_doc = 'N' then do; tier2 = 2; ttc_pd = ________;
end;
else if lvr = 70 and enq = 0 and low_doc = 'N' then do; tier2 = 3; ttc_pd = ________;
end;
else if lvr = 80 and enq = 0 and low_doc = 'N' then do; tier2 = 4; ttc_pd = ________;
end;
else if lvr = 95 and enq = 0 and low_doc = 'N' then do; tier2 = 5; ttc_pd = ________;
end;
else if lvr = 50 and enq = 3 and low_doc = 'N' then do; tier2 = 6; ttc_pd = ________;
end;
else if lvr = 60 and enq = 3 and low_doc = 'N' then do; tier2 = 7; ttc_pd = ________;
end; Page 24
...
Binning/cohorting

R code to generate SAS code for scoring a dataset:

sas_all <- character()

for(i in seq_along(tierdefs))
{
tvars <- tierdefs[[i]]
varnames <- lapply(varlist[tvars], `[[`, "name")
this_tier <- which(celltable$tier == i)
sas <- "if"
for(j in seq_along(tvars))
{
sas <- paste(sas, tvars[j], "=", as.numeric(celltable[this_tier, varnames[j]]))
if(j < length(tvars))
sas <- paste(sas, "and")
}
sas <- paste(sas, sprintf("then do; tier2 = %d; ttc_pd = %s;", celltable$tier2[this_tier],
celltable$ttc_pd[this_tier]))
sas[-1] <- paste("else", sas[-1])
sas_all <- c(sas_all, sas,
sprintf("else put 'ERROR: unhandled case, tier = %d n = ' _n_;", i))
}
writeLines(sas_all, sasfile)

Page 25
Stress testing simulation

• Banks run stress tests on their loan portfolios, to see what a downturn would
do to their financial health
• Mathematical framework is similar to the “Vasicek model”:
• Represent the economy by a parameter X
• Each loan has a transition matrix that is shifted based on X, determining
its risk grade in year t given its grade in year t - 1
• Defaults if bottom grade reached
• Take a scenario/simulation-based approach: set X to a stressed value, run N
times, take the average
• Contrast to VaR: “average result for a stressed economy”, as opposed to
“stressed result for an average economy”
• Example data: portfolio of 100,000 commercial loans along with current risk
grade, split by subportfolio
• Simulation horizon: ~3 years

Page 26
Application outline

• Front end in Excel (because the business world lives in Excel)

• Calls SAS to setup datasets
• Calls R to do the actual computations

• Previous version was an ad-hoc script written entirely in SAS, took ~4 hours
to run, often crashed due to lack of disk space
• Series of DATA steps (disk-bound)
• Transition matrices represented by unrolled if-then-else statements
(25x25 matrix becomes 625 lines of code)
• Reduced to 2 minutes with R, 1 megabyte of code cut to 10k
• No rocket science involved: simply due to using a better tool
• Similar times achievable with PROC IML, of which more later

Page 27
Application outline

• For each subportfolio and year, get the median result and store it
• Next year’s simulation uses this year’s median portfolio
• To avoid having to store multiple transited copies of the portfolio, we
manipulate random seeds

for(p in 1:nPortfolios) # varies by project

{
for(y in 1:nYears) # usually 2-5
{
seed <- .GlobalEnv$.Random.seed
for(i in 1:nIters) # around 1,000, but could be less
result[i] = summary(doTransit(portfolio[p, y], T[p, y]))

med = which(result == median(result))

portfolio[p, y + 1] = doTransit(portfolio[p, y], T[p, y], seed, med)
}
}

Page 28
Data structures

• For business reasons, we want to split the simulation by subportfolio

• And also present results for each year separately
→ Naturally have 2-dimensional (matrix) structure for output: [i, j]th entry
is the result for the ith subportfolio, jth year

• But desired output for each [i, j] might be a bunch of summary statistics,
diagnostics, etc
→ Output needs to be a list

• Similarly, we have a separate input transition matrix for each subportfolio

and year
→ Input should be a matrix of matrices

Page 29
Data structures

R allows matrices whose elements are lists:

T <- matrix(list(), nPortfolios, nYears)

for(i in 1:nPortfolios) for(j in 1:nYears)
T[[i, j]] <- getMatrix(i, j, ...)

M <- matrix(list(), nPortfolios, nYears)

M[[i, j]]$result <- doTransit(i, j, ...)
M[[i, j]]$sumstat <- summary(M[[i, j]]$result)

Page 30
Data structures

• Better than the alternatives:

• List of lists: L[[i]][[j]] contains data that would be in M[[i, j]]
• Lose ability to operate on/extract all values for a given i or j via
matrix indexing
• Separate matrices for each statistic of interest (ie, doing it Fortran-style)
• Many more variables to manage, coding becomes a chore
• No structure, so loops may involve munging of variable names
• Multidimensional arrays conflate data and metadata

• But can lead to rather cryptic code:

getComponent <- function(x, component)

{
x[] <- lapply(x, `[[`, component)
lapply(apply(x, 1, I), function(xi) do.call("rbind", xi))
}
getComponent(M, "sumstat")

Page 31
PROC IML: a gateway to R

• As of SAS 9.2, you can use IML to execute R code, and transfer datasets to
and from R:

PROC IML;
call ExportDataSetToR('portfol', 'portfol'); /* creates a data frame */
call ExportMatrixToR("&Rfuncs", 'rfuncs');
call ExportMatrixToR("&Rscript", 'rscript');
call ExportMatrixToR("&nIters", 'nIters');
...
submit /R;
source(rfuncs)
source(rscript)
endsubmit;
call ImportDataSetFromR('result', 'result');
QUIT;

• No messing around with import/export via CSV, transport files, etc

• Half the code in an earlier version was for import/export

Page 32
IML: a side-rant

• IML lacks:
• Logical vectors: everything has to be numeric or character
• Support for zero-length vectors (you don’t realise how useful they are
until they’re gone)
• Unoriented vectors: everything is either a row or column vector
(technically, everything is a matrix)
• So something like x = x + y[z < 0]; fails in three ways

• IML also lacks anything like a dataset/data frame: everything is a matrix

→ It’s easier to transfer a SAS dataset to and from R, than IML

• Everything is a matrix: no lists, let alone lists of lists, or matrices of lists

• Not even multi-way arrays

• Which puts the occasional online grouching about R into perspective

Page 33
Other SAS/R interfaces

• SAS has a proprietary dataset format (or, many proprietary dataset formats)
• R’s foreign package includes read.ssd and read.xport for importing,
and write.foreign(*, package="SAS") for exporting
• Package Hmisc has sas.get
• Package sas7bdat has an experimental reader for this format
• Revolution R can read SAS datasets
• All have glitches, are not widely available, or not fully functional
• First 2 also need SAS installed
• SAS 9.2 and IML make these issues moot
• You just have to pay for it
• Caveat: only works with R <= 2.11.1 (2.12 changed the locations of
binaries)
• SAS 9.3 will support R 2.12+

Page 34
R and SAS rundown

• Advantages of R
• Free! (base distribution, anyway)
• Very powerful statistical programming environment: SAS takes 3
languages to do what R does with 1
• Flexible and extensible
• Lots of features (if you can find them)
• User-contributed packages are a blessing and a curse
• Ability to handle large datasets is improving
• Advantages of SAS
• Pervasive presence in large firms
• “Nobody got fired for buying IBM SAS”
• Compatibility with existing processes/metadata
• Long-term support
• Tremendous data processing/data warehousing capability
• Lots of features (if you can afford them)
• Sometimes cleaner than R, especially for data manipulation

Page 35
R and SAS rundown

Example: get weighted summary statistics by groups

proc summary data = indat nway;

class a b;
var x y;
weight w;
output sum(w)=sumwt mean(x)=xmean mean(y)=ymean var(y)=yvar
out = outdat;
run;

outdat <- local({

res <- t(sapply(split(indat, indat[c("a", "b")]), function(subset) {
c(xmean = weighted.mean(subset$x, subset$w),
ymean = weighted.mean(subset$y, subset$w),
yvar = cov.wt(subset["y"], subset$w)$cov)
}))
levs <- aggregate(w ~ a + b, data=indat, sum)
cbind(levs, as.data.frame(res)) Thank
Thankgod
godfor
forplyr
plyr
})

Page 36
Challenges for deploying R

• Quality assurance, or perception thereof

• Core is excellent, but much of R’s attraction is in extensibility, ie
contributed packages
• Can I be sure that the package I just downloaded does what it says? Is it
doing more than it says?
• Backward compatibility
• Telling people to use the latest version is not always helpful
• No single point of contact
• Who do I yell at if things go wrong?
• How can I be sure everyone is using the same version?
• Unix roots make package development clunky on Windows
• Process is more fragile because it assumes Unix conventions
• Why must I download a set of third-party tools to compile code?
• Difficult to integrate with Visual C++/Visual Studio
• Interfacing with languages other than Fortran, C, C++ not yet integrated
into core

Page 37
Commercial R: an aside

• Many of these issues are fundamental in nature

• Third parties like Revolution Analytics can address them, without having to
dilute R’s focus (I am not a Revo R user)
• Other R commercialisations existed but seem to have disappeared
• Anyone remember S-Plus?
• Challenge is not to negate R’s drawcards
• Low cost: important even for big companies
• Community and ecosystem
• Can I use Revo R with that package I got from CRAN?
• If I use Revo R, can I/should I participate on R-Help,
StackOverflow.com?
• Also why SAS, SPSS, etc can include interfaces to R without risking too much

Page 38
Good problems to have

• Sign of R’s movement into the mainstream

• S-Plus now touts R compatibility, rather than R touting S compatibility
• Nobody cares that SHAZAM, GLIM, XLisp-Stat etc don’t support XML, C# or
Java

Page 39
Other resources

• SAS and R blog by Ken Kleinman and Nick Horton

• Online support for their book, SAS and R: Data Management, Statistical
Analysis, and Graphics
• Hadley Wickham’s site
• STAT480 covers Excel, R and SAS (the links to UCLA ATS files are broken,
use /stat/ instead of /STAT/)
• The DO Loop is the official SAS/IML blog
• inside-R, the Revolution Analytics community site
• R-bloggers: aggregated blogroll for R
• AnnMaria De Mars’ blog on SAS and social science (contains pictures of
naked mole rats)

Page 40