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Why is it more difficult to estimate the value at risk for a portfolio of loans...

Why is it more difficult to estimate the value at risk for a portfolio of loans rather than for a single loan? Why did this pose a problem for rating agencies that needed to assess the risk of packages of mortgage loans before the financial crisis?

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Answer #1

It is more difficult to estimate the value at risk for a portfolio of loans than for a single loan as:

For a single loan the risk and return calculations of that loan has to be calculated. But for a portfolio of loans, apart from calculating the risk and return, the correlation between the assets has to be calculated. This leads to understanding the inter-relationship between the loans so that the decision to sanction the loan or not becomes easy.

This poses a problem for rating agencies before the financial crisis as the inter relationship of the mortgage loans was not studied by the rating agencies.

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