The Termination of Commercial Mortgage Contracts through Prepayment and Default: A Proportional Hazard Approach with Competing Risks
Ciochetti, Brian A., Deng, Yongheng, Gao, Bin, Yao, Rui, Real Estate Economics
This article examines the factors driving the borrower's decision to terminate commercial mortgage contracts with the lender through either prepayment or default. Using loan-level data, we estimate prepayment and default functions in a proportional hazard framework with competing risks, allowing us to account for unobserved heterogeneity. Under a strict definition of mortgage default, we do not find evidence to support the existence of unobserved heterogeneity. However, when the definition of mortgage default is relaxed, we do find some evidence of two distinctive borrower groups. Our results suggest that the values of implicit put and call options drive default and prepayment actions in a nonlinear and interactive fashion. Prepayment and default risks are found to be convex in the intrinsic value of call and put options, respectively. Consistent with the joint nature of the two underlying options, high value of the put/call option is found to significantly reduce the call/put risk since the borrower forfeits both options by exercising one. Variables that proxy for cash flow and credit conditions as well as ex post bargaining powers are also found to have significant influence upon the borrower's mortgage termination decision.
A better understanding of commercial mortgage termination through default or prepayment has important academic as well as practical implications. With their relatively simple financial structure--one underlying property and one collateralized debt obligation--commercial mortgages provide an ideal economic setting to test the rationality of investors and the empirical applicability of contingent claim models. From a practitioner's perspective, the identification of factors relating to default and/or prepayment help efficiently determine not only the appropriate spreads in the underwriting of whole loans, but also diversification strategies affecting pools of loans by such categories as property type and geographic location. For fixed income investors, an appropriately specified empirical termination model can provide a structured methodology to incorporate contemporaneous information in the valuation of not only whole commercial loans, but also their securitized counterparts. Moreover, such a model provides a basis for regulators to efficiently set standards in risk-based minimum capital requirements for both life insurance companies as well as commercial banks.
Despite the importance of the topic, there has been a dearth of empirical research on commercial mortgage termination, primarily due to the lack of data with which to examine the asset class. Kau et al. (1990) provided a theoretical analysis of commercial mortgage valuation. On the empirical side, most related studies have been conducted using aggregate levels of data (Titman and Torous 1989 and Elmer and Haidorfer 1997). Yet disaggregate loan histories are needed to fully understand the relationship between loan characteristics and the economics of commercial mortgage termination.
Limited studies using loan-level data have focused on one termination event, either default or prepayment. In one of the early efforts to explain borrower behavior, Vandell et al. (1993) study foreclosure experience of commercial mortgage loans and find that the equity position, as measured by the contemporaneous market loan-to-value ratio (LTV), is highly significant in explaining mortgage default. However, short-term cash flow conditions, as proxied by original debt service coverage ratio (DCR), are statistically insignificant in explaining default risk. Property type is also found to affect default hazard rates. While this study enhances our understanding of the default experience, several issues hamper interpretation of the results. First, default is construed as of the date of loan foreclosure. Yet Brown, Ciochetti and Riddiough (2000) find that there is routinely a lag of 6 to 22 months between the start and completion of the foreclosure process. …