Pricing the Defeasance Option in Securitized Commercial Mortgages

Dierker, Martin; Quan, Daniel C.; Torous, Walter N.

doi:10.2139/ssrn.567463

Cited by 8 publications

(7 citation statements)

References 3 publications

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“…In line with our predictions, Dierker, Quan, and Tourous (2005) reports evidence on a sample of defeasance exercise in commercial mortgage backed securities that the value of the option to defease critically depends on the rate of return that can be earned on the released equity, the prevailing interest rate conditions and the contractual features of the option.…”

Section: Introductionsupporting

confidence: 84%

The Defeasance of Control Rights

2009

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We analyze one frequently used clause in public bonds called covenant defeasance. Covenant defeasance allows the bond issuer to remove all of the bond's covenants by placing the remaining outstanding payments with a trustee in an escrow account to be paid out on schedule. Bond covenants are predominantly noncontingent, action-limiting covenants. By giving the issuer an option to remove covenants, noncontingent control rights can be made state-contingent even when no interim signals are available. We provide a theoretical justification for covenant defeasance and show empirically that such a clause allows for the inclusion of more covenants in public bond issues. In line with the model's prediction, our empirical analysis documents a 13-25 basis points premium for defeasible bonds. This premium amounts to an annual saving of about $1m per year, or $11m over the lifetime of an average bond. JEL Classification Nos.: G32, D86, G12Keywords: Bonds, Covenants, Defeasance, Renegotiation 4 We would like to thank Bruno Bias, Catherine Casamatta, Paolo Fulghieri (discussant), RaDenis Gromb, Alexander Gümbel, Michel Habib, Florian Heider (discussant), Rachel Hayes, Michael Lemmon, Jean-Jaques Rochet, Narayan Naik, Michael Roberts (discussant), Rafael Repullo, Javier Suarez, Jean Tirole, Karin Thorburn, and Walter Torous (discussant) as well as conference and seminar participants at the 2010 AFA Meeting, CEPR 2009 Conference on Financial Markets, the EFA 2009 Meetings, the European Winter Finance Conference 2009 in Klosters, the IRMC 2010, the WFA 2010, CEMFI, Dauphine, Development Bank of Japan, Geneva, HEC, Kobe, Nagoya, Toulouse, Waseda, and WU Vienna for helpful comments. All remaining errors are our responsibility. The Defeasance of Control RightsThis version: August 30, 2010. ABSTRACTWe analyze one frequently used clause in public bonds called covenant defeasance. Covenant defeasance allows the bond issuer to remove all of the bond's covenants by placing the remaining outstanding payments with a trustee in an escrow account to be paid out on schedule. Bond covenants are predominantly noncontingent, action-limiting covenants. By giving the issuer an option to remove covenants, noncontingent control rights can be made state-contingent even when no interim signals are available. We provide a theoretical justification for covenant defeasance and show empirically that such a clause allows for the inclusion of more covenants in public bond issues. In line with the model's prediction, our empirical analysis documents a 13-25 basis points premium for defeasible bonds. This premium amounts to an annual saving of about $1m per year, or $11m over the lifetime of an average bond.JEL Classification Nos.: G32, D86, G12

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Section: Introductionsupporting

confidence: 84%

The Defeasance of Control Rights

2009

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“…Recent examples of structural models of defaultable corporate debt include Longstaff and Schwartz (1995), Jarrow and Turnbull (1995), Collin-Dufresne and Goldstein (2001), and Huang and Huang (2002). Examples of structural valuation models of commercial mortgage and commercial mortgage backed securities include Dierker, Quann, and Torous (2005), Kau (1990), and Titman and Torous (1989).…”

Section: Modelmentioning

confidence: 99%

Commercial Mortgage Backed Securities: How Much Subordination is Enough?

Downing

Wallace

2005

SSRN Journal

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“…In this issue, Dierker, Quan and Torous (2005), Downing, Stanton and Wallace (2005), Dunn and Spatt (2005) and Longstaff (2005) all focus on structural models in which option exercise is modeled as endogenous decisions made by borrowers to minimize the present value of their current mortgage position or, in the case of defeasance, to maximize the rate of return earned on released equity. There are, however, important differences in these models.…”

Section: Structural Model Contributionsmentioning

confidence: 99%

“…The Dierker, Quan and Torous (2005) model treats defeasance as an exchange option whereby the borrower gives up a portfolio of Treasury or agency securities and in return receives the market value of the commercial mortgage plus the liquidity benefits from accessed equity. Dierker, Quan and Torous (2005) and Longstaff (2005) both adapt the string market models of Longstaff and Schwartz (1995) and Longstaff, Santa-Clara and Schwartz (2001b,a) for valuation. These models allow for realistic term structure dynamics in which the covariance structure among forward rates is specified directly.…”

Section: Structural Model Contributionsmentioning

confidence: 99%

“…Because the observed term structure is matched exactly, Longstaff (2005) finds the model generates accurate market pricing for premium MBS using moderate and realistic assumptions about transaction costs and spreads facing borrowers. The Dierker, Quan and Torous (2005) implementation indicates important differences in the valuation of defeasance options across the largest metropolitan regions and mortgaged property types.…”

Section: Structural Model Contributionsmentioning

confidence: 99%

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Innovations in Mortgage Modeling: An Introduction

Wallace¹

2005

Real Estate Econ

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This special issue presents a selection of recent methodological advances in the academic literature on mortgage performance and valuation. The articles include a range of modeling techniques from rational structural models applied to pool-level data and loan-level reduced-form, or behavioral, models of prepayment and default. Both classes of model are shown to be effective for evaluating innovations in contracting such as defeasance options in commercial mortgage contracts and hybrid residential mortgage products. Finally, the articles highlight a number of important methodological linkages between recent advances in mortgage modeling and those found in the valuation of other forms of risky debt such as corporate bonds.The structural models presented here focus on pricing and modeling credit or call events that are specific to a particular class of borrower. These models focus on the underlying dynamics of interest rates and the assets that are the collateral on the mortgage. Credit (or call) events are triggered by random movements in the asset price relative to a threshold that is the exercise price on the option. By modeling credit or call events in terms of the underlying dynamics of asset prices and/or interest rates, the structural methodology functionally links option exercise events to the underlying fundamentals faced by the borrower. These articles build upon an extensive literature with a corporate debt focus: Leland many others.In contrast, reduced-form, or behavioral, approaches, do not explicitly model the value of the borrower's assets and capital structure. Instead credit and/or *

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Pricing the Defeasance Option in Securitized Commercial Mortgages

Cited by 8 publications

References 3 publications

The Defeasance of Control Rights

The Defeasance of Control Rights

Commercial Mortgage Backed Securities: How Much Subordination is Enough?

Innovations in Mortgage Modeling: An Introduction

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