The Termination of Commercial Mortgage Contracts through Prepayment and Default: A Proportional Hazard Approach with Competing Risks

Abstract

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. Copyright 2002 American Real Estate and Urban Economics Association.

Term Default, Balloon Risk, and Credit Risk in Commercial Mortgages

“…On the other hand, their results reveal that initial property income (measured by debt service coverage at origination) is a strong predictor of default. Ciochetti et al [2002] further extend the literature by including contemporaneous measures of LTV and DSC in their empirical analysis. They estimate default and prepayment functions for commercial mortgages using a competing risks proportional hazards model and loan-level data, and find that an asset value-based model alone cannot fully explain default incidence.…”

Housing sales in urban Beijing

“…Gabriel and Nothaft (2001) analyse the duration of rental vacancies in major USA metropolitan areas with ordinary least square regressions. Ciochetti et al (2003a) analyse the factors driving the borrower's decision to terminate commercial mortgage contracts with the lender through either prepayment or default. Data on loans from large USA insurance companies are used.…”

Subordination Levels in Structured Financing

“…For example, increasing volume of studies has shown that it is the contemporaneous loan-to-value ratio (LTV) and debt-service-coverage ratio (DSCR) rather than original LTV and DSCR that determines commercial mortgage default risk 10 (Vandell et al, 1993, Archer et al, 2001, Ambrose and Sanders, 2003, Ciochetti et al 2003, Ciochetti et al 2002, Chen and Deng, 2003and Deng, Quigley and Sanders, 2005.…”

“…Hazard model has been proven to be a very effective tool to estimate and predict commercial mortgage default probabilities (Vandell, 1993, Huang and Ondrich, 2002, Ciochetti et al, 2002and Chen and Deng, 2003. We follow the literature to include the most important variables such as the intrinsic value of call exercise and the intrinsic value of put exercise (contemporaneous LTV) as our covariates.…”