REAL ESTATE ECONOMICS 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 ac-count for unobserved heterogeneity. Under a strict definition of mortgage de-fault, we do not find evidence to support the existence of unobserved hetero-geneity. 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, respec-tively. 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 eco-nomic setting to test the rationality of investors and the empirical applicability of contingent claim models. From a practitioner’s perspective, the identifica-tion of factors relating to default and/or prepayment help efficiently deter-mine not only the appropriate spreads in the underwriting of whole loans, bu