Predicting Commercial Mortgage Foreclosure Experience

This study has two objectives: (1) it directly evaluates the relationship between commercial mortgage default incidence and characteristics of the mortgage, borrower, property, market, and general economic conditions, and (2) it uses this relationship to predict the exposure of life insurers to future mortgage defaults and to examine the relative importance of various causes of current and past credit quality problems. A theoretical model of the default decision predicts that the decision would be expected to be driven primarily by the borrower's current equity stake in the property, or the ratio of the market value of the loan to property value (M t/V t), but that the presence and magnitude of transaction costs associated with default would be expected to result in underexercise of the default option. Empirical estimation making use of American Council of Life Insurance (ACLI) and National Council of Real Estate Investment Fiduciaries (NCREIF) data confirms both expectations. A high proportion of the longitudinal variation in foreclosure incidence is explained by variations in M t/V t, but even at high ratios M t/V t in excess of 1.1. only 5% to 8% of mortgagors default, although this magnitude of underexercise is probably overstated because of problems in measuring M-super-t and for other reasons. Simulations using the model provide a pessimistic outlook for future defaults. Default rates are predicted to double in the five-year period 1988-93. Other simulations examine the relative importance of interest rate fluctuations, property value declines, and geographic or temporal correlations in lending during the 1976-88 period on current default experience. Copyright American Real Estate and Urban Economics Association.

Adjustable and Fixed Rate Mortgage Termination, Option Values and Local Market Conditions: An Empirical Analysis

This paper analyzes the probabilities of prepayment or default for Fixed Rate Mortgages (FRMs) and Adjustable Rate Mortgages (ARMs). Using data from the period 1985-1992, the analysis indicates that the likelihood of prepayment of thirty year FRMs was determined primarily by house price appreciation and personal income growth and the likelihood of prepayment of fifteen year FRMs was determined primarily by interest rate changes. ARMs were prepaid less frequently than FRMs, were less likely to be prepaid when interest rates declined and defaulted more often than FRMs. The analysis provides evidence that ARM holders are less mobile than FRM holders. Copyright American Real Estate and Urban Economics Association.

The Performance of Commercial Mortgages

This study examines the return characteristics of a large, well-diversified commercial mortgage portfolio. Mortgage-specific cash-flow histories are constructed for 2,480 loans originated over the period 1974 through 1990, and a contingent-claims approach to pricing risky debt is used to estimate inter-temporal market values. Quarterly holding-period returns are compared across selected mortgage groups and to alternate asset classes. Our findings suggest that both mortgage returns and volatility of return are comparable to those of other forms of fixed-income assets over the study period. Implied property price volatility is found to average 17%, a result significantly higher than reported in earlier studies. While mortgage returns are found to vary by property type and region of origin, cross correlation of returns is found to be high, illustrating the systematic effect of interest rates on the performance of commercial mortgages over the period 1974 through 1990. However, an increase in credit risk in the latter years of the study suggests that diversification may be a worthwhile objective for holders of these assets. We do not find evidence to suggest that abnormal returns were earned on commercial mortgage portfolios over the study period. Copyright American Real Estate and Urban Economics Association.

Can Urban Indicators Predict Home Price Appreciation? Implications for Redlining Research

Economists commonly control for neighborhood indicators, such as median income, in underwriting models that test for redlining. Many such indicators are highly correlated with neighborhood racial composition and therefore have the capacity to "explain away" the role of race in lending decisions. This paper argues that indicators should be included in models of underwriting only if they affect future home prices, and hence the value of the default option, in a consistent fashion. Testing the effect of nine census variables, taken from two recent redlining papers, on California tract appreciation from 1986 to 1994, a consistent relationship between indicators and home price is not found. Copyright American Real Estate and Urban Economics Association.

Local Economic Base, Geographic Diversification, and Risk Management of Mortgage Portfolios

Variability of local economic conditions underlie, in part, the default and prepayment risks of mortgages originated in a metropolitan area. In this study we examine the benefits of diversifying across metropolitan areas for reducing these risks. Employment data for the thirty largest metropolitan areas in the United States, divided into eight industry groups, are analyzed with the aid of factor and principal component analysis to determine if the variances of employment changes across the thirty areas are independent. Independence is investigated to assess the potential for diversification. Mean-variance portfolio analysis is then used to measure the gains from geographic diversification vis-a-vis a set of several alternative strategies for diversification. We conclude that geographic diversification is an important mortgage portfolio objective and that mean-variance strategies outperform the alternative strategies tested here. Copyright American Real Estate and Urban Economics Association.

Price premium and foreclosure risk

10.1111/j.1540-6229.2006.00165.xReal Estate Economics342211-24