Page 60

CRE Finance World, Winter 2014

performance. Except for some idiosyncratic events that we would expect to be rare, the number of defaults on performing properties should be very low. We understand that there is noise in the data we are using, nevertheless there is still a lot to be learned about borrower behavior that is less than fully-ruthless and in this article we will look at that across a number of different dimensions. In order to further investigate the default behavior, we split up the sample using several different criteria. Splitting up the sample by original loan term, we observe that the behavior tends to be more ruthless in shorter term loans. This is consistent with option theory because the longer the term (to loan maturity in this case) the greater the option value. Loans fully underwater with more than 7 years to maturity defaulted 36% of the time, but loans less than 7 years to maturity defaulted 60% of the time. Consistent with the theory, borrowers with more time to maturity were more likely to keep the loan current despite weak property conditions. Table 2 Long Term Mortgage Default Ruthlessness Source: Trepp and Freddie Mac Table 3 Short Term Mortgage Default Ruthlessness Source: Trepp and Freddie Mac This finding makes sense as the longer term loans generally indicate borrower’s expectation or intention to hold the property for a longer period. Also, the longer term means the property owner has a longer time period to improve the property’s operations and performance. Credit models can incorporate option valuation techniques to consider this time value effect. CRE Finance World Winter 2014 58 Another factor we look at is borrower behavior near balloon maturity. Since the default decision is basically a put option in a non-recourse loan, the embedded time value of the option depends on the time until the maturity of the option. Given that and based on option theory, the default option has a higher value if the mortgage has more remaining time before balloon maturity, and the borrower can be expected to be less ruthless. To test this, we compare the multifamily loans by whether mortgage’s under-performance occurred near maturities. The results confirm that the default option is more likely exercised when the underlying mortgage is near maturity. Table 4 Default Ruthlessness by Remaining Time to Maturity Source: Trepp and Freddie Mac We also test whether property investor’s ruthlessness changes across various economic environments, as both access to liquidity and expectations for economic growth vary based on economic conditions. In recessions, it is very difficult to improve underperforming properties and obtain financial assistances from lenders. We would speculate that there would be a higher ruthlessness of default when market conditions are weak, as only a subset of borrowers will have the capacity to support their properties in these periods. Loan performance in the recent major recession provides us a good chance to examine this hypothesis. The following table does show that if underwater performance occurred during the period between 2008 and 2012, the underlying mortgage default rate was slightly higher. For the near-maturity loans, the ruthlessness rises even higher (to 66%). Table 5 Default Ruthlessness in the Recession Source: Trepp and Freddie Mac Default Ruthlessness: Examining Borrower Default Behavior


CRE Finance World, Winter 2014
To see the actual publication please follow the link above