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CRE Finance World, Winter 2014

Clearly, Freddie Mac multifamily borrowers are less ruthless in their default decisions. This difference in ruthlessness is one of the reasons for the lower delinquencies for Freddie Mac loans relative to CMBS, and shows that the borrower behavior plays a role in the extremely low credit losses in Freddie Mac history. Why do Freddie Mac borrowers behave differently and why are borrowers of GSE portfolio more cautious in exercising their mortgage default options when property distress occurs? We believe several factors are responsible for that result. Before a Freddie Mac loan is sourced, it has to go through several filters starting with a carefully selected network of originators. Weaker properties and inexperienced borrowers are filtered out at initial stages. Borrowers and sellers in the Program Plus network understand Freddie Mac’s credit policies and standards. Thus the properties go through a rigorous and well-defined selection process that results in a selection of relatively uniform investment relative to the broader market. The resulting conservative selection of strong properties and strong borrowers (who have the ability to withstand adverse market situations) results in greater ability to support a property and more commitment to the property — in model terms it means higher option cost which results in lower ruthlessness. Given the attractive financing from GSEs, the stronger borrowers are motivated to remain in good standing with the enterprises is an additional factor that results in lower ruthless behavior in marginal situations. CRE Finance World Winter 2014 60 Summary In this article, we investigate the historical evidence from CMBS and Freddie Mac multifamily loans and confirm that the pure theory of ruthless default behavior is not supported. Rather, today’s commercial real estate borrowers often exercise the default option in a gradually optimal manner based on the market conditions, collateral characteristics and relationship with lenders. They tend to be more ruthless in defaulting when (1) economic conditions are weak, (2) loans have shorter term, (3) there is less time remaining to maturity, and (4) the property is in a more volatile market. Finally, the borrower selection process impacts ruthlessness and the CMBS borrowers are more likely to behave ruthlessly than the GSE borrowers. Borrowers with market expertise can assess with more confidence the benefits of supporting an underperforming property based on potential future upside. Further, borrowers who have access to capital and overall liquidity have greater ability to support a property until the market or the property performance improves. Consequently, for CMBS investors performing scenario analysis, using different default rates for the different categories of loans based on LTV/DCR buckets and characteristics such as the ones discussed above may be better than trying to use fixed cutoff numbers for DCR and LTV to examine each loan to determine if it will default or not. 1 Brickman, D., Guggenmos, S., and Li, J. 2011 “Mysteries Revealed — Why CMBS Multifamily Performance is So Much Worse than Agency and Life Company Experience” CRE Finance World Summer Default Ruthlessness: Examining Borrower Default Behavior


CRE Finance World, Winter 2014
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