Commercial Mortgage Termination and Pricing: Theory and Evidence from 1970 to 2015

''As the recession's gotten worse in the last six months or so, we're seeing increased vacancy, declining rents, falling prices-and so, more pressure on commercial real estate...we are somewhat concerned about that sector and are paying very close attention to it.''Federal Reserve Chairman Ben S. Bernanke testifying before the Senate Banking Committee in July of 2009Following the residential mortgage market collapse in 2008, the ''next shoe to drop'' was thought to be default in the commercial mortgage market. According to the Mortgage Bankers Association (MBA), the commercial mortgage market had total commercial and multifamily debt outstanding of $2.4 trillion during the second quarter of 2011. This figure represents a substantial decline from the $3.4 trillion of commercial and multifamily debt outstanding during the fourth quarter of 2008. Much of the decline can be attributed to existing loans being paid off at a faster pace than the origination of new commercial and multifamily mortgages, especially among banks, thrift institutions, and commercial mortgage-backed security (CMBS) issues.Default rates and commercial property prices also changed dramatically as a result of the mortgage market collapse. Default rates (i.e., loans that are 90+ days delinquent) on commercial loans held by banks and thrift institutions, and especially conduit CMBS loans, increased substantially from 2007 to 2010. The MBA and Commercial Real Estate (CRE) Finance Council report that between 2007 and 2010, the default rates of loans held by banks and thrift institutions increased from roughly 0.80% to more than 4%. Similarly, the default rates of conduit CMBS loans increased from roughly 0.20% to more than 5.5% over the same time period.1 Given this significant activity in the commercial mortgage market, our purpose with this paper is to survey the commercial mortgage literature and provide a more comprehensive understanding of commercial mortgage termination.The paper is organized as follows. We begin by comparing the literature on commercial mortgage default and residential mortgage default. We then review the literature on the determinants of commercial mortgage termination (i.e., mortgage default, prepayment, and foreclosure). We next discuss loan loss severities on defaulted and liquidated loans from the early 1990s to the present. We then transition to an analysis of the valuation and pricing accuracy of commercial mortgages and CMBSs. We also describe the role of special servicers in the foreclosure-workout process, and then close with concluding remarks.Comparing the Default Literature on Commercial Mortgages and Residential MortgagesRelative to the commercial mortgage market, the literature on the residential mortgage market is more abundant, primarily due to the greater availability of loan-level data. Jones and Sirmans (2015) provide a comprehensive analysis of residential mortgage default. They segregate the literature by four topics: (1) the determinants of mortgage termination, (2) the relative termination experience of fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs), (3) screening and signaling equilibriums, and (4) loan loss severity and severity rates. Loan characteristics have been found to be the strongest predictors of default. The borrower's FiCo score is the most consistent predictor of default, while home equity, loan-to-value (LTV) ratios, and the probability of negative equity are highly significant and positively related to the default decision. The unemployment rate and transaction costs significantly affect the probability and timing of default. House price appreciation lowers the probability of default, but higher house price volatility increases the probability of default.Although the literature on the relative termination of FRMs and ARMs is limited, the authors find that ARMs display significantly higher default risk than FRMs. The screening and signaling equilibriums suggest that riskier borrowers are more likely to self-select ARMs over FRMs. …