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Commercial Mortgage Pricing with Unobservable Borrower Default Costs
Author(s) -
Riddiough Timothy J.,
Thompson Howard E.
Publication year - 1993
Publication title -
real estate economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.064
H-Index - 61
eISSN - 1540-6229
pISSN - 1080-8620
DOI - 10.1111/1540-6229.00611
Subject(s) - unobservable , economics , default , mortgage underwriting , econometrics , probability of default , equity (law) , synthetic cdo , collateralized debt obligation , real estate , actuarial science , mortgage insurance , credit risk , finance , insurance policy , collateral , casualty insurance , political science , law
This paper develops a pricing model for commercial real estate mortgage debt that recognizes the influence of default transaction costs on the borrower's default decision. These costs are heterogeneous across borrowers and largely un‐observable to the lender/investor at the time of origination or loan purchase. A recognition of these unobservable costs can explain why borrower default decisions may differ from those predicted by “ruthless” mortgage‐default pricing models. We address the determinants of default choice and timing by replacing sharp default boundaries found in the ruthless models with “fuzzy” boundaries that account for investor uncertainty with respect to evaluating borrower default decisions. To implement our model, we estimate probabilities of default as a junction of time and net equity in the property. Then, given that default occurs, loss severities are modeled based on expected property value recovery net of foreclosure costs and time until the asset is actually sold. Under reasonable parameter value choices, resulting Monte Carlo simulations produce numerical mortgage price estimates as well as component default frequency and severity levels that realistically reflect default premiums and loss levels observed in the marketplace.