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 (Mt/Vt), 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 Mt/Vt, but even at high ratios Mt/Vt 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 Mt 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.