Commercial Mortgage Underwriting: How Well Do Lenders Manage the Risks?

37 Pages Posted: 30 Dec 2004

See all articles by Robert Grovenstein

Robert Grovenstein

University of Connecticut - Department of Finance

C. F. Sirmans

Florida State University - Department of Risk Management, Insurance, Real Estate & Business Law

John P. Harding

University of Connecticut - School of Business - Center for Real Estate and Urban Economic Studies

Sansanee Thebpanya

Bangkok University School of Business Administration - Dept. of Finance

Geoffrey K. Turnbull

Georgia State University - Department of Economics

Date Written: August 2004

Abstract

Loan-to-value ratio and debt service coverage ratios have long been viewed as the two important quantitative measures of the default risk of commercial mortgages. Option-based models of default provide strong theoretic support for the importance of original loan-to-value ratio. The same theoretical predictions have found strong empirical support in residential single-family mortgage analyses. However, recent empirical studies of commercial mortgage default have raised questions about the role of loan-to-value ratio in assessing the riskiness of commercial mortgages. These studies generally either find no relationship or a puzzling negative relationship between loan-to-value ratio and default.

In this paper, we use a very large data base of commercial loan histories to thoroughly investigate this issue. We find strong evidence that loan-to-value ratio (and debt service coverage ratio) is endogenous to the underwriting process. Lenders react to other (unmeasured) risk factors by a combination of credit rationing (lowering the loan amount) and pricing. As a result, unusually low loan-to-value ratio loans appear to have above average risk in other dimensions and their default probabilities are equal to or higher than average. We find that the pricing spread that lenders establish as part of the underwriting process serves as an excellent summary measure of the riskiness of the loan. We test the effectiveness of lenders' ability to appropriately price loan-to-value risk and find that, on average, there is no unpriced effect of loan-to-value ratio after controlling for the lender's pricing.

Suggested Citation

Grovenstein, Robert and Sirmans, C. F. and Harding, John P. and Thebpanya, Sansanee and Turnbull, Geoffrey K., Commercial Mortgage Underwriting: How Well Do Lenders Manage the Risks? (August 2004). Available at SSRN: https://ssrn.com/abstract=641285 or http://dx.doi.org/10.2139/ssrn.641285

Robert Grovenstein

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States

C. F. Sirmans

Florida State University - Department of Risk Management, Insurance, Real Estate & Business Law ( email )

Tallahasse, FL 32306
United States
850 644-4076 (Phone)

HOME PAGE: http://www.cob.fsu.edu/rmi

John P. Harding (Contact Author)

University of Connecticut - School of Business - Center for Real Estate and Urban Economic Studies ( email )

2100 Hillside Road
Unit 1041RE
Storrs, CT 06269-2041
United States
860-486-3227 (Phone)
860-486-0349 (Fax)

Sansanee Thebpanya

Bangkok University School of Business Administration - Dept. of Finance ( email )

Phaholyotin Road, Klong 1
Klong Luang
Pathumthani, 12120
Thailand

HOME PAGE: http://lily.bu.ac.th/~sansanee.t/

Geoffrey K. Turnbull

Georgia State University - Department of Economics ( email )

P.O. Box 3992
Atlanta, GA 30302-3992
United States
404-651-0419 (Phone)
404-651-2737 (Fax)

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