Macroeconomic Growth, Real Estate Market Conditions, and the Time Series Dynamics of CMBS Loan Default Risk

Abstract

Recent financial market turmoil calls for better understanding of the default risk of mortgages and mortgage-related securities. In this paper, I study commercial mortgage default risk using the performance data of nearly 50,000 CMBS loans. Particularly, I examine the time series dynamics of commercial mortgage default risk and the underlying systematic risk factors in both the macroeconomy and the real estate market. A first-passage model with equilibrium macroeconomic dynamics is presented, and the default hazard rate is solved. The solutions are then put into a state space form and the model is estimated with real world mortgage performance data using extended Kalman filter. Results show large variations of default risk over time in the commercial mortgage market, and that these variations are well explained by two mean-reverting latent risk factors -- a macroeconomic factor and a commercial property market-specific factor. The model and the results can be used in default risk prediction, hedging and pricing.

Keywords: Default risk, CMBS, first-passage model, default hazard rate, Cox proportional hazard model, state space model, extended Kalman filter