Default Clustering and Credit Risks in Commercial Mortgage-Backed Securities

27 Pages Posted: 24 May 2011

See all articles by Gang-Zhi Fan

Gang-Zhi Fan

Beijing Normal University-Hong Kong Baptist University United International College

Tien Foo Sing

National University of Singapore (NUS) - Department of Real Estate

Seow Eng Ong

National University of Singapore (NUS) - Department of Real Estate

Date Written: February 19, 2011

Abstract

This paper proposes an intensity-based pricing model with default dependence structure for CMBS bonds. Three features are incorporated into the proposed model. First, default is a Poisson jump process defined as a function of mortgage rating information in the model. Second, underlying property value risks are modeled using a high dimensional Brownian motion process in order to better capture the driving roles of systematic risk and idiosyncratic risk in determining property value. Third, default dependence structure is built into the extended model. Based on a set of input parameters, we simulate various pricing effects on a hypothetical CMBS using the proposed model structure. The results of the base-line intensity model show that yield spreads on CMBS bonds increase in the recovery rate, but decreases in the hazard rate. Security structured with smaller subordination tranche exposes CMBS bonds to higher default risks. The model also predicts that default clustering increases required yield spreads of CMBS bonds. At a 70% recovery rate and a 3% default hazard rate, yield spreads of Junior bonds are expected to increase by 169 basis points when counterparty risks increase by 50%. The results highlight the importance of clustering risks associated with counterparty default when valuing CMBS bonds.

Keywords: Default cluster, counterparty risk, intensity model, subordination structure

JEL Classification: G13, G32

Suggested Citation

Fan, Gang-Zhi and Sing, Tien Foo and Ong, Seow Eng, Default Clustering and Credit Risks in Commercial Mortgage-Backed Securities (February 19, 2011). Available at SSRN: https://ssrn.com/abstract=1843126 or http://dx.doi.org/10.2139/ssrn.1843126

Gang-Zhi Fan

Beijing Normal University-Hong Kong Baptist University United International College ( email )

2000 Jintong Road
Zhuhai, Guangdong 519087
China

Tien Foo Sing (Contact Author)

National University of Singapore (NUS) - Department of Real Estate ( email )

4 Architecture Drive
Singapore 117566
Singapore

Seow Eng Ong

National University of Singapore (NUS) - Department of Real Estate ( email )

4 Architecture Drive
Singapore 117566
Singapore
01-65-6516-3552 (Phone)
01-65-6774-8684 (Fax)

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