Default Clustering and Credit Risks in Commercial Mortgage-Backed Securities
27 Pages Posted: 24 May 2011
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: Suggested Citation
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