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The Termination of Mortgage Contracts through Prepayment and Default in the Commercial Mortgage Markets

Brian A. Ciochetti, Yongheng Deng, Bin Gao and Rui Yao
A better understanding of commercial mortgage termination through default or prepayment has important practical implications. With their relatively simple financial structure ¾ one underlying property and one collateralized debt obligation ¾ commercial mortgages provide an ideal economic setting to test the rationality of investors and the empirical applicability of contingent claim models. For practitioners, the identification of factors relating to default and/or prepayment helps efficiently determine not only the appropriate spreads in the underwriting of whole loans, but also diversification strategies affecting pools of loans by such categories as property type and geographic location. For fixed income investors, an appropriately specified empirical termination model can provide a structured methodology to incorporate contemporaneous information in the valuation of not only whole commercial loans, but also their securitized counterparts. Moreover, such a model provides a basis for regulators to set standards efficiently in risk-based minimum capital requirements for both life insurance companies and commercial banks.