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Commercial Mortgage Workout Strategy and Conditional Default Probability: Evidence from Special Serviced CMBS Loans

Jun Chen and Yongheng Deng
The existing literature in commercial mortgage defaults focuses on the process for loans in the current status to the default status. This study recognizes that commercial mortgage default is not a one-step process and examines a previously unexplored aspect in the whole default process, that is the stage between the initial delinquency to default. In the analysis of the conditional default risk during this stage, we distinguish the servicers’ behavior from the borrowers’ behavior and consequently break our empirical analysis into two parts. A multinomial logit model is applied to analyze the servicers’ choice of workout options and a proportional hazard model is applied to analyze the borrower’s default decision making process under time-varying conditions. Using the data sample that consists of 493 special serviced loans in 144 CMBS deals, we find that cash flow condition is the most significant factor in the servicers’ decision making process. We also find that borrowers make default decisions based upon both the equity position in the mortgage and the cash flow condition in the space market. In addition, key real estate space market variables, such as market-level vacancy rates, also provide useful information in explaining commercial mortgage defaults. Finally, we find that special service seems to be functioning as it reduces the probability that a troubled loan will default.