Commercial mortgage prepayments under heterogeneous prepayment penalty structures

Journal of Real Estate Research, The, Jul-Sep 2003 by Fu, Qiang, LaCour-Little, Michael, Vandell, Kerry D

7. "Burnout," or the extent to which the loan has already been exposed to positive refinancingincentives;

8. The prepayment penalty "type, and related characteristics;

9. The remaining term(s) until any reduction(s) in the current prepayment penalty;

10. The magnitude of expected reduction(s) in the current prepayment penalty; and

11. Uncertainty in the level(s) of future prepayment penalties.

These time-varying covariates relate to the pure options framework and do not include other factors that may be influential but arise outside of the pure options framework. Such variables may be associated with transaction costs, factors influencing borrower demand or information asymmetries. They may relate to the property, the borrower or the lender, as well as the loan terms and the macroeconomic environment. Those that have been identified in the literature on multifamily prepayment previously discussed include:

12. The current loan-to-value ratio;

13. The expected trend in the future loan-to-value ratio; and

14. Uncertainty with respect to the future loan-to-value ratio.

Variables (12) through (14) are primarily relevant to default. Since previous work (Kau, Keenan, Muller and Epperson, 1992) has shown the default option to be interrelated with the prepayment option in the sense that default is a form of prepayment and borrowers who would otherwise prepay may find it optimal to default if they are prevented from prepayment, it may be important to consider the default option, at least in a competing risks framework. LTV may also be important in prepayment from an institutional standpoint, since underwriting rules make refinancing high LTV loans difficult, especially if property values declines. This phenomenon has been documented in the single-family market (Green and LaCour-Little, 1999; and Mattey and Wallace, 1999a).

15. Seasoning, or elapsed time since origination.

This variable could represent a number of factors, including increasing or decreasing commitment or "attachment" to the investment over time ("attachment to neighborhood and the housing unit" has been shown to be important in single family prepayments), the increased probability of "trigger events" or the need to consume liquid assets to maintain the current investment.

16. Seasonality.

This variable could represent seasonally correlated trigger events that motivate sales or refinancings, such as end of the calendar, fiscal, or tax year, or the timing of quarterly reports, although it does not correspond directly to the seasonal patterns of household mobility that are evident in single family prepayment models.

17. Financial sophistication of the investor or information availability, proxied by loan size or networth of borrower;

18. Tax law changes, which could affect any of the option-theoretic or other variables influencing prepayment;

19. Borrower solvency, proxied by the contemporaneous debt-coverage ratio;

20. Type of borrower, which may proxy for borrower sophistication in recognizing prepayment advantages and knowledge of prepayment procedures;