Commercial Mortgage Underwriting: How Well Do Lenders Manage the Risks?

Abstract

Loan-to-value ratio and debt service coverage ratios have long been viewed as the two important quantitative measures of the default risk of commercial mortgages. Option-based models of default provide strong theoretic support for the importance of original loan-to-value ratio. The same theoretical predictions have found strong empirical support in residential single-family mortgage analyses. However, recent empirical studies of commercial mortgage default have raised questions about the role of loan-to-value ratio in assessing the riskiness of commercial mortgages. These studies generally either find no relationship or a puzzling negative relationship between loan-to-value ratio and default. In this paper, we use a very large data base of commercial loan histories to thoroughly investigate this issue. We find strong evidence that loan-to-value ratio (and debt service coverage ratio) is endogenous to the underwriting process. Lenders react to other (unmeasured) risk factors by a combination of credit rationing (lowering the loan amount) and pricing. As a result, unusually low loan-to-value ratio loans appear to have above average risk in other dimensions and their default probabilities are equal to or higher than average. We find that the pricing spread that lenders establish as part of the underwriting process serves as an excellent summary measure of the riskiness of the loan. We test the effectiveness of lenders' ability to appropriately price loan-to-value risk and find that, on average, there is no unpriced effect of loan-to-value ratio after controlling for the lender's pricing.