Pricing Defaulted Italian Mortgages

Michela Pelizza,Klaus R Schenk-Hoppé

doi:10.3390/jrfm13020031

Michela Pelizza, Klaus R Schenk-Hoppé

Open Access

https://doi.org/10.3390/jrfm13020031

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Abstract

Our paper forecasts the expected recovery rates of defaulted Italian mortgage loans backed by either residential or commercial real estate. We apply an exponential Ornstein–Uhlenbeck process to model the price dynamics at the provincial and regional level, and two haircut models to estimate the liquidation value. Compared to our findings, rating agencies such as Moody’s, which use geometric Brownian motion to model the price dynamics, paint a rosier picture with higher recovery rates. As a consequence, non-performing mortgage loans held by Italian banks might be overvalued.

Highlights

IntroductionForecasting expected recovery rates of defaulted mortgage loans relies on modelling the stochastic price process (typically price per square meter of a specific property type) as well as possibly employing a realistic liquidation model
Forecasting expected recovery rates of defaulted mortgage loans relies on modelling the stochastic price process as well as possibly employing a realistic liquidation model
Moody’s Investors Service (2004, 2019) valuation model of defaulted Italian mortgages is based on the assumption that prices per square meter follow a geometric Brownian motion, a popular model to describe stock prices

Summary

Introduction

Forecasting expected recovery rates of defaulted mortgage loans relies on modelling the stochastic price process (typically price per square meter of a specific property type) as well as possibly employing a realistic liquidation model. The recovery rate is the fraction of the value of an asset recovered from liquidating the collateral. The collateral is typically the value of the property. Our aim is to forecast expected recovery rates of defaulted Italian mortgage loans backed by either residential or commercial real estate. Moody’s Investors Service (2004, 2019) valuation model of defaulted Italian mortgages is based on the assumption that prices per square meter follow a geometric Brownian motion, a popular model to describe stock prices. Property price dynamics are important as they capture the loan-to-value ratio, which in turn determines loss given default and the recovery rate.

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