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Attribution Non-Commercial (BY-NC)

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Abstract Commercial mortgage backed securities (CMBS) are complex asset backed securities trading in markets that do not currently use derivatives pricing technology. This lack of usage is due to the complexity of the modeling exercise, and only the recent and costly availability of historical data. As such, CMBS markets provide a natural environment for the testing of market eciency with respect to this "costly" information. Using this information, this paper develops a CMBS pricing model to provide a joint test of the model and market eciency. Backtesting our pricing model for 4 years, although there is some evidence of abnormal trading prots, we cannot reject the eciency of the CMBS markets.

Introduction

The commercial mortgage backed securities (CMBS) market is a relatively new market, jump started by the Resolution Trust Corporation working out the commercial loan portfolios of many failed Thrifts and Savings & Loans in the early 1990s. The annual issuances of new CMBS rst exceeded 50 billion dollars in 1998 and the current outstanding balance of CMBS now exceeds $800 billion dollars.1 Third party vendors providing rudimentary cashow modeling and structuring software tools for the generation of scenario specic changes in CMBS yields were rst available in the late 1990s as well. At present, however, there is still no vendor that provides derivatives based CMBS pricing models for industry usage.2 This is in contrast to the residential mortgage backed

Executive Ocer WOTN, Ithaca, N.Y. 14850. Graduate School of Management, Cornell University, Ithaca, New York, 14853. raj15@cornell.edu. Martin J. Whitman School of Management, Syracuse University, Syracuse, N.Y. 13244. 1 From the Commercial Mortgage Securities Association, www.cmbs.org/statistics. 2 In fact, a private survey conducted by this papers authors of the major investment banks indicated no usage of derivatives pricing tools for CMBS by either the investment banks trading or risk managment departments as well.

Johnson Chief

securities market, where derivatives pricing technology has been in signicant usage for over a decade (see Fabozzi (2000)). This lack of usage is due to the historical evolution of the market (being real estate based), the complexity of the modeling exercise, and only the recent (but costly) availability of relevant historical data. The complexity of CMBS modeling is due to the simultaneous inclusion of four signicant risks - market, credit, prepayment and liquidity. In addition, CMBS are quite complex. To value a CMBS, one must rst understand the cash ows to the underlying CMBS loan pools, the cash ow allocation rules to the various bond tranches, the prepayment restrictions, and the prepayment penalties. These provisions can, and often do, dier across the dierent CMBS trusts. Also, implementation of a model requires signicant computational eort due to the quantity of the outstanding loans in any particular CMBS trust, the dimension of the valuation problem (due to the number of risks present), and the number of outstanding CMBS trusts. Finally, estimation of the relevant parameters is itself a non-trivial problem, given the sparsity and the diversity of historical CMBS data, especially with respect to the history and current composition of the existing CMBS loan pools. Only recently have vendors made available (at a signicant fee) the relevant historical data and computational tools, but in a form not conducive to risk management analysis. Even though the relevant risk management technology is publicly available information, as argued above, its implementation requires signicant expertise and out of pocket costs for computing facilities and historical information. As such, the CMBS markets provide a natural environment for the testing of market eciency with respect to this "costly" risk management information. Every such test of market eciency, however, necessarily involves a joint test with a pricing model. Formulating a new model for pricing CMBS, this paper provides such a joint test of CMBS market eciency and our new pricing model. Hence, a secondary contribution of this paper is the development, implementation, and testing of a risk management model for pricing CMBS. Of the four relevant risks discussed previously, we model interest rate risk using a multifactor Heath, Jarrow, Morton (1992) model. Credit risk is modeled using the reduced form methodology introduced by Jarrow and Turnbull (1992), (1995). Because we are valuing CMBS from the markets perspective, following the recent insights of Due and Lando (2001) and Cetin, Jarrow, Protter, Yildirim (2004), an intensity process is used to incorporate prepayment risk with regional property value indices included as explanatory variables. Lastly, liquidity risk is incorporated into both the estimation of CMBS fair values and the testing of various trading strategies, motivated by the recent insights of Cetin, Jarrow, Protter (2004) in this regard. In total, our model includes 64 correlated factors generating the randomness inherent in the CMBS loan pool cash ows. This represents 4 interest rate factors and 60 property value indices. In addition, each commercial mortgage loan has three independent random variables generating its delinquency status, default and prepayment risk. As such, the complexity of the modeling structure necessitates using Monte Carlo simulation for the computation of fair values. 2

We t our CMBS model using daily forward rate curves, National Council of Real Estate Investment duciaries (NCREIF) regional property value indices, various Bloombergs Real Estate Investment Trust (REIT) stock price indices, and Trepps comprehensive historical commercial loan database that includes information on loan characteristics, defaults, prepayments, and recovery rates, see Reilly and Golub (2000), Trepp and Savitsky (2000). Standard procedures were used to parameterize the term structure model (see Jarrow (2002)). A competing risk hazard rate procedure was used to t both default and prepayment risk, consistent with the observation that the occurrence of default precludes prepayment, and conversely. Market quotes obtained from Trepps CMBS Pricing ServiceTM were used for the joint testing of the model and market eciency. Trepps market quotes for the entire universe of investment grade CMBS are updated daily and they represent an average of end of day marked-to-market prices, contributed by multiple dealers and institutional investors.3 Because CMBS trade over-the-counter, Trepps CMBS Pricing Service provides the best historical pricing database for analysis. It is important to note that non IO, investment grade CMBS trade in relatively liquid markets, and the Trepp database is comparable to other xed income databases frequently used in empirical investigations of credit risk models (see, e.g. Duee (1999)). To the extent that these quotes do not represent prices at which actual trades could have be executed, our conclusions must be accordingly tempered. We compared the estimated model prices to market prices from July 2001 to April 2005. If we had used spreads instead of prices, this would be equivalent to computing the bonds option adjusted spreads (OAS). We observe statistically signicant price dierences, rejecting the joint hypothesis of the model and market eciency. To study whether the source of this rejection could be due to CMBS market ineciency, we back tested our model to see if it could generate abnormal returns. In this regard, respecting the information available to the market at the relevant times, we formed trading strategies to take advantage of the mispricings as identied by the model. Using these trading strategies, we compared the performance of undervalued and overvalued CMBS portfolios, matched by risk (both credit and interest rate) from July 2001 to April 2005. In these tests, for all risk categories, the undervalued portfolios signicantly outperformed the overvalued portfolios. For example, in comparing cumulative returns from the undervalued short tenor AAA portfolio (33.26%) to the overvalued short tenor AAA (17.60%), we see a cumulative outperformance of 15.65% over the testing period. We also compared the undervalued and the overvalued portfolios to those of matching equal risk CMBS indices over the testing period. Consistent with the under- versus overvalued comparison, the undervalued portfolios outperformed the matched CMBS index and the overvalued underperformed the matched CMBS index for all risk categories over the testing horizon.

3 Many of the largest institutions in the country rely on Trepp CMBS PricingT M for daily and month-end valuations. See http://trepp.com/m/ovr_pricing.cgi?whichTrepp=m&whichLoan= for more information.

We analyzed these abnormal returns for omitted risk factors related to interest rates, property value, and market risk. We found that the overvalued and undervalued portfolio returns are correlated with various interest rate risk factors, providing some evidence that these abnormal returns may be due to omitted risk premia. Omitted risk premia is consistent with an ecient CMBS market. Alternatively, we also provide a behavioral nance explanation for these correlations, that is inconsistent with an ecient market. Which explanation is correct awaits subsequent research. Since we cannot unambiguously reject an ecient CMBS market, we also provide a simple adjustment to our model that generates unbiased estimates for CMBS prices, useful for hedging or marking-to-market, in the circumstance that the CMBS market is ecient. There is an enormous literature related to mortgage backed securities, both residential and commercial. For residential mortgage backed securities, the papers related to our methodology include Schwartz and Torous (1992),(1989), Deng, Quigley, Van Order (2000), McConnell and Singh (1994), Stanton (1995), Kau, Keenan and Smurov (2004), and Goncharov (2004). With respect to CMBS, Snyderman (1991) and Esaki, LHeureux and Snyderman (1999) provide summary statistics on commercial mortgage defaults and loss severities from 1972 - 1997. Archer, Elmer, Harrison and Ling (2004) study a default model for multifamily commercial mortgages. Ambrose and Sanders (2003), Ciochetti, Lee, Shilling and Yao (2004), and Yildirim (2005) estimate competing risk hazard and prepayment models for CMBS. These studies do not investigate valuation or hedging of CMBS. Titman and Torous (1989) study the valuation of a class of CMBS called bullet bonds. Childs, Ott and Riddiough (1996) simulate a structural model for CMBS valuation to determine the models implications for tranche values. They do not empirically test their model. An outline for this paper is as follows. Section 2 provides a brief description of CMBS. The model is described in section 3, the empirical processes in section 4, and the estimates are provided in section 5. Section 6 provides the joint tests of market eciency, and section 7 concludes the paper.

CMBS are a subset of a class of nancial securities known as asset backed securities. CMBS are bonds of various seniorities, whose payments are made from the cash ows obtained from a CMBS trust. A CMBS trust is a legal entity that consists of a collection of commercial mortgage loans, called the underlying loan pool. These commercial mortgage loans are usually xed rate loans of a particular maturity, although they can include oating rate loans as well. The properties underlying these loans can be diverse, both geographically and economically. Issued against the cash ows of the CMBS loan pool are a collection of bonds. These bonds are usually xed rate with a given maturity. Dierent classes of bonds are issued (called bond tranches) with dierent seniorities with respect to the cash ows from the loan pool. While all bonds receive in-

terest payments (subject to availability), the outstanding principal balance of the bonds are reduced in the order of seniority by scheduled amortization and prepayment of principal. Principal repayment can occur due to voluntary prepayments or recoveries in the event of default. In reverse order to seniority, the least senior bonds lose their underlying principal rst from defaults. In addition, most CMBS trusts issue a class of bonds call interest only (IO) bonds, whose cash ows come solely from the loan pool interest payments, but only after all the senior bond coupons are paid. IO bonds make no principal payments. A typical conduit transaction is structured using a CMBS trust that contain anywhere from one to sever hundred underlying loans (mostly rst liens), and issues about 10 dierent bond tranches including at least one IO bond. There are over 650 CMBS trusts trading over-the-counter across both xed-rate and oating-rate collateral including both US and foreign collateral. For a more detailed description see Sanders (2000).

The Model

This section constructs the CMBS valuation model. The model presented is not the most complex formulation possible. Extensions and generalizations will be discussed in footnotes. However, given the current limitations in the availability of accurate and consistent data, more complex formulations would provide little, if any, additional explanatory power in the subsequent implementation. CMBS face market (interest rate), credit, prepayment, and liquidity risks.4 In the initial formulation, we abstract from liquidity risk. That is, we assume frictionless and competitive bond markets. Liquidity risk is only addressed in the empirical implementation. This decomposition is similar to the logic underlying the computation of option adjusted spreads for residential mortgage backed securities. OAS measure all market impacts (including mispricings and liquidity risk)5 , after controlling for interest rate and prepayment risk via the use of a model. We concentrate on modeling the interest rate, credit and prepayment risks inherent in CMBS. The interest rate risk is handled using a multi-factor Heath, Jarrow, Morton (1992) model for the term-structure evolution. To model the credit risk component, we utilize the reduced form credit risk methodology rst introduced by Jarrow and Turnbull (1992),(1995). This is done because our goal is to value CMBS from the markets perspective, and not the borrowers. As shown by Due and Lando 2001) and Cetin, Jarrow, Protter, Yildirim (2004), given the markets information set - a subset of the borrowers- default times are inaccessible. Lastly, we model prepayment risk using an intensity process. This is also done because from the markets perspective, prepayment often appears as a surprise. As with credit risk, this is due to asymmetric information with respect to the propertys economic condition, transaction costs, and the borrowers personal situation (see Stanton (1995) for

4 There is often a fth type of risk discussed with respect to CMBS called extension risk. Extension risk is discussed below. 5 See Jarrow (2007) for an explanation of OAS spreads in the context of an HJM model.

a justication of this approach for residential mortgages). We are given a ltered probability space (, z, (zt )t[0,T ) , P) satisfying the usual conditions (see Protter (1990)) with P the statistical probability measure. The trading interval is [0, T ]. Traded are default free bonds of all maturities T [0, T ], with time t prices denoted p(t, T ), and various properties, commercial mortgage loans, and CMBS bonds introduced below. The spot rate of interest at time t is denoted rt . Let (Xt )t[0,T ] represent a vector of state variables, adapted to the ltration, describing the relevant economic state of the economy. For example, the spot rate of interest could be included in this set of state variables. We assume that markets are complete and arbitrage free so that there exists a unique equivalent martingale probability measure Q under which discounted t prices are martingales. The discount factor at time t is e 0 rs ds . Since we are interested in valuing CMBS, most of the model formulation will be under the probability measure Q.

Commercial mortgage loans (CMLs) are issued against commercial properties. These CMLs can be xed rate or oating. For this discussion, we concentrate on xed rate loans. Floating rate notes can be handled in a similar fashion. Our computer implementation, to be discussed below, handles these explicitly. These mortgage loans are issued to borrowers based on the quality (economic earning power) of the underlying property. If the property loses value, the borrower may decide to default on the loan. As such, CMLs face both market (interest rate) and credit risk. Description Fixed rate CMLs are similar to straight corporate bonds with the exception that the loans principal is partly amortized over the life of the loan. Typical CMLs have a (T /n) balloon payment structure. In the (T /n) balloon payment structure, the loan has a xed maturity date T , a principal payment F , scheduled payments P paid at equally spaced intervals over the life of the loan (usually monthly), and a coupon rate per payment period c = C/F where C is the dollar coupon payment. The payments P are determined as if the loan would be completely amortized in n periods. But, instead of lasting n periods, a balloon payment occurs at time T < n representing the remaining principal balance at that time, denoted BT . The payment per period is (1 + c)n P = cF (1 + c)n 1 and balloon payment is BT = F (1 + c)T P 6 (1 + c)T 1 . c

For analysis, one can think of CMLs as an ordinary coupon bond with a face value of BT and a coupon payment of P . As common to residential mortgages, CMLs have an embedded prepayment option. Unlike residential mortgages, CMLs cannot be prepaid during a lockout period, denoted [0, TL ]. After the lockout period, the loan can be prepaid, but there is a time dependent prepayment penalty. These prepayment penalties can take various forms (see Trepp and Savitsky (2000)), and they are designed to make prepayment unattractive based on the changing level of interest rates. At present, roughly 85% of all new issue CML borrowers are permitted to prepay the CML only by incurring the costs of defeasance. Defeasance loans require the borrower to replace the mortgage loan payments P with a collection of US Treasury Strips that match the remaining payments on the loan (for an analysis of the defeasance option in CMBS, see Dierker, Quan and Torous (2005)). As such, prepayments under defeasance actually increase the value to the lender as the US Treasury will neither default nor prepay such cashows in the future. In the case of CMLs in CMBS, the lender is an institutional investor who is entitled to cashows from such defeased loans that are included in the trust backing their CMBS. To address the powerful credit and prepayment aspect of defeasance loans, in our model we treat loans in the interval characterized by defeasance in the prepayment restriction schedules as fully locked-out until such loans emerge from the defeasance period. Despite the prevalence of defeasance, and other prepayment restrictions such as yield maintenance and xed penalties, prepayment can and does occur, primarily due to cash-out renancings. In a cash-out renancing, CML borrowers incur the costs related to prepayment penalties on their loans, if such costs are outweighed by the benets of the rise in the value of the property securing the loans. Since our historical database includes many loans that are not defeasance, and since a signicant portion of new issue loans in the CMBS market today are not exclusively defeasance loans, it is essential that our methodology includes a general procedure for accommodating the risks of prepayments in CMBS. Letting Bt denote the remaining principal balance of the loan at time t, we represent the total prepayment amount as Bt (1 + Yt ) where Yt is the time t prepayment cost as a percentage of the remaining principal balance. Yt is determined by the specic mortgage loans prepayment penalities and can dier across mortgages. Valuation To value a CML, we x a particular loan. Let Ut be a vector of deterministic loan specic characteristics. There are 4 possible states of the loan (current c, delinquent l, defaulted d, and prepaid p). Both default and prepayment are absorbing states, and current/delinquency are repeating states for the loan. Let C(t) be a process taking values in the set {0, 1, 2, 3, ...}, counting the number of times up to and including time t that the loan switches between the current and the delinquent states. Note that C(0) = 0. Let the loan be 7

initialized in the current state (we could have initialized in the delinquent state instead). We assume that C(t) follows a Cox process with an intensity (t) = {1{C(t) is odd} c (t, Ut , Xt ) + 1{C(t) is even} l (t, Ut , Xt )} under the martingale measure.6 If C(t) is odd, then the intensity governing switching to current is c (t, Ut , Xt ). If C(t) is even, then the intensity governing switching to delinquent is l (t, Ut , Xt ). We can dene a point process N (t) = {1 if C(t) is even, 0 if C(t) is odd} = {1 if delinquent, 0 if current} with N (0) = 0. The relationship between the point process N (t) and the counting process C(t) is given by dN (t) = 1{N (t)=1} dC(t) + 1{N (t)=0} dC(t) where dN (t) = N (t)N (t). Note that N (t) also follows a Cox process with the same intensity (t) = {1{N(t)=1} c (t, Ut , Xt ) + 1{N (t)=0} l (t, Ut , Xt )} under the martingale measure. There is an implicit assumption here, that needs to be made explicit. This process supposes that the probability of current or delinquent is independent of being current or delinquent. This assumption is equivalent to supposing that current or delinquency are uninformative with respect to next periods current or delinquency status. An analogy might be that of a household paying an electric bill. The households are usually current, but in some months, they are delinquent. Being delinquent does not mean the household will be more likely to be delinquent in the next month. However, the electric company does notice that those households that are delinquent in a month, are more likely to default then are those that are current. This is reected in the process next described. Let d be the random default time on this loan and denote its point process by Nd (t) 1{ d t} . We assume that the point process follows a Cox process with an intensity d (t) = d (t, Nt , Ut , Xt ) under the martingale measure. The Cox process assumption implies that conditional upon the information set generated by (Nt , Xt )t[0,T ] up to time T , Nd (t) behaves like a Poisson process. If default occurs, the recovery on the loan is assumed to be d (B d + P ). The trust receives d percent of the remaining principal balance plus the prorated scheduled principal payment.7 We assume that t = (t, Ut , Xt ) is a function depending upon the state of the loan and the economy, implying a stochastic recovery rate. Under this intensity process, the probability that a default will occur on the loans balloon payment date [T dt, T ] is approximately d (T, NT , UT , XT )dt.8 Allowing for default on the balloon payment date captures what is often called extension risk in the CMBS literature. Extension risk is the risk that, on the

6 This intensity process and others introduced below are assumed to satisfy the necessary measurability and integrability conditions required to guarantee that expression (3) exists and is well-dened, see Lando (1998). 7 For notational simplicity, we assume that the prorated portion of the loan payment is the entire payment P . However, in the subsequent valuation software, the exact prorated portion of the loan payment is computed. 8 The default process could be generalized to allow a positive probability of a default at time T . Unfortunately, our database does not have sucient defaults on the balloon payment date to allow estimation of this more general model.

balloon payment date, the borrower will not be able (or willing) to make the balloon payment, but is able (or willing) to continue making the coupon and amortization payments P . The belief is that by extending the loan, the balloon payment will be made at a later date. The trustee of the CMBS trust decides whether or not to extend the loan and the conditions of the extension. The balloon date could be extended (usually less than 3 years) and the underlying coupon rate, tenor, and leverage of the loan may be altererd in workout proceedings, though generally with no alternation to the trust documentation. If extension occurs, one can think of this situation as being equivalent to the occurrence of default, but the extension process is initiated to increase the recovery rate on the loan. Let p be the random prepayment time on this loan and denote its point process by Np (t) 1{ p t} . Again, we let the prepayment point process be a Cox process with intensity p (t) = p (t, Nt , Ut , Xt ) under the martingale measure. If the loan is prepaid, the trustee receives B p (1 + Y p ) dollars. This represents principal plus the prepayment penalty. For analytic convenience, we assume that conditional upon the information set generated by (Nt , Xt )t[0,T ] up to time T , Nd (t) and Np (t) are independent Poisson processes. Given the previous notation, as viewed from time t, the cash ow to a CML at time T is

T X

j=t+1

P 1{j< d } 1{j< p } e

T j

rs ds

T d

+ d (B d + P )1{ d T } 1{ d p } e

rs ds

T p

(1)

rs ds

The rst two terms in expression (1) give the promised payments on the CML if there is no default and no prepayment. The third term gives the accumulated payment up to time T if a default occurs prior to a prepayment, and the fourth term gives the accumulated payment up to time T if a prepayment occurs prior to a default. Given the martingale measure Q, the time t present value of these cash ows is Et {

T X

j=t+1

P 1{j< d } 1{j< p } e

j t

rs ds

d t

T t

rs ds

+ d (B d + P )1{ d T } 1{ d p } e

rs ds

p t

(2)

rs ds

where Et () denotes expectation under the martingale measure. Under the Cox processes, standard techniques yield Et {

T X

P e

+ (BT + P )e

j=t+1

+ +

s (Bs + P )d (s)e

T

s (ru +d (u))du t

ds e

T t

p (s)ds

(3)

k t

s (Bs + P )d (s)e

s (ru +d (u))du t

ds p (k)e

p (s)ds

dk

+ +

Bs (1 + Ys )p (s)e

t T t

s (ru +p (u))du t

ds e

T t

d (s)ds

Bs (1 + Ys )p (s)e

s (ru +p (u))du t

ds d (k)e

k t

d (s)ds

dk}.

This valuation expression is proved in the appendix. For the implementation, we calculate the expectation in expression (3) using Monte Carlo simulation.

CMBS Bonds

A CMBS trusts assets consist of a pool of loans whose values were modeled in the previous section. A typical trust, in turn, issues a collection of i = 1, ..., m ordinary coupon bonds and at least one IO bond. Description The ordinary coupon bonds have coupon rates ci , face values Fi , and stated maturity dates Ti at issuance with increasing maturities T1 T2 ... Tm . In a typical sequential pay, senior/subordinated structure, the principal cashows from the trust are allocated based on the bonds stated maturities at issuance. The most senior bonds (maturity T1 ) receive their scheduled principal payments in any month rst, until their principal balance is reduced to zero. Then, the next most senior bonds (maturity T2 ) receive their scheduled principal payments (if any cash ows remain) in any given month until their principal balance is reduced to zero, and so forth to the least senior bonds (maturity Tm ). Coupon cash ows are allocated pro-rata subject to the availability of such coupon cashows. In the case of interest shortfalls, coupon cash ows are allocated in order of seniority and subject to the documentation of the trust. Also, any loan prepayments and/or default recovery payments received are allocated according to seniority as well. These prepayments or defaults on the loans result in prepayment of the principal on the CMBS bonds prior to their maturity. In reverse fashion, any losses in default are subtracted from the least senior bonds (maturity Tm ) principal rst, then working backwards up to the most senior bonds (maturity T1 ) principal. The outstanding principal balance of the IOs at all times is a reection of the notional amount of some collection of principal paying bonds secured by the trusts principal cashows. While the IO bonds have a stated maturity date T0 , implying no principal repayment and only the payment of coupons, their notional balance declines in lockstep with the principal paying bonds from which they are stripped. The interest payments received on the IOs are the 10

cumulative interest payments from the loan pool, less the cumulative coupons paid to the principal paying CMBS coupon bonds. Valuation For the purposes of this section, however, we let the random cash ows at time t to bonds i = 0, 1, ..., m be denoted vi (t). We let bond i = 0 correspond to the IO bond. Then, the time t value of these bonds is given by the following expression Ti X j vi (j)e t rs ds } if t < Ti . (4) bi (t) = Et {

j=t+1

Because of the complexity of the valuation problem, the expectation in this expression will be evaluated using Monte Carlo simulation, described in a subsequent section.

This section describes the stochastic processes for the term structure of interest rates and state variables used in the empirical implementation. We use a multiple factor HJM model for interest rate risk and standard diusion processes for the state variables.

We can specify the evolution of the term structure using forward rates under the martingale measure. The Stochastic Process

p(t,T Let f (t, T ) = logT ) be the instantaneous (continuously compounded) forward rate at time t for the future date T . We use a K factor model HJM model. K X j=1

(5)

RT PK where K is a positive integer, (t, T ) = j=1 j (t, T ) t j (t, u)du, j (t, T ) min[ rj (T )f (t, T ), M ] for M a large positive constant, rj (T ) are deterministic functions of T for j = 1, ..., K , and Wj (t) for j = 1, ..., K are uncorrelated Brownian motions initialized at zero. Under this evolution, forward rates are almost lognormally distributed.

11

The spot rate process, used for valuation, can be deduced from the forward rate evolution. Let rt f (t, t). drt = [f (t, t)/T ]dt + (t, t)dt + But (t, t) = PK j (t, t) Rt

t K X j=1

j=1

j (t, t)du = 0, so

K X j=1

(6)

For the subsequent analysis, we will need to know the evolution of constant maturity zero-coupon bonds. It is shown in an appendix that

K X Z t+T dp(t, t + T ) ( j (t, u)du)dWj (t). = (rt f (t, t + T ))dt p(t, t + T ) j=1 t

(7)

The Empirical Methodology To estimate the forward rate process given in expression (5), we employ a principal component analysis as discussed in Jarrow (2002). Given is a time series of discretized forward rate curves {f (t, T1 ), f (t, T2 ), ..., f (t, TNr )}m where Nr t=1 is the number of discrete forward rates observed, the interval between sequential time observations is and m is the number of observations. Then, percentage f (t+,TN )f (t,TNr ) m }t=1 . From the changes are computed { f (t+,T1 )f (t,T1 ) , ..., f (t,T1 ) f (t,TNr ) percentage changes, the Nr Nr covariance matrix (from the dierent maturity forward rates) is computed, and its eigenvalue/eigenvector decomposition calculated. The normalized eigenvectors give the discretized volatility vectors { rj (T1 ) , ..., rj (TNr ) } for j = 1, ..., Nr .

The state variables in our model correspond to various indices related to the property values underlying the CMBS trusts. All indices are assumed to correspond to the prices of actively traded assets (i.e. values of dierent portfolios of properties). To the extent that these indices do not correspond to actively traded assets, the resulting property prices will contain more noise, and the price processes parameters estimated with larger sampling errors. Nonetheless, under the plausible assumption that this additional noise has zero mean, the resulting estimates will still be unbiased. Since our model only uses these property value indices to determine fair value, and not to hedge, this assumption will not have a signicant eect on the subsequent analysis. There are three levels of property value indices. The rst set of state variables correspond to the price of a particular type of property located in a particular region of the country, e.g. hotels in New York City. The second 12

set of state variables correspond to an index for a particular property type (but across the entire country), e.g. hotels. Lastly, the third state variable is an index across all property types across the entire country, e.g. a REIT general stock price index. The idea underlying this decomposition comes from portfolio theory, where the rst state variable is an individual stock price, the second state variable is an industry index, and the third state variable is the market index. This construction is formulated to facilitate simulation of the state variable processes in a subsequent section. The Stochastic Process We specify the stochastic processes for these state variables in reverse order. All stochastic processes are specied under the martingale measure. The evolution for the economy-wide property index, and the regional property index are dH(t) = rt H(t)dt + (H)H(t)dZ H (t)

H dHi (t) = rt Hi (t)dt + i (H)Hi (t)dZi (t) for i = 1, ..., nH H H (t), Zi (t) are Brownian motions for all i, (H), i (H) are H H H dZ H (t)dZi (t) = HH dt, dZj (t)dZi (t) = HH dt, and i ji

(8) (9)

where Z constants the state for all i, variable Brownian motions are all correlated with the forward rate Brownian H motions: dZ H (t)dWi (t) = H dt and dZj (t)dWi (t) = H dt. i ji The propertyregion index satises X dHj(i) (t) dhi (t) dp(t, t + Tk ) ik ( = rt dt + rt dt) + ij(i) ( rt dt) hi (t) p(t, t + Tk ) Hj(i) (t)

k=1 K

(10)

+ i (

where ik , ij(i) , i , i (h) are constants for all i, k, j(i), the propertyregion index represented by hi (t) is the property type corresponding to the property index h H Hj(i) (t),9 and Zi (t) are Brownian motions independent of Z H (t), Zi (t), Wk (t) for all i, k. The K maturity bonds Tk are chosen to be distinct. Note that in expression (10), the zero coupon bond price returns correspond to constant maturity bonds, i.e. their maturity is always Tk for k = 1, ...K. This formulation is chosen because in the subsequent simulation, under this system, there are only (1 + nH + K) correlated Brownian motions to be simulated. The remaining nh Brownian motions associated with expression (10) are independent. This substantially reduces the size of the simulation from one where (1 + nH + K + nh ) correlated Brownian motions need to be generated. Since all three classes of stochastic processes represent the prices of traded assets, their drifts are set equal to the spot rate of interest under the martingale

9 This is the reason for the double indexing of j(i). j(i) is the property index corresponding to i.

13

measure. The drift of a traded asset equals the spot rate of interest, however, only if there are no dividends nor storage costs from holding the asset. In the case of commerical properties, there are two osetting considerations in this regard. First, there are rental fees from owning commerical property and second, there are maintenance costs. On average, one would expect that the rental fees exceed the maintenance costs, making the drift rate for our commercial property indices lower than the spot rate of interest. This is only true on average, however, since not all commerical properties are protable based on cash ows alone. Unfortunately, we could not nd any data sources to capture these rental and maintenance fees. As a rst approximation, therefore, we set their drifts equal to the spot rate of interest. Although the subsequent estimation procedures do not depend on the specication of the drift process, our simulation methodology does. This introduces a potential model misspecication into our valuation methodology. The Empirical Methodology To compute the parameters of expressions (8) and (9), we use the quadratic variation, which is invariant under a change of equivalent probability measures. This invariance implies that our estimation procedure does not depend on the drifts of the commercial property indices. We illustrate this estimation with respect to expression (9). The procedure is identical for expression (8) as well. Given is a time series of {Hi (t)}m where the interval between sequential t=1 time observations is and m is the number of observations. Dene Hi (t) [Hi (t + ) Hi (t)]. We compute m X Hi (t) 2 1 (11) giving an estimate of i (H)2 . Hi (t) m t=1 (12)

Next we calculate m X Hj (t) Hi (t) 1 giving an estimate of j (H) i (H)HH . ji Hj (t) Hi (t) m t=1

(13) This is computed for k = 1, ..., K for distinct T1 , ..., TK yielding K equations in K unknowns {H , ..., H }. Solving this system gives the estimates. This is 1i Ki done for all i = 1, ..., nH . To estimate the parameters of expression (10), we discretize this expression, and change to the statistical measure. X Hj(i) (t) hi (t) p(t, t + Tk ) ik ( rt = i + rt ) + ij(i) ( rt ) hi (t) p(t, t + Tk ) Hj(i) (t)

k=1 K

To obtain the correlation between the forward rates and the regional property index H for j = 1, ..., K we compute ji m K X f (t, t + Tk ) Hi (t) 1 X rj (Tk ) i (H) H . giving an estimate of ji f (t, t + Tk ) Hi (t) m t=1 j=1

14

+ i (

(14)

eh eh where i is a constant and i (t) i (h)Zi (t).10 In this expression Zi (t) is the Brownian motion under the empirical measure and i is the adjustment in the drift due to the market price of risk associated with the change of measure.11 We assume that the market price of risk is a constant. Standard regression analysis provides the estimates for the parameters in expression (14). This time series regression is run nh times.

Each commercial loan i has a default and prepayment intensity process that depends on its delinquency status, the state variable vector Xt and a vector of loan specic characteristics Uti that are deterministic (non-random), e.g. the net operating income of the underlying property at the loan origination. The Stochastic Processes The current and delinquent intensity processes for each loan have the same functional form, diering only in the loan specic variables used. We let c (t, Uti , Xt ) = ec +c Ut +c Xt l (t, Uti , Xt ) = el +l Ut +l Xt

i i

and

(15) (16)

for loan i

where c , c , c , l , l , l are vectors of constants. The default and prepayment intensity processes are similar, but they include the delinquency status of the loan N (t) as an additional state variable. d (t, Nt , Uti , Xt ) = ed +d Nt +d Ut +d Xt p (t, Nt , Uti , Xt ) = e

i p +p Nt +p Ut + p Xt i

and

(17) (18)

for loan i

where d , d , d , d , p , p , p , p are vectors of constants. These intensity processes are given under the martingale measure for inclusion in the valuation equations. However, estimation of these intensities is under the statistical measure. Fortunately, given the assumption that delinquency, default and prepayment risk are conditionally diversiable, these intensity functions will be equivalent under both the empirical and martingale measures, see Jarrow, Lando, Yu (2005). This assumption is reasonable if the intensity processes, through the state variables employed, include all relevant systematic risks in the economy. This inclusion leaves only idiosyncratic risk to determine the actual occurrence of delinquency, default and prepayment. The

1 0 To the extent that commerical properties have a positive cash ow, the constant will i capture this consideration as well. 1 1 Formally, dZ h (t) = dZ h (t) + i dt. i i (h)

i

15

alternative approach is to modify expressions (15) and (16) by estimates of the market prices of delinquency, default and prepayment risk.12 The Empirical Methodology Given are commercial loan payment histories including scheduled principal payments, defaults, losses, prepayments, loan characteristics; and time series observations for the state variables (Nt , Xt )T where the interval between sequential t=1 time observations is . For empirical estimation, expressions (15) and (16) are replaced with their discrete approximations c (t, Uti , Xt ) = 1/(1 + e(c +c Ut +c Xt ) ) l (t, Uti , Xt ) = 1/(1 + e(l +l Ut +l Xt ) ).

1 1+et

i i

In the estimation, we have l (t) = for t = c + + c Xt and 1 c (t) = 1+et . Note that the parameter(s) within t in the estimation are equal and opposite in sign for l (t) and c (t).13 Next, d (t, Nt , Uti , Xt ) = 1/(1 + e(d +d Nt +d Ut +d Xt ) ) p (t, Nt , Uti , Xt ) = 1/(1 + e(p +p Nt +p Ut +p Xt ) ).

i i

(21) (22)

These discrete approximations have the interpretation of being the probability of default and prepayment over [t, t + ], respectively, conditional on no default or prepayment prior to time t. These expressions are estimated in a competing risk paradigm (see Deng, Quigley, Van Order (2000), Ambrose and Sanders (2003), Ciochetti, Lee, Shilling and Yao (2004)) using maximum likelihood estimation. Competing risk means that the occurrence of default precludes prepayment, and conversely. The estimation methodology explicitly incorporates this interdependence.

The Estimates

This section discusses the data and the results from the estimations.

The term structure data was obtained from the Federal Reserve Board.14 It consists of daily constant maturity yields from 3 months up to 20 years. The data set starts on January 4, 1982 and goes to May 16, 2005. We convert

1 2 Let denote the random processes representing the market prices of delinquency, default a i or prepayment risk, respectively. The transformation is a a (t, Ut , Xt ), see Jarrow, Lando, Yu (2005) for details. 1 3 This can be seen as follows. Since (t) + (t) = 1, dl (t) = dc (t) . c l d d 1 4 See www.federalreserve.gov/releases/h15.

16

these constant maturity yields into a term structure of (smoothed) continuously compounded forward rates with maturities 3 month, 6 month, 1, 2, 3, 5, 7, 10, and 20 years. In our sample period, spot rates have ranged from a maximum of approximately 12 percent to a low of approximately 1.5 percent. Table 1 provides the volatility coecients for the 3 month, 6 month, 1, 2, 3, 5, 7, 10, and 20 year forward rates and the percentage variance explained by the rst four factors based on monthly observation intervals ( = 1/12).15 As indicated, the rst four factors explain 93 percent of the variation in monthly forward rate movements. For the subsequent analysis, we set K = 4 in expression (5).

The REIT stock price index, H(t), is obtained from Bloomberg. The Bloomberg real estate investment trust index is a capitalization-weighted index of real estate investment trusts, excluding mortgage related REITs. To be included in the index, the trusts must have a capitalization of at least $15 million. We have monthly observations of this index over the time period June 1998 to May 2005. To conrm the appropriateness of the Bloomberg REIT index as a measure of national commercial real estate values, we compared it to the general NCREIF property value index, using quarterly observation intervals. The correlation between the returns on the two indices is .92, conrming its appropriateness. The property value indices, Hi (t), are obtained from Bloomberg as well. Analogous to the REIT stock price index, we have monthly observations over the same time period.16 There are six property types considered (nH = 6): industrial (IN), lodging (LO), multifamily (MF), oce (OF), retail (RT), and other (OT). Lastly, the propertyregion indices, hi (t), are obtained from NCREIF. These indices are obtained quarterly and they correspond to 9 regions: east north central, mideast, mountain, northeast, pacic, southeast, southwest, west north, and other. This gives a total of 54 dierent indices (nh = 54). For the constant maturity zero-coupon bond prices in expression (14), we used the maturities 1 year, 2 years, 5 years and 7 years. Note that for the propertyregion indices, LO (lodging) and OT (other) have the same index across all regions due to the absence of a propertyregion index for these property types. The indices were high in 1998, declined and then increased again to their maximum values in 2005. The estimated values for the state variable parameters are given in Tables 2 and 3. As indicated, all the property value indices are negatively correlated with the rst and third interest rate factors, but positively correlated to the second and fourth. The property value indices are positively correlated with

1 5 Daily observation intervals were not used because daily variations in rates are partly caused by the smoothing procedure. Monthly observation intervals reduces the importance of this smoothing noise in the estimated coecients. 1 6 Longer time histories are available, but the default, loss and prepayment data provided by Trepp begins in 1998 and for consistency in the statistical analysis of the property value state variables, their estimation was chosen to begin in 1998 as well. Future research could relax this restriction and use the longer data set for the estimation of these property value parameters.

17

each other. Table 3 contains the coecients, standard errors, and R2 from time series regression equation (10) based on monthly observations. Note that the R2 , ranging between 2 to 68 percent, are similar in magnitude to those observed in the empirical asset pricing literature for stock returns. Although when considered individually, most coecients are insignicantly dierent from zero (due to multicollinearity issues), their collective inuence is statistically signicant for most regressions (as indicated by the high R2 s).

The loan history database - including defaults, prepayments, and loan characteristics - was provided by Trepp.17 This database contains information on over 100,000 commercial loans. The data provides monthly observations of the relevant variables over the time period June 1998 to May 2005. In this database, the loans are classied as current, 30-59 days delinquent, 60-89 days delinquent, 90 plus days delinquent and defaulted. Loans exhibiting REO or Foreclosure status are considered to be in default. Defaults are distinct from delinquencies. Since our model has only three classications (current, delinquent, or default), not ve, we needed to determine a coarser partitioning of the classication. A statistical analysis was done to see if 30-59 days delinquent should be classied as delinquent or current, and 90 plus days delinquent should be classied as delinquent or default. We conducted a 6 year study of delinquency transitions of more than 2.3 million loan life observations. Table 4 shows the transitions over all loans from healthy to worse or conversely over the period 6/1998 to 6/2004. A healthy state is dened as current (0 days delinquent). A worse state is dened as the next higher delinquency status. So, for example a loan that is current in month 1, is characterized as having transitioned to a worse state in month 2 if its delinquency status in month 2 is 30-59 days delinquent. Similarly, if a loan in month 1 is 90 plus days delinquent, it is said to have transitioned to a healthy state if it becomes 0 days delinquent in month 2. Loans that persist in non-transition for multiple months either due to aberrations in the data (found in loans exhibiting 30-59 or 60-89 loan delinquency status for multiple months in a row) or due to categorization (90 plus days delinquent is, by denition, a multiple month state) are not transitioned until they migrate to either healthy (0 days delinquent) or a worse delinquency or defaulted (REO, Foreclosure) state. Historically, more loans that were 30-59 days delinquent went to current then on to a further delinquent status, hence they were so classied as current. In contrast, more loans that were observed in 60-89 days delinquent migrated to a worse state, and were therefore classied as delinquent Finally, the majority of 90 days plus delinquent loans did not default. Hence, they too were classied as delinquent. In summary, in our model current loans are dened as actually current and 30-59 days delinquent, while delinquencies are classied as 60-89

1 7 See

18

days delinquent and 90 days plus delinquent. Defaulted loans are those loans that are classied as either REO or in foreclosure. For the intensity process estimation, the loan specic characteristics included are: (1) age of the loan (as a percent of the life of the loan), (2) the delinquency status of the loan (dlqstatus), (3) an American Council of Life Insurers (ACLI) foreclosure survivor bias variable (fore index)18 , (4) the net operating income at origination divided by the loan balance at origination (noi), (5) the prepayment restriction (normalized, monthly) (pen), (6) the logarithm of the original loan balance (origloanbal), (7) the debt service coverage ratio at origination (dscr), (8) the loan to value ratio at origination (ltv), (9) the weighted average coupon at origination (wac), (10) the loan spread at securitization (only for xed rate loans) (coupon spread), (11) a dummy variable for property type (IN, LO, NF, OF, OT), and (12) a dummy variable for geographical location (R1-R8). The choice of many of the variables were dictated by data availability. Our database contained reliable data on loan characteristics at origination, but not afterwards.19 In addition to the property value state variables {H(t), Hi (t), hi (t) for all i} discussed above, included in the set of state variables is the spot rate of interest {rt } and a measure of the slope of the yield curve {f (t, t +10 years) rt }. This yields a total of 62 state variables. This number of state variables is consistent with both default and prepayment risk being conditionally diversiable (see the discussion following expression (16)), an assumption we impose to facilitate estimation. The loans are rst split into two categories: those that are credit tenant leases (CTLs) and those that are not. CTLs are loans whose payments are guaranteed by a parent company (e.g. WalMart). For non-CTLs and CTLs, separate intensity processes are estimated. Due to the small sample size of CTLs, we use the prepayment intensity process of the non-CTLs, and the default intensity process of the non-CTLs but only if the parent companys identity is unknown. If the parent companys identication is available, the default intensity from the hazard rate estimation is replaced with the default rate intensity of the parent company. The estimation procedure for the parent companys default intensity is described at the end of this section. The hazard rate estimation is also done separately for xed rate and oating rate loans. Table 5 contains a summary of the loans contained in the estimation. As indicated, for non-CTLs there are (94, 011) xed rate loans and (7, 198) oating rate loans. The number of defaults for xed rate is (2, 153) and (130) for the oating rate. The analogous number of prepayments are (8, 989) xed rate and (2, 960) oating, respectively. Prepayments are more numerous in our sample then are defaults. The number of defaulting oating rate loans in our

is the aveage foreclosure rate over the past 14 years for each propertyregion, constructed from the ACLI foreclosure database. 1 9 For example, some, but not all of the loans had data on NOI after origination. The sparsity of the updated NOI observations made this variable inappropriate to use. In addition, the updated NOI information is self reported and not reliable. Whereas, at the origination date, the information is audited by the originator.

1 8 This

19

database is quite small which makes the estimates for oating rate loans less reliable. The number of CTL loans is smaller, totaling (1, 368). A statistical analysis was not done on CTLs given the small sample size. The parameter estimates for the intensity processes are given in Tables 6A and 6B for nonCTLs. Table 6A contains the current and delinquency intensity process coecients for xed and oating rate loans. Note that the coecients are equal and opposite in sign for current and delinquency. We concentrate on explaining the intensity of going from current to delinquent. For xed rate loans: (i) as the age of the loan increases, the likelihood of delinquency increases, (ii) as historical foreclosures increase (fore index), the likelihood of delinquency declines, (iii) the net operating income (noi) is insignicantly dierent from zero20 , (iv) the higher the prepayment penalties (pen), the higher the likelihood of delinquency, (v) the larger the original loan balance, the higher the likelihood of delinquency, (vi) the higher the debt service coverage ratio (dscr), the higher the likelihood of delinquency, (vii) the higher the loan to value at securitization (ltv), the lower the likelihood of delinquency21 , and (viii) the higher the weighted average coupon (wac) and coupon spread, the lower the likelihood of delinquency. As the property indices increase (hi (t), Hi (t), H(t)), the likelihood of delinquency declines. As either the spot rate (spot) or the slope of the forward rate curve (f (t, 10) r(t)) increases, the likelihood of delinquency increases. All of these comparative statics are as expected. For oating rate loans, similar interpretations follow for many of the coecients. The descriptions for oating rate loans are omitted for brevity and because of the smaller sample size. Table 6B contain the default and prepayment processes. The signs of these coecients are mostly as expected. For xed rate loans: (i) the larger the age of the loan, the more likely to prepay and default, (ii) if the loan is delinquent, then the probability of prepayment declines and the probability of default increases, (iii) as historical foreclosures increase (fore index), the likelihood of default decreases and prepayment increases, (iv) net operating income (noi) appears to have no impact on either the likelihood of default or prepayment, (v) the higher the prepayment penalties (pen), the higher the likelihood of default and the lower the likelihood of prepayment, (vi) the larger the original loan balance, the less likely the loan is to prepay but the more likely it is to default, (vii) the higher the debt service coverage ratio, the less likely to prepay or default, (viii) the higher the loan to value at securitization (ltv), the higher the likelihood of default and prepayment, (ix) the higher the weighted average coupon (wac), the higher the probability of default and lower the probability of prepayment, and (x) the higher the coupon spread at origination, the higher the probability of prepayment and the lower the probability of default. Continuing with xed rate loans, as the spot rate (rt ) increases or the term structure becomes more

2 0 This is probably due to the endogeneity of the origination process. The terms of the loan contract are set to reect the NOI of the given property, making its explanatory power zero. 2 1 Again, this is probably due to the origination process. Those loans that have high initial loan to value ratios are probably viewed as having less default risk at origination. Otherwise, the originators would have reduced the loan to value ratio of the borrowing entity.

20

steep (f (t, t + 10) rt ), default and prepayment are more likely. Lastly, as the propertyregion index (hi (t)) increases, prepayment increases but default is unchanged. As the property index (Hi (t)) increases, the likelihood of default declines, and the likelihood of prepayment increases. Finally, as the REIT index increases (H(t)) both default and prepayment decline. For oating rate loans, similar interpretations follow for many of the coecients. However, because of the smaller sample size (see Table 5), less of the coecients are signicantly dierent from zero. A standard method for measuring out-of-sample performance is the area under the ROC curve. For comparison across models, a value of 0.5 for the ROC measure indicates a random model with no predictive ability, while a value of 1.0 indicates perfect forecasting. Table 7 contains the ROC accuracy ratios for the dierent intensity processes estimated. As indicated, the ROC ratios, ranging from 72% to 95%, are quite high for all models. These numbers are comparable to those obtained in the estimation of corporate bankruptcies (see Chava and Jarrow (2004)).

The nal process to estimate is the loss severity rate for loan i.22 We t a linear regression model to our loss severity database consisting of 919 loans.23 1 i = 0 + 1 Uti + 3 Xt t where 1 is a constant and 2 , 3 are vectors of constants. The regression estimates are contained in Table 8. We see that as the age of the loan or the original loan balance or the loan to value ratio increases, the loss severity increases. Second, as the spot rate or slope of the forward rate curve increases, the loss severity declines. Many of the coecients are insignicant from zero, however, including all the property value indices.

To estimate the default intensity process for known CTLs, we use credit default swap data or credit rating data. First, given the known CTLs name, we obtain default swap quotes from Bloomberg for tenors T (this could be 1, 2 or 3 years, depending upon the name of the CTL). We use the longest tenor available in order to better match the maturity of the CMBS. The default swap quote is (see Lando (1998, p. 207) cds (T ) = (1 )d where is the recovery rate on the rms debt and d is the default rate on the rms debt, assuming both a constant recovery rate and default intensity. To

2 2 The TREPP software also requires a time to recovery, we set this as 12 months. This implies that the actual loss severity used in the valuation was (1 ) p( d , d + 12 months). 2 3 We do not constrain our regression equation to lie between zero and one.

21

obtain the recovery rates for specic industries for senior secured debt, we use Moodys (2005, exhibit 23, p. 21. Then, d = cds (T ) . 1

If there is no credit default swap data, we instead use the rms Moodys credit rating, and from Moodys (2005) we obtain the default intensity for that credit rating.

The Simulation

Given the parameter estimates from the previous section, the next step is to compute the values of the CML and the CMBS bonds using expressions (3) and (4). The state contingent cash ow allocations to the various CMBS bond tranches are quite complicated, and they dier, depending upon the CMBS trust. Furthermore, at any given date, the future cash ows will also depend on the history of the previous payments for each of the existing CMBS trusts. To circumvent these obstacles, we obtained permission to use the Trepp scenario generating professional software service through WOTN and Trepp. The Trepp service tracks all CMBS trusts (archiving the loan pool history) and it provides software for modifying the loan pool payments for events of default, loss and prepayment in order to determine its inuence on the CMBS bond cash ows. In particular, for each existing CMBS trust, the Trepp engine enables the user to input a scenario for each of the underlying loans. The outputs are the cash ows to the various bond tranches (including changes in yields due to the scenario modication). As such, this provides the intermediate step in our simulation algorithm. Using the above modeling structure and parameter estimates, we are able to generate, using variance reduction techniques, the equivalent of 10,000 dierent scenarios24 to input into the Trepp software. A description of the simulation algorithm and variance reduction techniques are provided in the appendix. The resulting cash ows to the loans and bonds, enable us to compute expressions (3) and (4) as discounted averages over the set of simulated scenarios.

This section jointly tests our model and CMBS market eciency using historical data and market prices for the CMBS bonds from July 2001 to April 2005.25 For each month over this observation period, starting with July 2001, we estimate the models parameters using only data available to the market at that time.

2 4 10,000 scenarios was selected because the standard error of a simulation converges to zero at the rate 1/ N . For N=10,000, the error will be approximately 1 percent of the resulting values. The number of scenarios actually run using control variates was 2,500. 2 5 We begin with July 2001, and not earlier, because that is the rst date for which we have a large enough sample of bonds priced by Trepps pricing service.

22

With these estimates, we compute the CMBS bond prices (denoted bi (t) from expression (4)) as explained above, and compare them to the market prices at that date (denoted mi (t)). The market prices were obtained from Trepps CMBS Pricing ServiceTM . These prices are the average of the bid and oer quotes obtained by polling multiple dealers and institutional investors. These prices are updated daily and they are widely used in the CMBS industry for marking-to-market positions. These prices are not matrix prices. Because CMBS trade over-the-counter, Trepps CMBS Pricing Service provides the best historical pricing database for analysis. It is important to note that non IO, investment grade CMBS trade in relatively liquid markets, and the Trepp database is comparable to other xed income databases frequently used in empirical investigations of credit risk models (see, e.g. Duee (1999)). To the extent that these quotes still might not represent prices at which actual trades could have be executed, we modied our testing procedure to make this possibility less likely. First, to further avoid stale quotes, we restricted our sample to include only investment grade bonds that are more actively traded in the market and, therefore, more frequently updated by Trepp. In this regard, we omitted all bonds rated below baa3 and the IO bonds.26 Finally, to further reduce the impact of using market quotes, instead of transaction prices, we used only monthly trading intervals. For monthly trading intervals, the dierences between transaction prices and market quotes is expected to be minimal. The comparison between model and market prices is repeated for every month in the back-testing period. For this back-testing, we used more than 3000 bonds from 336 distinct trusts (the bond index is i and the monthly time index is t). In addition to computing theoretical CMBS bond prices, we also computed the CMBS bonds weighted average lives (WAL) and the option adjusted weighted average lives (OAWAL). The formulas are at time 0: ! T X 1 W ALi = t promised principal paymentst , principal t=1 ! T X X 1 1 t principal paymentst () . OAW ALi = principal t=1 ||

The percentage dierence [W AL OAW AL]/W AL is a measure of the optionality present in a CMBS; the larger the dierence, the larger the embedded optionality.27 These computations generate the data for the subsequent analyses.

2 6 Although the IO bonds are rated investment grade, we also exclude them from subsequent consideration because: (a) they tend to be traded less frequently than are investment grade, principal bearing bonds, and (b) because they are typically stripped across the entire capital structure and thus share default exposure attributes similar to below investment grade securities 2 7 An alternative, and equally usable measure, would be the percentage dierence between the CMBS model price with and without the embedded options.

23

Goodness of Fit

For evaluating the model performance, we compute a time series of the pricing dierences i (t) bi (t) mi (t) for all i and t. (23) If we had used spreads instead of prices, this would be equivalent to computing the bonds option adjusted spreads (OAS). These price dierences are summarized in Tables 9A and 9B. Table 9A groups the average i (t) across time based on ratings, while Table 9B groups the average i (t) across time based on the weighted average life (WAL). Since the par value of the bond is 100, these errors can be interpreted as percentages. For example, for a1 in Table 9A, the percentage pricing error is 7.1538. As indicated, for either grouping of the bonds, there is a statistically signicant bias in the models price. The model appears to overvalue the bonds. Tables 9A and 9B reject the hypothesis that the model prices equal the market prices. This rejection could be due to either model error or market mispricing. This is the content of the next section.

This section generates trading strategies based on i (t) to investigate if the CMBS market is inecient. The analogy of the pricing dierence i (t) to an OAS facilitates the intuition underlying this strategy. The ideal trading strategy for this determination is to construct an arbitrage opportunity that involves going long undervalued bonds (highest OAS) and shorting overvalued bonds (lowest OAS). Unfortunately, there is no well-organized market for shorting cash CMBS.28 Consequently, we investigate the relative performance of undervalued and overvalued portfolios, pairwise matched to control for risk. In this matching, credit risk is measured by the bonds credit rating and interest rate risk by the bonds weighted average life (WAL). It is dicult to directly control for property value risk in this comparison. However, since the CMBS trusts usually are diversied across property types and geographic locations, property value risk is less of a concern. Nonetheless, we also formed indices, stratied by credit ratings and weighted average lives, of all the CMBS bonds in our database in an attempt to control for property value risk premia. The indices are equally weighted portfolios of all the bonds in our CMBS universe falling into the appropriate classication. In total we have six CMBS indices corresponding to the ratings/WAL classications selected. Table 10 contains a listing of the total number of CMBS in each risk category, for each month, over our testing horizon. As indicated, the average number of bonds in each risk category exceed 120, with the exception of the long tenor aaa bonds which averaged only 96. Consequently, there are sucient bonds in each risk

2 8 Over our sample period, total return swaps on CMBS indices were traded sporadically, while credit default swaps on CMBS were not actively traded. Today, both CMBS credit default swaps and total rate of return swaps on several market indices are actively traded. These new securities eectively enable one to short many risks embedded in CMBS. This is a vibrant subject for future academic inquiry.

24

category to justify the belief that these indices reect returns to well-diversied portfolios of CMBS, reecting the markets compensation for property value risks. Procedure This section describes the procedure utilized to construct the over- and undervalued CMBS bond portfolios. At time 0 (July 2001), we rst group the bonds into roughly equal risk categories based on credit rating (for credit risk) and WAL (for interest rate risk). IOs and bonds with credit classes ba1, ba2, ba3, and Unrated are excluded because Trepp does not provide reliable market quotes for these infrequently traded bonds. The groupings selected were: 1. {aaa, 2 WAL < 6}, 2. {aaa, WAL >6}, 3. {(aa1,aa2,aa3), WAL>2}, 4. {(a1,a2,a3), WAL>2}, 5. {(baa1,baa2,baa3), WAL>2}. For each of these equal risk groupings, we sort i (0) across i from highest to lowest. Those with the highest i (0) represent undervalued bonds and those with the lowest i (0) represent overvalued bonds. We invest $1 million in each bond in the top decile and $1 million in each bond in the bottom decile. Although this implies that the upper and lower decile portfolios may have dierent dollar investments, this will not eect the subsequent return calculations. These 10 portfolios are held until time t = 1 (one month later). The returns on the 10 portfolios (marking-to-market) were computed taking into account all cash ows obtained over the rst time period. At time 1, we liquidate both portfolios, and repeat the same procedure that we employed at time 0. We continue in this fashion until the end of the sample period time T (April 2005). It is important to emphasize that in this computation, we do not include explicit transaction costs. However, because we are comparing two matched portfolios, both exhibiting similar rebalancing across time, the transaction costs would be roughly equivalent for both portfolios. This implies that, as a rst approximation, the relative performance dierential between the two portfolios should be unaected by the exclusion of explicit transaction costs. Results Tables 11a and 11b contain the average monthly and the cumulative returns, respectively, on the overvalued, undervalued and CMBS index portfolios over the time period July 2001-April 2005.

25

The average monthly returns are contained in Table 11a. As indicated, the returns on the undervalued portfolios exceed those for the overvalued portfolios for all 5 risk groupings. For example, for the short tenor aaa the dierence is 0.29% per month. A control for property value risk is obtained by a pairwise comparison of the undervalued and overvalued portfolios with the CMBS index portfolios. As seen therein, the undervalued portfolio returns exceed those for the equal risk CMBS indices, and the equal risk CMBS indices exceed the returns on the overvalued portfolios, for all 5 risk categories. Only the short aaa undervalued less overvalued dierence is signicant at the 95 percent condence level as indicated by the p-values given in column 6. However, the likelihood that all 5 risk grouping undervalued portfolios would outperform the overvalued portfolios over this time period, under the null hypothesis that the model cannot identify mispricings, is (1/2)5 = 0.0156. This is unlikely. Note also that all the dierences to the index are signicant at the 95 percent condence level. Combined, this evidence is consistent with a CMBS market ineciency. These same observations are conrmed by the cumulative returns in Table 11b. The cumulative returns on the undervalued portfolios outperform the overvalued portfolios for all 5 risk groupings. For example, the undervalued short AAA bonds outperformed the overvalued short AAA bonds by 15.65% over this time period, while the long aaa outperformed the overvalued by 7.85%. Again, the likelihood that all 5 risk grouping undervalued portfolios would outperform the overvalued portfolios over this time period, under the null hypothesis that the model cannot identify mispricings, is 0.0156. Controlling for property value risk, the undervalued portfolios also outperform the CMBS index returns for every risk grouping considered. Yet, the possibility still exists that these abnormal returns are due to unaccounted for risk premia, as compensation for omitted risk factors. The next subsection of the paper explores this possibility.

To test for the possibility of omitted risk premia, we utilize a standard intertemporal CAPM (see Merton (1990, p. 511)), where the expected return on the over- and under-valued portfolios can be written using a multi-beta model as

p ERt = rt + M X i=1 i pi (ERt rt )

p i where Rt is the p portfolios return over [t, t + 1], Rt is the return over [t, t + 1] th on a portfolio perfectly correlated to the i systematic risk component, and pi is the beta of portfolio p to the ith risk component portfolio. There are M possible risk factors. Using the relation j j Rt = ERt + j t

26

where the j have zero means and are independent across t and j, we can rewrite t the multi-beta model as

p Rt = rt + M X i=1 i pi (Rt rt ) + t

where the t =

To construct our regression model, it is reasonable to assume that one of the systematic risk factors is a CMBS portfolio of equal credit and WAL risk as the over- or under- valued portfolio under consideration. Letting the return on the index CMBS portfolio be denoted by i = 1, we can write this last expression as:

p 1 Rt = rt + p1 (Rt rt ) + M X i=2 i pi (Rt rt ) + t .

M X i=1

pi

i t

And, it is reasonable to also assume that the beta of the over- or under- valued portfolio with respect to the index is unity, i.e. p1 = 1, yielding our nal regression model to test for omitted risk premia:

p 1 Rt Rt = + M X i=2 i pi (Rt rt ) + t .

(24)

In this specication, we include a constant to capture the abnormal returns. To estimate this model, we use the following assets (portfolios) to capture various risk premia: (i) the REIT stock price index to capture property value risk premium, (ii) the 1 year, 2 year, 5 year, and 7 year zero-coupon bond prices to capture interest rate risk premium, and (iii) a stock market index, the SMB index (small minus big), and the HML index (high minus low) to capture equity market risk premium29 . Tables 12A and 12B contain the regression results, using monthly returns, for the various risk categories. These two regression tables dier only by the inclusion or not of both SMB and HML. Because the two regressions are similar, we concentrate on the results presented in Panel B that includes both the SMB and HML indices. First, we see that all of the abnormal returns for both the overvalued and undervalued portfolios (as measured by the ) are insignicantly dierent from zero, except for the short aaa grouping, and this dierence is negative (it should be positive). Controlling for omitted risk premia appears to remove all of the abnormal trading prots. In this risk adjustment, only the interest rate factors appear to

2 9 The market portfolio consists of all NYSE, AMEX and NASDAQ rms, and the SML and HML indices are obtained from Ken Frenchs website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french.

27

be signicant. All of the property value and market indices have coecients insignicantly dierent from zero (except one). These regressions support the hypothesis that all of the abnormal trading prots associated with the overvalued and undervalued portfolios can be attributed to omitted interest rate risk premia. Consequently, we cannot unambiguously reject the hypothesis that the CMBS market is eciently priced.

If the CMBS market is ecient, then it is essential to modify the original model to remove the model errors. Let us recall the specics of the model structure to identify the possible misspecications. First, all of the CMBS risks, including the embedded options (default and prepayment), depend on the specication of the interest rate and property value processes. If these processes are misspecied, then the model prices will be in error. Second, although the model structure explicitly incorporates interest rate, credit, and prepayment risk, due to the frictionless and competitive market assumption, it excludes liquidity risk. Consequently, the i (t) dierences could be due to this omission. As shown in Cetin, Jarrow, Protter (2004), liquidity risk can generate such a bias between model prices, based on the classical model with no liquidity risk and market prices. In addition, we have one remaining potential source of model error related to the default intensity. In valuing the CMBS bonds cash ows, we used the intensity process estimated under the statistical measure (and not the intensity process under the martingale measure). If default risk is not diversiable (see Jarrow, Lando, Yu (1995)), then this would introduce a positive pricing error in i (t). Given the complexity of the model construction and the inherent limitations of the CMBS database, we employ the procedure discussed in Jacquier and Jarrow (2000) to generate an extended pricing and hedging model to overcome any model error related to stochastic process misspecication, liquidity or nondiversiable risk. After this extension, we will perform an additional test to see if the interest rate or property value processes could be the cause of the (residual) model error. The extended model, denoted bi (t), is obtained via the expression b bi (t) bi (t) + rating (t) b rating (t) P (25) !

j (t)

where

j rating class

N (t)

and N (t) equals the number of bonds at time t in the same rating class to which bond i belongs.

28

The intuition underlying this extended model is that any model error due to liquidity risk and/or non-diversiable default risk is captured by the average mispricing with respect to the bonds rating. It is conjectured that the bonds rating will be correlated with all of these model misspecications. Indeed, market liquidity is related to a bonds rating because institutions often restrict their investments to investment grade bonds. Furthermore, empirical studies have documented a correlation between a bonds rating and its default risk (see Moodys (2005)), and default risk has been correlated to recovery rates (see Altman, Brady, Resti and Sironi (2003) and Acharya, Bharath, Srinivasan (2004)). Using this extended model, the relevant pricing dierences for model performance are now given by

i (t)

By construction, the average pricing error i (t) for a rating class is zero, i.e. the new model prices the rating classes correctly. Table 13 contains summary statistics for i (t) grouped by WAL. As indicated, the percentage pricing error diers from that in Table 5B (sign and magnitude), and it is insignicantly dierent from zero for all WAL groupings except WAL less than 2.5 years. Given the extended models error are now unbiased (by construction), we test for model misspecication with respect to the interest rate and property value processes. If the adjusted CMBS model is not properly specied, one would expect that the pricing errors would be correlated with interest rates or property values. To test for this sort of misspecication, we ran the following time series regression on the pricing errors for each bond i:

i (t)

(26)

(27)

where rt is the time t spot rate, (f (t, 10) rt ) measures the slope of the forward rate curve at time t, and H(t) is the REIT stock price index. The spot interest rate and the slope of the forward rate curve reect interest rate risk while the REIT stock price index reect property value risk. Table 14 contains the average coecients, the standard errors of the estimates, and the average R2 from these regressions, grouped by rating categories. All coecients have insignicant t-scores (less than 2). It appears that the remaining pricing errors are not correlated with interest rates or property values. This evidence indicates that our simple adjustment for model misspecication as given in expression (25) yields an unbiased pricing model for CMBS useful for hedging or marking-to-market if the CMBS market is ecient.

In contrast to omitted risk factors, there is a behavioral nance explanation for the abnormal trading strategy returns, that is inconsistent with market eciency. Due to the complexity of the CMBS trust structure and the interaction 29

of the various embedded options, the optionality cannot be accurately measured without a model. As documented next, the undervalued portfolios consist of higher coupon bonds with low optionality relative to the overvalued portfolios in the same "equal risk" category. This observation is consistent with the market mis-estimating the risk of the embedded options in a manner correlated with interest rates. Note that over our sample period, the market experienced a period of declining interest rates and increasing commercial property values. To document these facts, lets consider the short tenor aaa bonds. The returns for the short aaa bonds (as for all bonds) are due to four sources: (a) interest/coupon payments, (b) gains/losses on the sales of securities after the one month holding period, (c) prepayment penalties allocated to the securities if prepaid, and (d) gains/losses on any principal paid down (expected or unexpected due to amortization, prepayment or default recoveries). Table 15 provides this breakdown in dollar prots for the trading strategies. For convenience, we combine sources (b) and (c) into one category. As indicated, the undervalued portfolios provide larger returns on all four sources. The largest dierence (in percentage terms) between the undervalued and overvalued deciles is attributable to principal paydowns. Further supporting this statement, as documented in Table 15, we see that the undervalued portfolios experienced less principal paydowns (32 versus 459). Second, the undervalued portfolio exhibits less embedded option risk as measured by the percentage dierence (WAL-OAWAL)/WAL, (1.90% versus 19.02%). And, the undervalued portfolios had higher average coupons (7.01 versus 6.23) and consequently, higher average prices as well. Based on the dierences in coupons between these two portfolios, one would expect the undervalued bonds to have more embedded optionality, but this is not the case. A model for the embedded options is necessary to obtain this understanding. These same conclusions also apply to the remaining bond portfolios as documented in Table 16, where the undervalued portfolios are seen to have higher average coupons (except perhaps the aa) and uniformly lower embedded optionality. The shorter average tenor of the overvalued portfolios relative to the undervalued portfolios seems to indicate that the risks of the CMBS within equal risk categories are not being accurately priced. And, these mispricings would be correlated with the interest rate risk factors. Only subsequent research can distinguish between these two competing hypotheses for the abnormal trading strategy returns documented previously in Table 11.

Conclusion

This paper provides a joint test of our CMBS pricing model and market ineciency. The CMBS pricing model includes interest rate, credit, prepayment and liquidity risk. The models parameters are estimated using a comprehensive CMBS database, and the models prices are compared to market prices over a ve year period. The joint test is rejected. To investigate if the joint tests rejection is due to market ineciency, the models mispricings are back tested

30

for trading prots over a 46 month period. The back testing results are consistent with the existence of abnormal trading prots. However, controlling for omitted risk premia appears to remove these abnormal trading prots. These omitted risk premia are also consistent with a behavioral nance explanation in an inecient market. At present, we cannot unambiguously reject the eciency of CMBS markets. In light of this ambiguity, a simple adjustment to our model is also provided to generate an unbiased pricing model useful for hedging and marking-to-market, for those who believe that the CMBS market is ecient. Thanks are expressed to WOTN, LLC for providing nancial support, to the Intel Corporate Early Access Program for allowing use of their Xeon computational cluster, to Trepp, LLC for the use of their software and database, and to Joshua Barratt for helpful comments and suggestions throughout the execution of this project.

References

V. Acharya, S. Bharath and A. Srinivasan. 2004. Understanding the Recovery Rates on Defaulted Securities. working paper, London Business School. W. Archer, P. Elmer, D. Harrison and D. Ling. 2002. Determinants of Multifamily Mortgage Default. Real Estate Economics 30(3), 445-473. E. Altman, B. Brady, A. Resti and A. Sironi. 2003. The Link between Default and Recoveyry Rates: Theory, Empirical Evidence and Implications. working paper, New York University. B. Ambrose and A. Sanders. 2003. Commercial Mortgage Backed Securities: Prepayment and Default. Journal of Real Estate Finance and Economics 26, March-May. U. Cetin, R. Jarrow, P. Protter. 2004. Liquidity Risk and Arbitrage Pricing Theory. Finance and Stochastics 8, 311-341. U. Cetin, R. Jarrow, P. Protter and Y. Yildirim. 2004. Modeling Credit Risk with Partial Information. Annals of Applied Probability 14(3), 1168-1178. S. Chava and R. Jarrow. 2004. Bankruptcy Prediction with Industry Eects. Review of Finance 8, 537-569. P. Childs, S. Ott and T. Riddiough. 1996. The Pricing of Multiclass Commercial Mortgage Backed Securities. Journal of Financial and Quantitative Analysis 31 (4), 581 - 603. B. Ciochetti, G. Lee, J. Shilling and R.Yao. A Proportional Hazards Model of Commercial Mortgage Default with Originator Bias. Journal of Real Estate Finance and Economics 27(1), 5 23. Y. Deng, J. Quigley, and R. Van Order. 2000. Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options. Econometrica 68 (2), 275 - 307. M. Dierker, D. Quan and W. Torous. 2005. Valuing the Defeasance Option in Securitiezed Commercial Mortgages. Real Estate Economics 33 (4), 663 680. 31

D. Due and D. Lando. 2001. Term Structure of Credit Spreads with Incomplete Accounting Information. Econometrica 69, 633-664. G. Duee. 1999. Estimating the Price of Default Risk. The Review of Financial Studies 12 (1), 197 226. H. Esaki, S. LHeureux and M. Snyderman. 1999. Commercial Mortgage Defaults: An Update. Real Estate Finance Spring, 80 - 86. F. Fabozzi. 2000. Bond Markets, Analysis and Strategies. 4th edition, Prentice Hall. P. Glasserman. 2004. Monte Carlo Methods in Financial Engineering. Springer Verlag. Y. Goncharov. 2004. An Intensity-Based Approach to the Valuation of Mortgage Contracts and Computation of the Endogenous Mortgage Rate. to appear in the International Journal of Theoretical and Applied Finance. D. Heath, R. Jarrow, and A. Morton. 1992. Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation. Econometrica 60, 77 - 105. E. Jacquier and R. Jarrow. 2000. Bayesian Analysis of Contingent Claim Model Error. Journal of Econometrics 94, 145 - 180. R. Jarrow. 2002. Modeling Fixed Income Securities and Interest Rate Options. 2nd edition, Stanford University Press: Palo Alto, CA. R. Jarrow. 2007. A Tutorial on Zero Volatility and Option Adjusted Spreads. Advances in Mathematical Finance, Birkhauser, Boston MA. R. Jarrow, D. Lando, and F. Yu. 2005. Default Risk and Diversication: Theory and Applications. Mathematical Finance 15 (1), 1-26. R. Jarrow and S. Turnbull. 1992. Credit Risk: Drawing the Analogy. Risk Magazine, 5 (9). R. Jarrow and S. Turnbull. 1995. Pricing Derivatives on Financial Securities Subject to Credit Risk. Journal of Finance 50 (1), 53-85. J. Kau, D. Keenan and A. Smurov. 2004. Reduced Form Mortgage Valuation. working paper, University of Georgia. D. Lando. 1998. On Cox Processes and Credit Risky Securities. Review of Derivatives Research 2, 99-120. D. Lando. 2004. Credit Risk Modeling, Princeton U. Press. J. McConnell and M. Singh. 1994. Rational Prepayments and the Valuation of Collateralized Mortgage Obligations. Journal of Finance 49 (3), 891 - 921. R.C. Merton. 1990. Continuous Time Finance. Blackwell Pub. Moodys. 2005.Default and Recovery Rates of Corporate Bond Issuers, 1920-2004. Moodys Investors Service, N.Y. P. Protter. 1990. Stochastic Integration and Dierential Equations: A New Approach. Springer-Verlag: New York. M. Reilly and B. Golub. 2000. CMBS: Developing Risk Management for a New Asset Class. in Handbook of Commercial Mortgage Backed Securities. Fabozzi editor, Chapter 10, 171 - 181. A. Sanders. 2000. Commercial Mortgage Backed Securities. Frank J. Fabozzi, ed., Investing in Commercial Mortgage Backed Securities, New York: John Wiley & Sons, chapter 2. 32

E. Schwartz and W. Torous. 1989. Prepayment and the Valuation of Mortgage Backed Securities. Journal of Finance 44 (2), 375 - 392. E. Schwartz and W. Torous. 1992. Prepayment, Default, and the Valuation of Mortgage Pass-Through Securities. Journal of Business 65 (2), 221 - 239. M. Snyderman. 1991. Commercial Mortgages: Default Occurrence and Estimated Yield Impact. The Journal of Portfolio Management Fall, 82 - 87. R. Stanton. 1995. Rational Prepayment and the Valuation of Mortgagebacked Securities. Review of Financial Studies 8 (3), 677-708. S. Titman and W. Torous. 1989. Valuing Commercial Mortgages: An Empirical Investigaion of the Contingent Claims Approach to Pricing Risky Debt. Journal of Finance 44 (2), 345 - 373. R. Trepp and J. Savitsky. 2000. An Investors Framework for Modeling and Analyzing CM. in Handbook of Commercial Mortgage Backed Securities, Fabozzi editor, Chapter 5, 93 - 112. Y. Yildirim. 2005. Estimating Default Probabilities of CMBS loans with Clustering and Heavy Censoring. forthcoming, Journal of Real Estate Finance and Economics.

Appendix

Derivation of Expression (3)

Given the information set up to {NT , XT }, Nd (t) and Np (t) are independent Poisson processes with Qt ( d > T | NT , XT ) = e The density is dQt ( d = s | NT , XT ) = d (s)e

s t T t

d (s)ds

d (u)du

ds

Similar expressions hold for Np (t). From expression (2), we have terms similar to T Et (Et {1{T < d } 1{T < p } e t rs ds | NT , XT }) = Et (e

T t

rs ds

T t

rs ds

T t

d (s)ds

T t

p (s)ds

).

Et (Et { d (B d + P )1{ d T } 1{ d p } e

d t

rs ds

| NT , XT })

d t

= Et (Et { d (B d + P )1{ d T } [1{ d p <T } + 1{T p } ]e = Et (Et { d (B d + P )1{ d p <T } e +Et (Et { d (B d + P )1{ d T } e

d t d t

rs ds

| NT , XT })

rs ds

| NT , XT })

rs ds

| NT , XT }Et {1{T p } | NT , XT })

33

The rst term can be written Z TZ k Et (Et { s (Bs + P )1{ d =s, p =k} e

t t

s t

ru du

ds dk | NT , XT })

k t

t

Z = Et (

s (Bs + P )d (s)e

s t

d (u)du

s t

ru du

ds p (k)e

p (u)du

dk).

Z = Et (

d (s)e

t

s t

d (u)du

s t

ru du

ds e

T t

p (s)ds

).

In Heath Jarrow Morton (1992), the equation for the bond price process is

K X Z t+T dp(t, T ) ( j (t, u)du)dWj (t). = rt dt p(t, T ) j=1 t

t+T f (t,u)du t

Simulation Algorithm

The simulation algorithm is now described in more detail. (step 1) Generate discrete time observations of the sample paths for H H h h W1 (t), ..., W4 (t), Z H (t), Z1 (t), ..., Z6 (t), Z1 (t), ..., Z54 (t) over a time period t = 0, ..., T representing 30 years. The discrete observation period is weekly. These sample paths are generated under the martingale measure. (step 2) Given the Brownian motion paths, generate sample paths for the term structure of interest rates using expressions (5)-(7) and the state variables using expressions (8)-(10).

34

Given that the above simulation is done for each loan in a CMBS loan pool, aggregating to generate the loan pools cash ow (approximately 100 loans per pool), then generating the all bond tranches cash ows (approximately 10 bonds per trust), across all CMBS trusts (for approximately 650 trusts), this simulation results in a large computational exercise. To facilitate this computation, we perform this simulation on a cluster of PCs using parallel processing and variance reduction techniques. The variance reduction techniques reduced the simulation calls to the Trepp engine from 10,000 to 2,500, maintaining the same accuracy. Two techniques used are: 35

(step 3) Given the state variables and term structure of interest rate paths, compute c (t, Uti , Xt ), l (t, Uti , Xt ). Check to see if the loan is current or delinquent at time 0. (step 4) Generate Ei for i = 1, ..., 2 (number of loans in database) independent unit exponential random variables. If current at time 0, compute Rt i i = inf{t > 0 : 0 l (s, Us , Xs )ds Ei } for i = 1, ..., (number of loans in l i database). If l > T , stop. If i T , then starting at time i , generate Ei l l for i = 1, ..., 2 (number of loans in database) independent unit exponential Rt i random variables. Compute i = inf{t > 0 : l c (s, Us , Xs )ds Ei } for c i i = 1, ..., (number of loans in database). If c > T , stop. If i T , repeat c the process to obtain the next switch to delinquency or until time T is reached. Instead, if the loan is delinquent at time 0, then perform the previous steps with the obvious changes. This step generates the state variables Nti for each loan i. i i (step 5) Given Nti for each loan i, compute p (s, Nti , Us , Xs ), d (s, Nti , Us , Xs ) i i i and t = (t, Ut , Xt ). Note that the computation of the default intensity and the recovery rate is for non-CTL loans. For CTL loans, d and are assumed to be constants, and computed independently of the above process. d is computed from credit default swap data or Moodys rating data, and is computed from Moodys recovery rate data for senior secured debt. For CTL loans, the process proceeds as for non-CTL loans, except for the substitution of the default intensity and recovery rate process as explained above. Generate Ei for i = 1, ..., 2 (number of loans in database) independent unit Rt i exponential random variables. Compute i = inf{t > 0 : 0 d (s, Nti , Us , Xs )ds d Ei } for i = 1, ..., (number of loans in database) and Rt i i = inf{t > 0 : 0 p (s, Nti , Us , Xs )ds Ei } for i = (number of loans in p database) + 1, ..., 2 (number of loans in database). Compute i = i (t, Uti , Xt ) t and set the time to recovery 12 months. (step 6) Input (rt )T , min( i , i ), and i into the Trepp software. t=1 d p (step 7) Collect the cash ows in expression (1) for the CMLs and expression (4) for the CMBS bonds. Denote the cash ows for any of these securities by (Vt ())T for the scenario . t=1 (step 8) Repeat steps (1)-(7) 10,000 times. Compute time 0 values of the securities using T ! X X t 1 0 rs ()ds Vt ()e . || t=1

stratied sampling and a control variate (see Glasserman (2004)). The control variate is the sum of the discounted promised cash ows, but not including any defaults or prepayments, representing an otherwise riskless bond.

36

Maturities\Factors 3 months 6 months 1 year 2 year 3 year 5 year 7 year 10 year 20 year % Var

1 -0.1723 -0.2568 -0.2924 -0.2922 -0.2057 -0.1624 -0.1329 -0.0860 -0.0792 62.3300

2 0.0303 0.0264 -0.0205 0.0140 -0.0108 -0.0038 -0.0545 0.1858 -0.2017 17.2725

3 -0.1129 -0.1019 -0.0255 0.0161 0.0665 0.0626 0.0869 0.1090 0.0456 8.8499

4 0.0813 0.0356 -0.0959 -0.0238 -0.0424 0.0467 0.0288 0.0484 0.0631 4.1965

5 -0.0560 0.0190 -0.0280 0.0862 -0.0688 0.0503 -0.0335 -0.0186 -0.0025 2.9405

6 0.0185 -0.0124 -0.0421 0.0138 0.0324 0.0291 0.0429 -0.0518 -0.0552 1.8838

7 -0.0133 0.0262 -0.0476 0.0289 0.0491 -0.0467 -0.0230 0.0037 0.0161 1.3456

8 0.0363 -0.0513 0.0008 0.0223 0.0138 0.0130 -0.0424 0.0000 0.0107 0.7956

9 0.0154 -0.0207 0.0016 0.0325 -0.0267 -0.0419 0.0338 0.0056 -0.0001 0.3856

TABLE 1:

Forward rate volatility functions. The estimates correspond to the factor volatilities j (T ) for j = 1,,9 and T = 3 months, , 20 years obtained from a principal components analysis using monthly

percentage changes in forward rates. % Var is the percentage of the variance explained by each factor. The estimation is over the time period 04-Jan-1982 to16-May2005.

(H )

__

0.1221

__

Panel A: The monthly standard deviation ( H ) of the economy wide REIT stock price index H .

__

index i

IN 0.1260

LO 0.2180

MF 0.1150

OF 0.1272

OT 0.2180

RT 0.1597

(H i )

Panel B: The monthly standard deviations ( H i ) of the property type REIT stock price indices H i for the property types industry (IN), lodging (LO), multifamily

(MF), office (OF), other (OT), and retail (RT).

maturity

1 year -0.2424

2 years 0.1697

5 years -0.1705

__

7 years 0.2681

__

H j

__

Panel C: The monthly correlations H between the economy wide REIT stock price index H and the four zero-coupon bond prices p(t , T ) with maturities T = 1 j

year, 2 years, 5 years, and 7 years.

index i

IN 0.9239

LO 0.7062

MF 0.9038

__

OF 0.9541

OT 0.7062

RT 0.8891

__

iH H

__

Panel D: The monthly correlations iH H between the economy wide REIT stock price index H and the property type stock price indices H i for the property types

industry (IN), lodging (LO), multifamily (MF), office (OF), other (OT), and retail (RT).

H ij

H Panel E: The monthly correlations ij between the property type REIT stock price indices H i for the property types industry (IN), lodging (LO), multifamily

(MF), office (OF), other (OT), and retail (RT) and the zero-coupon bond prices p (t , T ) with maturities 1 year, 2 years, 5 years and 7 years.

ijHH

IN LO MF OF OT RT

HH Panel F: The monthly correlations ij across the various property type REIT stock price indices H i for the property types industry (IN), lodging (LO),

TABLE 2: State variable parameter estimates using monthly observations over the time period June 1998 to May 2005.

Property IN IN IN IN IN IN IN IN IN LO LO LO LO LO LO LO LO LO MF MF MF MF MF MF MF MF MF OF OF OF OF

Region EastNorthCentral Mideast Mountain Northeast Pacific Southeast Southwest WestNorthCentral Other EastNorthCentral Mideast Mountain Northeast Pacific Southeast Southwest WestNorthCentral Other EastNorthCentral Mideast Mountain Northeast Pacific Southeast Southwest WestNorthCentral Other EastNorthCentral Mideast Mountain Northeast

( 0 , stderr )

(-0.1732, 0.1571) (-0.002, 0.06825) (0.1304, 0.0933) (0.0421, 0.0356) (0.0274, 0.0518) (-0.0904, 0.1146) (0.1304, 0.1062) (-0.5825, 0.3372) (0.0425, 0.0408) (-0.3303, 0.4859) (-0.3303, 0.4859) (-0.3303, 0.4859) (-0.3303, 0.4859) (-0.3303, 0.4859) (-0.3303, 0.4859) (-0.3303, 0.4859) (-0.3303, 0.4859) (-0.3303, 0.4859) (0.0274, 0.0904) (0.0955, 0.0378) (0.6241, 0.7896) (0.0353, 0.0626) (0.0088, 0.0485) (0.0564, 0.0438) (0.0178, 0.0285) (0.2044, 0.2072) (0.0177, 0.0288) (0.955, 1.362) (0.0891, 0.0574) (-0.2153, 0.4485) (0.3464, 0.2882)

( 1 , stderr )

(2.809, 44.64) (-30.32, 19.4) (5.443, 26.53) (10.91, 10.12) (8.615, 14.73) (3.885, 32.56) (10.81, 30.18) (32.44, 95.82) (6.936, 11.6) (32.14, 139.7) (32.14, 139.7) (32.14, 139.7) (32.14, 139.7) (32.14, 139.7) (32.14, 139.7) (32.14, 139.7) (32.14, 139.7) (32.14, 139.7) (19.34, 25.33) (14.35, 10.61) (103.6, 221.2) (10.05, 17.54) (19.72, 13.61) (-2.86, 12.27) (-4.789, 7.989) (7.241, 58.05) (5.475, 8.076) (-72.91, 393.6) (14.25, 16.6) (-65.22, 129.6) (22.2, 83.26)

( 2 , stderr )

(-11.2, 60.24) (32.11, 26.17) (6.969, 35.81) (-11.64, 13.66) (-8.386, 19.88) (-12.27, 43.94) (-14.33, 40.73) (-53.79, 129.3) (-3.414, 15.66) (-37.1, 187.6) (-37.1, 187.6) (-37.1, 187.6) (-37.1, 187.6) (-37.1, 187.6) (-37.1, 187.6) (-37.1, 187.6) (-37.1, 187.6) (-37.1, 187.6) (-21.24, 34.2) (-15.26, 14.33) (-38.6, 298.6) (-12.78, 23.68) (-20.62, 18.37) (6.284, 16.57) (5.362, 10.79) (9.869, 78.38) (-4.536, 10.9) (215.4, 528.9) (-12.91, 22.31) (69.03, 174.1) (0.190, 111.9)

( 3 , stderr )

(-1.457, 38.42) (13.76, 16.69) (-21.43, 22.84) (-2.047, 8.71) (-4.649, 12.68) (-2.988, 28.02) (-3.186, 25.98) (-35.26, 82.48) (-10.35, 9.986) (-17.47, 120.7) (-17.47, 120.7) (-17.47, 120.7) (-17.47, 120.7) (-17.47, 120.7) (-17.47, 120.7) (-17.47, 120.7) (-17.47, 120.7) (-17.47, 120.7) (-13.94, 21.84) (3.239, 9.148) (-29.2, 190.7) (4.764, 15.12) (-4.752, 11.73) (-2.756, 10.58) (1.211, 6.888) (1.759, 50.05) (-3.376, 6.964) (-153.6, 322.7) (-4.977, 13.61) (-5.72, 106.2) (-24.34, 68.26)

( 4 , stderr )

(8.414, 23.38) (-15.16, 0.16) (10.25, 13.9) (3.957, 5.301) (5.663, 7.718) (10.86, 17.05) (6.067, 15.81) (52.15, 50.19) (7.784, 6.077) (17.54, 73.82) (17.54, 73.82) (17.54, 73.82) (17.54, 73.82) (17.54, 73.82) (17.54, 73.82) (17.54, 73.82) (17.54, 73.82) (17.54, 73.82) (14.86, 13.35) (0.217, 5.592) (-19.5, 116.6) (-1.633, .244) (7.279, 7.171) (-0.025, 6.47) (-1.041,4.211) (-14.15, 30.6) (3.198, 4.257) (11.53, 195.7) (6.556, 8.253) (-4.30, 64.42) (5.606, 41.39)

( , stderr )

(-0.3208, 5.922) (0.9718, 2.573) (1.552, 3.52) (-0.7124, 1.343) (0.0774, 1.955) (0.06418, 4.319) (3.778, 4.004) (-9.74, 12.71) (0.1974, 1.539) (10.23, 5.938) (10.23, 5.938) (10.23, 5.938) (10.23, 5.938) (10.23, 5.938) (10.23, 5.938) (10.23, 5.938) (10.23, 5.938) (10.23, 5.938) (5.969, 3.445) (4.834, 1.443) (-65.37, 30.07) (-2.688, 2.385) (-3.001, 1.85) (-1.158, 1.669) (-1.054, 1.086) (-17.85, 7.894) (-0.5456, 1.098) (41.58, 65.73) (0.03146, 2.772) (-3.362, 21.64) (5.31, 13.9)

( , stderr )

(2.439, 6.157) (-0.474, 2.675) (-1.53, 3.66) (0.6221, 1.396) (-0.288, 2.032) (1.36, 4.491) (-1.816, 4.163) (14, 13.22) (-0.03857, 1.6) (-5.805, 10.22) (-5.805, 10.22) (-5.805, 10.22) (-5.805, 10.22) (-5.805, 10.22) (-5.805, 10.22) (-5.805, 10.22) (-5.805, 10.22) (-5.805, 10.22) (-3.82, 3.217) (-6.113, 1.347) (50.16, 28.08) (3.286, 2.227) (2.318, 1.728) (1.64, 1.559) (1.356, 1.014) (14.27, 7.371) (0.8145, 1.025) (-39.09, 68.52) (-1.728, 2.89) (10.26, 22.56) (-7.284, 14.49)

R2 0.0578 0.2236 0.2405 0.5930 0.3768 0.1425 0.2288 0.0623 0.5385 0.0620 0.0620 0.0620 0.0620 0.0620 0.0620 0.0620 0.0620 0.0620 0.2347 0.6170 0.1077 0.3397 0.4336 0.5263 0.6864 0.1537 0.6768 0.0520 0.4266 0.0233 0.0810

N 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83

OF OF OF OF OF OT OT OT OT OT OT OT OT OT RT RT RT RT RT RT RT RT RT

Pacific Southeast Southwest WestNorthCentral Other EastNorthCentral Mideast Mountain Northeast Pacific Southeast Southwest WestNorthCentral Other EastNorthCentral Mideast Mountain Northeast Pacific Southeast Southwest WestNorthCentral Other

(0.0991, 0.1786) (0.153, 0.07547) (-0.4211, 0.2985) (-0.4328, 0.2368) (-0.6208, 0.65) (0.0109, 0.1871) (0.126, 0.06249) (0.1035, 0.0619) (0.0381, 0.0428) (0.0551, 0.0368) (0.0823, 0.0504) (0.0312, 0.0307) (0.6927, 0.4831) (0.0605, 0.0381) (0.9533, 1.422) (0.1429, 0.0653) (0.0569, 0.0605) (0.0534, 0.0558) (0.163, 0.06646) (0.0499, 0.0323) (0.1007, 0.0576) (0.1364, 0.1426) (0.123, 0.05491)

(-23.41, 51.61) (-18.77, 21.8) (65.41, 86.23) (-7.092, 68.4) (-47.09, 187.8) (95.09, 53.8) (23.86, 17.96) (19.97, 17.82) (18.61, 12.3) (16.98, 10.58) (-2.673, 14.52) (16.39, 8.84) (-118.9, 138.9) (16.87, 10.97) (-376.6, 376) (36.51, 17.29) (0.1952, 16) (23.57, 14.76) (14.29, 17.57) (-2.356, 8.556) (13.44, 15.25) (-9.245, 37.71) (23.72, 14.52)

(49.28, 69.34) (23.61, 29.29) (-90.47, 115.9) (17.13, 91.9) (15.83, 252.3) (-177, 72.24) (-25.26, 24.12) (-20.64, 23.93) (-26.32, 16.52) (-20.1, 14.21) (4.457, 19.49) (-20.91, 11.87) (142.8, 186.5) (-18.26, 14.72) (471, 505.9) (-45.06, 23.26) (-5.563, 21.52) (-31.44, 19.85) (-26.55, 23.64) (4.518, 11.51) (-19, 20.52) (8.446, 50.74) (-32.5, 19.54)

(-64.09, 42.31) (-7.197, 17.87) (37.76, 70.69) (-53, 56.07) (2.188, 154) (166.6, 46.47) (7.204, 15.52) (-2.38, 15.39) (7.942, 10.63) (-0.332, 9.142) (-1.986, 12.54) (1.736, 7.636) (51.18, 120) (-0.920, 9.472) (-122.2, 320) (10.48, 14.71) (9.777, 13.61) (9.043, 12.56) (18.34, 14.96) (-1.884, 7.281) (16.61, 12.98) (16.33, 32.09) (15.95, 12.36)

(39.42, 25.66) (3.475, 10.84) (-17.46, 2.87) (37.12, 34) (24.39, 93.36) (-85.46, 8.43) (-1.101, .492) (5.183, 9.417) (0.5753, .502) (5.032, 5.592) (0.8211, 7.67) (2.834, 4.671) (-74.09, 73.4) (3.741, 5.794) (15.37, 194.6) (0.706, 8.946) (-3.65, 8.278) (-0.259, 7.63) (-3.731, 9.09) (0.591, 4.428) (-9.35, 7.892) (-12.5, 19.52) (-5.02, 7.514)

(12.28, 8.618) (2.583, 3.641) (-0.1899, 14.4) (22.33, 11.42) (-10.71, 31.36) (3.675, 2.287) (1.484, 0.7635) (0.7127, 0.7574) (0.6232, 0.523) (1.255, 0.4498) (1.148, 0.617) (0.3487, 0.3757) (2.466, 5.904) (1.162, 0.4661) (45.25, 34.85) (-2.432, 1.603) (-0.0784, 1.483) (0.1701, 1.368) (-3.219, 1.629) (-0.2275, 0.793) (-0.7918, 1.414) (3.284, 3.496) (-0.9569, 1.346)

(-12.1, 8.984) (-2.273, 3.795) (4.981, 15.01) (-16.3, 11.91) (15.34, 32.69) (-2.023, 3.935) (-4.942, 1.314) (-1.634, 1.303) (-0.371, 0.899) (-1.716, 0.774) (-0.567, 1.062) (0.691, 0.6465) (-0.976, 10.16) (-1.47, 0.802) (-28.9, 43.81) (1.096, 2.014) (0.4228, 1.864) (0.0187, 1.719) (2.242, 2.048) (0.513, 0.9969) (0.2998, 1.777) (-4.95, 4.394) (0.1066, 1.692)

0.1165 0.3531 0.0464 0.1080 0.0412 0.2065 0.4320 0.3858 0.5141 0.6221 0.4926 0.6912 0.0669 0.6087 0.0757 0.4240 0.3783 0.4359 0.4401 0.6892 0.4293 0.1554 0.4950

83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83 83

TABLE 3: The NCREIF regional x property value indices regression parameter estimates using monthly observations over the time period June 1998 to May 2005.

The regression estimated is:

4 H j (i ) (t ) hi (t ) p (t , t + Tk ) H (t ) rt = 0 + k ( rt ) + ( rt ) + ( rt ) + i (t ) . The regions are specified in column 2. Property types H j (i ) (t ) hi (t ) p (t , t + Tk ) k =1 H (t )

are: industry (IN), lodging (LO), multifamily (MF), office (OF), other (OT), and retail (RT). Given are the coefficients, the standard errors, the R^2, and the number of observations.

Transition to the Same or Better State Current (0 days delinquent) 99% Delinquent (30-59 days) 62% Delinquent (60-89 days) 36% Delinquent (90+ days) 61%

This table gives the monthly transition frequencies of moving from the present state (column 1) to the same or better state (column 2) versus a worse state (column 3), for all commercial mortgage loans over the time period June 1988 to June 2004.

TABLE 5:

The number of commercial loans in the database from June 1988 to June 2004.

The loans are partitioned into those that are credit tenant leases (CTLs), fixed versus floating rate, prepaid and defaulted. There are a total of 102,577 loans in the sample.

Fixed rates Current Delinquent Estimate StdErr Estimate StdErr 8.38195 0.15849 -8.38195 0.15849 -0.00037 1.57494 -0.94843 0.94830 1.31866 -1.39621 -3.70456 -3.03486 -3.30865 -2.61916 -2.28950 -3.80976 -3.14409 -3.76712 0.45991 -7.71530 0.00000 0.00036 0.33835 -0.00455 0.00591 -0.01976 0.66337 -0.00994 0.27295 -0.38494 -0.45925 0.00116 0.03986 0.03908 0.02458 0.03398 0.02957 0.07946 0.08014 0.08093 0.08049 0.08231 0.07855 0.07914 0.07952 0.03154 0.75599 0.00000 0.00001 0.00622 0.00023 0.00308 0.00044 0.01120 0.00051 0.01442 0.00897 0.01074 0.00037 -1.57494 0.94843 -0.94830 -1.31866 1.39621 3.70456 3.03486 3.30865 2.61916 2.28950 3.80976 3.14409 3.76712 -0.45991 7.71530 0.00000 -0.00036 -0.33835 0.00455 -0.00591 0.01976 -0.66337 0.00994 -0.27295 0.38494 0.45925 0.00116 0.03986 0.03908 0.02458 0.03398 0.02957 0.07946 0.08014 0.08093 0.08049 0.08231 0.07855 0.07914 0.07952 0.03154 0.75599 0.00000 0.00001 0.00622 0.00023 0.00308 0.00044 0.01120 0.00051 0.01442 0.00897 0.01074

Floating rates Current Delinquent Estimate StdErr Estimate StdErr -0.44635 0.44911 0.44635 0.44911 -0.01870 2.70221 -2.48318 0.48016 1.76591 -0.43966 -1.13054 0.44784 1.08380 1.41365 1.33022 -0.65106 -0.13140 -0.50560 1.75788 -14.45546 0.19173 0.00119 0.36036 -0.03135 0.02993 -0.03415 0.35981 0.03837 0.00856 0.00000 0.00000 0.00401 0.17415 0.17822 0.09555 0.12039 0.17860 0.13042 0.13584 0.17257 0.15064 0.14691 0.12932 0.15191 0.16802 0.10395 3.65702 0.02133 0.00014 0.02245 0.00118 0.00572 0.00173 0.03823 0.00296 0.04985 0.01870 -2.70221 2.48318 -0.48016 -1.76591 0.43966 1.13054 -0.44784 -1.08380 -1.41365 -1.33022 0.65106 0.13140 0.50560 -1.75788 14.45546 -0.19173 -0.00119 -0.36036 0.03135 -0.02993 0.03415 -0.35981 -0.03837 -0.00856 0.00000 0.00000 0.00401 0.17415 0.17822 0.09555 0.12039 0.17860 0.13042 0.13584 0.17257 0.15064 0.14691 0.12932 0.15191 0.16802 0.10395 3.65702 0.02133 0.00014 0.02245 0.00118 0.00572 0.00173 0.03823 0.00296 0.04985

hi (t )

P1 P2 P3 P4 P5 R1 R2 R3 R4 R5 R6 R7 R8 age fore_index noi Pen origloanbal

H i (t )

dscr ltv spot

H (t )

f(t,10)-r(t) wac coupon_spread

Fixed rates Prepayment Default Estimate StdErr Estimate StdErr -10.17425 0.26556 -10.96945 0.62179 0.00999 -0.76690 1.03100 0.76025 -0.66798 2.61076 -0.11877 0.08622 0.01629 -0.30567 -0.27244 -0.04961 -0.13450 0.01616 12.12135 -2.73125 1.57502 0.00000 -0.00099 -0.30611 0.01023 -0.01227 0.00892 0.16979 -0.00521 0.17895 -0.26759 0.11350 0.00303 0.04558 0.08956 0.03599 0.04735 0.07094 0.06601 0.06345 0.06357 0.05859 0.05530 0.06146 0.06300 0.08402 0.10185 0.23559 1.73865 0.00000 0.00005 0.01013 0.00049 0.00937 0.00069 0.02056 0.00094 0.02689 0.01247 0.00866 0.00120 0.61829 -0.31815 -0.05465 0.99022 -1.84097 0.38011 0.57580 0.27483 0.10622 -0.29227 0.41256 0.72144 0.69116 3.24458 5.38979 -6.54448 0.00000 0.00109 0.05524 -0.00954 -0.42866 0.01134 0.21948 -0.00924 0.32873 0.11301 -0.05213 0.00361 0.12335 0.13029 0.07467 0.10278 0.14846 0.21373 0.21331 0.21869 0.21279 0.21897 0.21108 0.21030 0.22325 0.11491 0.05646 2.40202 0.00000 0.00006 0.02320 0.00107 0.06687 0.00123 0.04018 0.00194 0.05438 0.03162 0.03074

Floating rates Prepayment Default Estimate StdErr Estimate StdErr -5.96589 0.37231 -10.56163 1.81182 0.00635 -0.29873 -0.00907 0.43529 0.14559 1.13073 -0.90655 -2.54044 -1.21579 -2.72888 -1.42898 -1.36791 -1.37845 -1.76993 5.65398 -12.37204 -37.01782 -0.00103 -0.00047 -0.25369 -0.00119 -0.04519 0.00337 0.19869 0.01634 0.12641 0.00000 0.00000 0.00495 0.09849 0.14605 0.05969 0.09793 0.11049 0.11770 0.14439 0.09787 0.09491 0.08182 0.09878 0.10332 0.24891 0.09260 97.27080 3.46089 0.00140 0.00021 0.01434 0.00100 0.01466 0.00124 0.03339 0.00182 0.04374 0.00000 0.00000 0.01305 0.77465 0.51097 0.98026 1.40881 0.73403 0.55404 -0.31433 -0.27854 0.40176 -0.79431 0.10608 -0.07969 1.17817 2.53818 4.12130 -13.54602 -0.00965 0.00068 0.02793 -0.00816 -0.64949 0.01509 -0.09297 0.01601 -0.21663 0.00000 0.00000 0.01449 0.54003 0.60623 0.34609 0.41788 0.59531 0.46859 0.57016 0.55158 0.42190 0.46454 0.45364 0.48463 0.56496 0.36382 0.21198 8.32882 0.01657 0.00036 0.06852 0.00460 0.21575 0.00550 0.15982 0.00824 0.21081 0.00000 0.00000

hi (t )

P1 P2 P3 P4 P5 R1 R2 R3 R4 R5 R6 R7 R8 age dlqstatus fore_index noi Pen origloanbal

H i (t )

dscr ltv spot

H (t )

f(t,10)-r(t) wac coupon_spread

TABLE 6:

int ensity =

Intensity process parameter estimates based on monthly observations over the time period June 1998 to May 2005.

(1 + e

1

i coefficienti var iablei

). Separate estimates are done for fixed versus floating rate loans.

Panel A: The parameter estimates for a competing risk current versus delinquent point process. Panel B: The parameter estimates for a competing risk default versus prepayment point process. The first column contains the variables: hi (t ) = ith property x region stock price index at time t R1 R2 R3 R4 R5 R6 R1 R2 R3 R4 R5 R6 R7 R8 R9 age dlqStatus fore_index noi pen origloanbal = industrial property dummy variable = lodging property dummy variable = multifamily property dummy variable = office property dummy variable = other property dummy variable = retail property dummy variable (omitted) = East north central region dummy variable = Mideast region dummy variable = Mountain region dummy variable = Northeast region dummy variable = Pacific region dummy variable = Southeast region dummy variable = Southwest region dummy variable = West North Central dummy variable = other region dummy variable (omitted) = (1-remaining term/original term) = Delinquency status = ACLI foreclosure index = net operating income at origination divided by the original loan balance = penalties divided by outstanding balance at time t = logarithm of the original loan balance = ith property stock price index at time t = debt service coverage ratio at origination = loan to value ratio at origination = spot rate of interest at time t = Reit stock price index at time t

H i (t )

dscr ltv r(t)

H (t )

= 10 year forward rate minus the spot rate at time t = weighted average coupon at origination = coupon minus treasury rate spread at loan origination

Floating rates

TABLE 7: Receiver operating characteristic (ROC) accuracy ratios using monthly observations over the time period June 1998 to May 2005.

The ROC ratio measures forecasting ability, with a score of 0.5 indicating random selection. Separate ROC ratios are provided for forecasting prepayment, default, current, or delinquency for both fixed and floating rate loans.

Intercept

Estimate -0.08135 0.00239 0.08041 0.11096 0.02349 0.04434 0.08982 0.03269 -0.10908 -0.02175 -0.05972 -0.0777 0.02644 -0.05022 0.20105 0.05325 0.02438 -0.00004 0.00090 -0.07397 0.00098 -0.01359

StdErr 0.21166 0.00155 0.05162 0.06412 0.03664 0.03809 0.06518 0.12901 0.12899 0.1303 0.1297 0.1314 0.12782 0.12789 0.13071 0.05995 0.00918 0.00047 0.00032 0.01867 0.00085 0.02500

R2

0.1680

hi (t )

P1 P2 P3 P4 P5 R1 R2 R3 R4 R5 R6 R7 R8 age origloanbal

H i (t )

ltv spot

H (t )

f(t,10)-r(t)

TABLE 8: 2005.

The parameter estimates for the loss severity regression using monthly observations over the time period June 1998 May

The regression equation is loss = i coefficient i var iablei . The variables in the first column are: hi (t ) = ith property x region stock price index at time t R1 = industrial property dummy variable

R2 R3 R4 R5 R6 R1 R2 R3 R4 R5 R6 R7 R8 R9 age origloanbal

H i (t )

ltv spot

= lodging property dummy variable = multifamily property dummy variable = office property dummy variable = other property dummy variable = retail property dummy variable (omitted) = East north central region dummy variable = Mideast region dummy variable = Mountain region dummy variable = Northeast region dummy variable = Pacific region dummy variable = Southeast region dummy variable = Southwest region dummy variable = West North Central dummy variable = other region dummy variable (omitted) = (1-remaining term/original term) = logarithm of the original loan balance = ith property stock price index at time t

= loan to value ratio at origination = spot rate of interest at time t = Reit stock price index at time t H (t ) f(t,10)-r(t) = 10 year forward rate minus the spot rate at time t. The remaining columns give the coefficients and their standard errors. The R^2 is also provided.

N 46 46 46 46 46 46 46 46 46 46

avg( ) 7.1538* 6.1022* 6.5469 4.9759* 5.5188* 6.2538* 2.6231* 7.3284* 8.6955* 10.9503*

stdev( ) 2.1888 2.0055 3.9829 1.0774 1.6151 2.7423 0.7151 5.0916 3.5805 4.8909

N 46 46 46 46 45

Panel B: Pricing errors grouped by weighted average life (WAL). TABLE 9: Summary statistics for the CMBS pricing errors.

The pricing errors are given by = [model price market price], for all CMBS bonds grouped by rating categories (Panel A) and weighted average life (Panel B) using monthly observations over the time period July 2001 April 2005.

Jul-01

Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03 Jul-03 Aug-03 Sep-03 Oct-03

Short AAA (2-6 WAL) 126 129 138 133 136 138 148 147 147 148 148 143 148 148 150 151 150 151 149 153 149 149 147 148 146 146 148 149

Long AAA (>6 WAL) 115 117 123 116 119 120 126 124 123 119 114 105 111 107 100 97 92 91 86 89 84 83 84 80 75 70 69 67

AA (>2 WAL) 124 127 136 133 136 137 147 146 146 147 148 142 148 148 150 150 150 150 148 152 149 149 148 148 146 145 147 147

A (>2 WAL) 126 129 138 135 138 139 149 148 148 149 150 144 150 150 152 152 152 152 150 154 151 152 150 150 149 147 149 150

BBB (>2 WAL) 121 124 129 127 128 129 135 135 139 141 141 138 142 144 145 145 145 145 143 147 144 145 145 147 144 142 144 144

Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Average Total GRAND Total

148 150 151 153 150 154 152 152 152 152 250 278 274 271 269 265 265 166 7,449 39,590

146 148 149 151 149 152 151 151 151 152 254 285 281 282 280 279 276 167 7,481

149 151 152 153 152 155 154 153 153 154 256 284 281 280 277 276 276 168 7,559

144 145 146 148 146 149 148 148 148 149 253 280 277 276 276 275 274 162 7,280

TABLE 10: The numbers of bonds in the CMBS indices, per month, over the time period July 2001 to April 2005.

The bonds are partitioned into the five buckets {aaa, 2<WAL<6}, {aaa, WAL >6}, {(aa1, aa2, aa3), WAL>2}, {a1, a2, a3), WAL >2}, {(baa1, baa2, baa3), WAL >2} where the first argument is the credit rating and the second argument is the weighted average life.

p-value

p-value

Panel A: Average monthly trading strategy returns for various CMBS bond portfolios over the time period July 2001 April 2005 partitioned by risk classes. Indicated is the credit rating of each portfolio. Short corresponds to a weighted average life of less 6 years, and long to a weighted average life of greater than six years. Columns one and two contain the returns for the portfolios constructed using the top decile and bottom decile ranked CMBS bonds based on pricing errors. Column 3 gives the difference in the returns between the top and bottom decile portfolios. Column four is the return on an equal risk portfolio, column five is the difference between the top decile portfolios return and the index return. Column six gives the p-value (probability that the two averages are equal). Column seven gives the difference between the bottom decile portfolios return and the index return, followed in column eight by the p-value for the difference.

Top Decile

Bottom Decile

Diff Top-Bottom

Index Returns

Diff Top-Index

Panel B: Cumulative trading strategy returns for various CMBS bond portfolios over the time period July 2001 April 2005 partitioned by risk classes. Indicated is the credit rating of each portfolio. Short corresponds to a weighted average life of less 6 years, and long to a weighted average life of greater than six years. Columns one and two contain the returns for the portfolios constructed using the top decile and bottom decile ranked CMBS bonds based on pricing errors. Column 3 gives the difference in the returns between the top and bottom decile portfolios. Column four is the return on an equal risk portfolio, column five is the difference between the top decile portfolios return and the index return. TABLE 11: Trading Strategy Returns for various CMBS bond portfolios over the time period July 2001 April 2005.

The CMBS database Index (analogous to the Lehman Brothers CMBS index) has a cumulative return of 30.42 percent over this same time period. The CMBS database Index has the weights across ratings (short aaa (.5182), long aaa (.2822), aa (.0633), a (.0677), b (.0686)).

Panel A OV-IND Short aaa UV-IND Short aaa OV-IND Long aaa UV-IND Long aaa OV-IND aa UV-IND aa OV-IND a UV-IND a OV-IND bbb UV-IND bbb OV-IND

intercept

-0.0033 (0.0007)* 0.0005 (0.0009) -0.0015 (0.0009)* 0.0003 (0.0011) -0.0025 (0.0016)* -0.0002 (0.0017) -0.0021 (0.0013)* -0.0003 (0.0012) -0.0007 (0.0011) -0.0006 (0.0014) -0.0012

H( t ) / H( t )

-0.0054 (0.0070) 0.0076 (0.0088) -0.0009 (0.0093) 0.0065 (0.0115) 0.0042 (0.0159) 0.0067 (0.0169) -0.0001 (0.0127) 0.0001 (0.0118) -0.0103 (0.0113) 0.0034 (0.0135) 0.0008

P1( t ) / P1

-0.2394 (0.1295)* 0.3132 (0.1646)* -0.4069 (0.1725)* 0.0957 (0.2133) -0.9185 (0.2965)* 0.2646 (0.3151) -0.8343 (0.2368)* 0.2195 (0.2200) -0.5517 (0.2101)* 0.1240 (0.2515) -1.0432

P 2( t ) / P 2( t )

0.4117 (0.1541)* -0.6558 (0.1959)* 0.5057 (0.2052)* -0.1312 (0.2537) 1.2384 (0.3528)* -0.4825 (0.3749) 1.0942 (0.2818)* -0.4239 (0.2617) 0.8146 (0.2500)* -0.3492 (0.2993) 1.2510

P 5( t ) / P 5( t )

-0.1500 (0.1122) 0.0972 (0.1427) -0.2127 (0.1495) -0.1928 (0.1848) -0.4080 (0.2570) -0.1298 (0.2731) -0.2072 (0.2052) -0.0236 (0.1906) -0.0707 (0.1821) -0.0281 (0.2180) 0.3043

P 7( t ) / P 7( t )

-0.1571 (0.0727)* 0.2204 (0.0925)* 0.0308 (0.0968) 0.1819 (0.1198) -0.0774 (0.1665) 0.2803 (0.1770)* -0.1924 (0.1330) 0.1622 (0.1235) -0.2264 (0.1180)* 0.1704 (0.1412) -0.6754

Mkt-RF

0.0001 (0.0001) 0.0001 (0.0001) 0.0002 (0.0001)* 0.0000 (0.0001) 0.0001 (0.0001) 0.0000 (0.0002) 0.0000 (0.0001) 0.0001 (0.0001) 0.0000 (0.0001) 0.0000 (0.0001) 0.0001

N

45 45 45 45 45 45 45 45 45 45 45

F-test

52.2618 24.9843 2.9528 0.9021 8.1769 2.7922 11.3258 2.8669 10.1427 3.0718 6.4293

R2

0.892 0.798 0.318 0.125 0.564 0.306 0.641 0.312 0.616 0.327 0.504

Panel B OV-IND Short aaa UV-IND Short aaa OV-IND Long aaa UV-IND Long aaa OV-IND aa UV-IND aa OV-IND a UV-IND a OV-IND bbb UV-IND bbb

intercept

-0.0032 (0.0007)* 0.0005 (0.0009) -0.0014 (0.0009) 0.0003 (0.0012) -0.0022 (0.0016) -0.0002 (0.0017) -0.0020 (0.0013) -0.0002 (0.0012) -0.0006 (0.0012) -0.0006 (0.0014)

H( t ) / H( t )

-0.0037 (0.0079) 0.0047 (0.0100) 0.0009 (0.0104) 0.0049 (0.0130) 0.0116 (0.0179) 0.0041 (0.0192) 0.0041 (0.0145) 0.0021 (0.0134) -0.0037 (0.0127) -0.0008 (0.0151)

P1( t ) / P1

-0.2492 (0.1328)* 0.3022 (0.1683)* -0.4321 (0.1743)* 0.0760 (0.2183) -0.9409 (0.3017)* 0.2438 (0.3239) -0.8409 (0.2433)* 0.2005 (0.2255) -0.5502 (0.2132)* 0.0944 (0.2547)

P 2( t ) / P 2( t )

0.4165 (0.1572)* -0.6495 (0.1992)* 0.5183 (0.2063)* -0.1207 (0.2583) 1.2483 (0.3570)* -0.4712 (0.3833) 1.0967 (0.2879)* -0.4146 (0.2669) 0.8124 (0.2522)* -0.3330 (0.3014)

P 5( t ) / P 5( t )

-0.1247 (0.1229) 0.1365 (0.1558) -0.1419 (0.1613) -0.1305 (0.2020) -0.3584 (0.2792) -0.0622 (0.2997) -0.1971 (0.2251) 0.0283 (0.2087) -0.0900 (0.1972) 0.0694 (0.2357)

P 7( t ) / P 7( t )

-0.1764 (0.0810)* 0.1931 (0.1027)* -0.0216 (0.1063) 0.1373 (0.1331) -0.1169 (0.1840) 0.2323 (0.1975) -0.2017 (0.1484) 0.1235 (0.1375) -0.2154 (0.1300)* 0.1014 (0.1553)

Mkt-Rt

0.0001 (0.0001) 0.0001 (0.0001) 0.0002 (0.0001)* 0.0000 (0.0001) 0.0001 (0.0002) 0.0001 (0.0002) 0.0000 (0.0001) 0.0001 (0.0001) 0.0000 (0.0001) 0.0001 (0.0001)

SMB

-0.0001 (0.0001) 0.0000 (0.0001) -0.0001 (0.0001) -0.0001 (0.0002) -0.0002 (0.0002) 0.0000 (0.0002) -0.0001 (0.0002) -0.0001 (0.0002) -0.0001 (0.0002) -0.0001 (0.0002)

HML

0.0000 (0.0001) 0.0001 (0.0002) 0.0001 (0.0002) 0.0002 (0.0002) -0.0001 (0.0003) 0.0002 (0.0003) -0.0001 (0.0002) 0.0001 (0.0002) -0.0002 (0.0002) 0.0003 (0.0002)

N

45 45 45 45 45 45 45 45 45 45

F-test

37.8264 18.2642 2.4065 0.7489 6.1548 2.0639 8.2164 2.1507 7.6667 2.4722

R2

0.894 0.802 0.348 0.143 0.578 0.314 0.646 0.323 0.630 0.355

TABLE 12: The regression analysis for omitted risk premia in the monthly portfolio returns over the time period July 2001 April 2005.

Indicated is the credit rating of each portfolio. Short corresponds to a weighted average life of less 6 years, and long to a weighted average life of greater than six years. The regression estimated is Rt Rt = + pi Rt rt + t where Rt Rt = over-valued (OV) or under-valued (UV) portfolio return less the indexed (IND)

p 1 i

p 1

i =2

portfolio return, Rt are risk factor returns, and rt is the spot rate of interest. The risk factors include the economy wide REIT stock price index H , four different zero-coupon bonds P (t , T ) / P (t , T ) (with maturities 1 year, 2 years, 5 years, and 7 years), a general stock market index Mkt Rt, the small minus big index SMB, and

__

the high minus low index HML . * denotes significance at 95% level. The F-test is based on H 0 : pi = 0 for all i. The stock price indices were obtained from Ken Frenchs website. Panel A excludes the HML and SMB indices.

N 46 46 46 46 45

TABLE 13: Summary statistics for the adjusted models CMBS pricing errors over the time period July 2001 April 2005.

The pricing errors = [adjusted model price market price]. The pricing errors are partitioned by weighted average life (WAL). Given is the sample size, average pricing error, and the standard deviation of the pricing error.

intercept 1.8284 7.1987 0.4114 4.3097 0.3626 6.2513 0.3038 4.1590 -0.3006 3.3457 1.6475 4.7273 -0.8484 7.7001 1.3836 7.8066 0.6305 7.7014 0.1002 9.8400

spot -0.1240 1.9454 -0.0860 1.0781 -0.1145 1.6220 -0.6570 1.1014 0.0576 0.8231 -0.1532 1.3009 0.2738 2.0746 -0.2842 2.1117 -0.0460 1.9830 0.0652 2.6172

f(t,10)-spot 0.2202 1.9154 -0.0109 1.0778 0.0793 1.6010 -0.2005 1.0970 0.0705 0.8228 -0.1048 1.2727 0.1362 1.9933 -0.0966 2.0747 0.2513 1.9713 0.1641 2.5770

H (t )

-0.0085 0.0350 -0.0014 0.0198 -0.0016 0.0294 0.0067 0.0200 0.0002 0.0152 -0.0062 0.0232 -0.0004 0.0356 -0.0031 0.0380 -0.0072 0.0363 -0.0030 0.0470

R2 0.5168 0.5853 0.5261 0.6371 0.5950 0.5072 0.1098 0.5144 0.6076 0.5641

TABLE 14: Regression equation coefficients for CMBS pricing error biases. The regression equation estimated is errort = c0 + c1 spot + c 2 ( f (t ,10) spot ) + c3 H (t ) where f(t,10) is the 10 year forward rate, spot is the three month

Treasury bill yield, and H (t ) is the economy wide REIT stock price index. In all cases, the coefficients are not significant at 95% level. Standard errors are given below the parameter estimates.

Short AAA

Undervalued

Overvalued

$5,000,000.00 ($1,171,582.00) ($645,100.00) $3,183,318.00 459 106.2513 6.23 2.60 2.11 19.02%

(a) Cumulative Interest $5,730,000.00 (b)+(c) Cumulative Gains/Losses + Prepayment Penalties $134,378.00 (d) Cumulative Pay Downs at Par ($11,000.00) Cumulative Total Dollar Profits $5,853,378.00 Number of Pay downs at Par 32 Average Dollar Price 110.4864 Average Coupon 7.01 Average WAL 5.34 Average OAWAL 5.24 (WAL-OAWAL)/WAL 1.90%

TABLE 15: Monthly cash flows of the short AAA overvalued and undervalued portfolios over the yime period July 2001 May 2005.

Short AAA Profile (2-6 WAL) Undervalued Overvalued Average Dollar Price 110.4864 106.2513 Average Coupon 7.01 6.23 Average WAL 5.34 2.60 Average OAWAL 5.24 2.11 Diff (WAL - OAWAL)/WAL 1.90% 19.02% Long AAA Profile (>6 WAL) Average Dollar Price Average Coupon Average WAL Average OAWAL Diff (WAL - OAWAL)/WAL All AA Profile (>2 WAL) Average Dollar Price Average Coupon Average WAL Average OAWAL Diff (WAL - OAWAL)/WAL All A Profile (>2 WAL) Average Dollar Price Average Coupon Average WAL Average OAWAL Diff (WAL - OAWAL)/WAL All BBB Profile (>2 WAL) Average Dollar Price Average Coupon Average WAL Average OAWAL Diff (WAL - OAWAL)/WAL Undervalued Overvalued 108.7338 107.8653 6.62 6.24 8.18 6.82 8.11 6.72 0.80% 1.42% Undervalued Overvalued 108.0502 108.7182 6.85 6.86 8.26 5.43 8.18 4.93 0.97% 9.22% Undervalued Overvalued 107.5509 108.7124 7.15 6.94 8.22 5.78 8.18 5.12 0.46% 11.35% Undervalued Overvalued 101.6154 107.8686 7.49 7.19 8.57 6.08 8.64 5.28 -0.79% 13.25%

TABLE 16: Summary statistics of the overvalued and undervalued bond portfolios using monthly observations over the time period July 2001 May 2005.

WAL is the weighted average life. OAWAL is the option adjusted weighted average life, that is adjusted through simulation for the embedded default and prepayment options in the CMBS bonds.

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