Examination of Potential Misrepresentation in CMBS

Abstract

Although CMBS suffered large scale losses during the past financial crisis, currently, this segment of the structured finance market has almost recovered to its pre-crisis level. While evidence was found regarding the systematic misrepresentation of loan quality information in residential mortgages, there was no evidence of large scale misreporting in CMBS. This paper examines important financial variables reported in commercial mortgages such as Underwritten Net Operating Income (UWNOI). I find that, prior to the financial crisis, UWNOI was consistently over-estimated by an average of 7.8%. This overstatement leads to Loan-to-Value ratio and Debt-Service Coverage Ratio being misreported as 67.1% from 84.2% and DSCR as 1.72 from 1.59. The levels of aggregate over-estimation substantially differed among originators and the variations explained the performance differences between originators. Each 1% increase in over-estimation resulted in a 20% higher likelihood in delinquency. The ratings issued by rating agencies failed to capture the adverse impact from over-estimation on CMBS performance.