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November 2010

Asymmetric Information, Adverse Selection and the Pricing of CMBS

A paper by Xudong An (San Diego State University), Yongheng Deng (National University of Singapore), and Stuart Gabriel (University of California, Los Angeles).

In a forthcoming paper to be published in the Journal of Financial Economics, RMI affiliated researcher Prof. Yongheng Deng, with his co-authors, investigated the "lemons problem" in the commercial mortgaged-backed securities (CMBS) market.

The "lemons problem" which arises from the information asymmetry between the seller and buyer, was first highlighted by Akerlof (1970) in his seminal paper: "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism". In this paper, An, Deng and Gabriel built an information economic model of loan sales in the securitization markets to examine the differences between "conduit lending", where mortgage lenders originated loans specifically for direct sales to the securitization market, and the "portfolio lending", where lenders originate commercial mortgage loans with intent to hold those loans in their investment portfolios. They provided a theoretical basis for the pricing puzzle observed in the CMBS markets, where conduit loans are priced higher than portfolio loans, notwithstanding the pervasive perception that conduit loans are originated with lower quality. Their empirical analysis is congruent with their theoretical predictions, demonstrating that the conduit loans have a 34 basis points (bps) premium over portfolio loans.

For the theoretical model developed, the payoff of a loan is decomposed into three components: (i) payoffs adjusted for observable risk characteristics associated with the loan underwriting terms, (ii) the payoff reflecting the unobservable risk characteristics such as the lender private information about the loan risk developed during the underwriting process or loan holding period, and (iii) a random shock. In portfolio loan sale case, the seller is assumed to know the value of the unobservable risk characteristics, while the buyer has only information about the distribution of the unobservable risk characteristics.

In the competitive equilibrium for the portfolio loan sales characterized by the authors, only a fraction of the mortgage pool representing the lower quality loans ("lemons") will be traded. In addition, the greater the information asymmetry between the buyer and seller of loans, the more severe is the "lemons problem". That is, bad loans drive out good loans in the portfolio loan securitization market. Furthermore, the magnitude of the "lemons discount" of portfolio loan sales varies positively with the dispersion of loan quality in the mortgage pool and inversely with seller's cost of holding the loans in the portfolio. Their theoretical results concluded that the total surplus associated with the securitization trade is higher for conduit loans than for portfolio loans, thus supporting their conjecture of the role conduit loans play in the market.

The empirical analysis is performed with a dataset (with 141 deals and 16,760 loans) on CMBS issued in the United States using a reduced-form pricing model. The spread of the net coupon paid to the CMBS investors over the comparable maturity Treasury rate is the dependent variable, while the independent variables include a set of economic and debt market factors that affect the market-wide CMBS loan pricing, a vector of publicly observable CMBS loan characteristics, and an indicator "dummy" variable for taking the value of 1 for conduit and 0 for portfolio loans respectively. Thus, the coefficient associated with the indicator "dummy" variable would represent the presence or absence of the "lemons discount" in the pricing of conduit relative portfolio loans.

The empirical results suggest that conduit loans have a 33 basis points pricing premium over portfolio loans at deal level, and a 34 basis points premium at loan level. This pricing differential is consistent with their theoretical prediction of a "lemons effect", where portfolio loan lenders utilize private information to sell low quality loans into the CMBS market.

In conclusion, this paper provides both a theoretical model and empirical evidence of asymmetric information and adverse selection in the market for CMBS.

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Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)