Multifamily Mortgage Credit Risk: Lessons from Recent History

Abstract

This article uses an innovative default model to explain increases in conventional multifamily mortgage default rates in the 1980s. Factors behind these changes are well known, but quantification of relative influences has not yet been performed. Our theoretical model has investors or borrowers defaulting if the underlying project has both negative equity and negative cash flows, a "double trigger." This leads to modeling default probabilities as a function of primary underwriting ratios, rental market conditions after loan origination, and institutional factors. A binary logit model is estimated with data on over 7,500 conventional multifamily mortgages purchased by Fannie Mae and Freddie Mac from 1983 to 1995. The results are used in simulations to explain why default rates increased in the 1980s and 1990s. We find that the increase was due to lax underwriting, declines in the tax benefits of owning real estate, and declines in rental market conditions. Default rates would have been worse had it not been for declines in interest rates.

JEL Classification: G2, G1, H5, D6