The Pricing of Multiclass Commercial Mortgage-Backed Securities

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Abstract
This paper considers the pricing of multiclass commercial mortgage-backed securities. A contingent-claims pricing methodology that overcomes state variable dimensionality problems is developed to examine mortgage pools with many distinct underlying assets and whose loan cash flow values are subject to interest rate uncertainty. Security structure and the correlation structure of collateralizing assets within a pool are found to be important determinants of tranche price and required yield spread. By disentangling default loss risk from default-related call risk, we show it is possible that mezzanine investment classes may require lower yield spreads than higher priority investment classes. Of particular interest is the finding that reduced cash flow volatility obtained through pool diversification may actually decrease the value of the first-loss (junior) tranche. When examining the relationship of pool size and tranche value, we find that five to 10 distinct mortgages are required to realize most of the effects of asset diversification.

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