The Imitation Game: The Imitation Game: How Encouraging Renegotiation Makes Good Borrowers Bad.

The article investigates opportunistic behavior by commercial mortgage borrowers seeking principal reductions, focusing on discounted payoffs (DPOs) in commercial mortgage-backed securities (CMBS). It develops a principal-agent model where lenders cannot perfectly observe borrowers' private use values of properties, and renegotiation costs influence borrower strategies. Exploiting a 2009 IRS rule change (Revenue Procedure 2009-45) that lowered regulatory barriers to loan modifications, the study finds that borrowers with high private use values ("high types") are more likely to transfer loans into special servicing and request principal reductions when lenders have greater capacity to negotiate DPOs. Empirical analysis using Trepp data shows increased transfers and higher likelihood of full loan payoffs post-rule change, particularly among loans unlikely to have been distressed before, indicating strategic borrower behavior that may reduce lender recoveries. The findings highlight the role of asymmetric information in commercial real estate lending and suggest that regulatory policies facilitating predefault renegotiation can unintentionally encourage strategic borrower actions.