Final Exam

What is meant by the term "agency costs"? How did agency costs play a role in the credit crisis?

"Agency costs" is a term used to describe the costs in a situation where the interests of two parties are not perfectly aligned. There were potential agency costs between the originators of mortgages and investors, and employees of banks who earned bonuses and the banks themselves.

Which of the following is a typical bid-offer spread on the swap rate for a plain vanilla interest rate swap? A. 3 basis points. B. 8 basis points. C. 13 basis points. D. 18 basis points.

3 basis points.

The Put Option Impact

As borrowers exercised their put option, the supply of homes on the market further increased (pushing home prices even lower). Which lead to bizarre incentives for homeowners.

Which of the following describes the waterfall typically used for mortgages pre-crisis? A. A distribution of cash flows to tranches with priority given to tranche with the highest rating. B. A distribution of cash flows to tranches in proportion to their outstanding principals. C. A distribution of losses to tranches so that tranches bear losses in proportion to their outstanding principals. D. None of the above.

A distribution of cash flows to tranches with priority given to tranche with the highest rating.

A floating for floating currency swap is equivalent to: A. Two interest rate swaps, one in each currency. B. A fixed-for-fixed currency swap and one interest rate swap. C. A fixed-for-fixed currency swap and two interest rate swaps, one in each currency. D. None of the above.

A fixed-for-fixed currency swap and two interest rate swaps, one in each currency.

Explain why the AAA-rated tranche of an ABS CDO is more risky than the AAA-rated tranche of an ABS.

A moderately high default rate will wipe out the tranches underlying the ABS CDO so that the AAA-rated tranche of the ABS CDO is also wiped out. A moderately high default rate will at worst wipe out only part of the AAA-rated tranche of an ABS.

Which of the following would be described by the term "liar loan"? A. A situation where the lender concealed information from the borrower. B. A situation where the lender lied to the borrower about the interest rate. C. A situation where the borrower lied about his or her income. D. None of the above.

A situation where the borrower lied about his or her income.

What is a subprime mortgage?

A subprime mortgage is a mortgage where the risk of default is higher than normal. This may be because the borrower has a poor credit history or the ratio of the loan to value is high or both.

Which of the following is true of an interest rate swap? A. A swap is usually worth close to zero when it is first negotiated. B. Each forward rate agreement underlying a swap is worth close to zero when the swap is first entered into. C. Comparative advantage is a valid reason for entering into the swap. D. None of the above.

A swap is usually worth close to zero when it is first negotiated.

In 2008 the TED spread reached a high of A. About 150 basis points. B. About 250 basis points. C. About 450 basis points. D. About 550 basis points.

About 450 basis points.

Which of the following describes an interest rate swap? A. The exchange of a fixed rate bond for a floating rate bond. B. A portfolio of forward rate agreements. C. An agreement to exchange interest at a fixed rate for interest at a floating rate. D. All of the above.

All of the above.

Which of the following is a use of a currency swap? A. To exchange an investment in one currency for an investment in another currency. B. To exchange borrowing in one currency for borrowings in another currency. C. To take advantage of situations where the tax rates in two countries are different. D. All of the above.

All of the above.

What is it meant by an ABS CDO?

An ABS CDO is an ABS created from particular tranches (e.g. the BBB tranches) of a number of different ABSs.

What is it meant by an ABS?

An ABS is a set of tranches created to form a portfolio of mortgages or other assets.

Which of the following describes the S&P/Case-Shiller index? A. A stock market index. B. An index of interest rates on mortgages. C. An index of house prices. D. An index showing the dollar amount of mortgages granted each month.

An index of house prices.

Explain the impact of an increase in default correlation on the risks of the senior tranche of an ABS. What is its impact on the risks of the equity tranche?

As default correlation increases, the senior tranche of a CDO becomes more risky because it is more likely to suffer losses. It therefore becomes less valuable. As default correlation increases, the equity tranche becomes more valuable. To understand why this is so, note that in the limit when there is perfect correlation there is a high probability that there will be no defaults and the equity tranche will suffer no losses.

What are the values of interest rate swaps?

At initiation: Designed to have an initial value of zero. After initiation: Valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond. Currency swaps are also valued the same way.

Which of the following tends to lead to an increase in house prices? A. An increase in interest rates. B. Regulators specifying a maximum level for the loan-to-value ratio on mortgages. C. Banks reducing the minimum FICO score that borrowers are required to have. D. An increase in foreclosures.

Banks reducing the minimum FICO score that borrowers are required to have.

Which of the following were introduced before the credit crisis that started in 2007? A. Basel II. B. Dodd-Frank. C. Basel III. D. Requirements for living wills.

Basel II

Why are interest rate swaps so popular?

Because some companies have a comparative advantage when borrowing in fixed-rate markets, and others find comparative advantage when borrowing in floating-rate markets. Swaps allow companies to borrow where they have a comparative advantage, but still pay their debt according to their rate-type preference.

What was the role of GNMA in the mortgage-backed securities market of the 1970's?

GNMA guaranteed qualifying mortgages against default and created securities that were sold to investors.

Which of the following is NOT true: A. The bonus structure at banks can lead to short-term horizons for decision making. B. Securitization involves the transfer of risk. C. The term "agency costs" describes the situation where the incentives of two parties in a business relationship are not perfectly aligned. D. Correlations decrease in stressed market conditions.

Correlations decreased in stressed market conditions.

Which of the following describes regulatory arbitrage? A. Finding a way of reducing capital requirements without changing the risks being taken. B. Buying products that are not subject to regulation. C. Shorting products that are not subject to regulation. D. Trading with the government.

Finding a way of reducing capital requirements without changing the risks being taken.

A bank enters into a 3-year swap with company X where it pays LIBOR and receives 3%. it enters into an offsetting swap with company Y where it receives LIBOR and pays 2.95%. Which of the following is true? A. If company X defaults, the swap with company Y is null and void. B. If company X defaults, the bank will be able to replace company X at no cost. C. If company X defaults, the swap with company Y continues. D. The bank's bid-offer spread is 0.5 basis points.

If company X defaults, the swap with company Y continues.

When was the birth of the swap market?

In 1981, IBM and The World Bank both had debt. IBM's debt was in German and Swiss currency. The World Bank's debt was US dollar denominated. The two companies agreed to "swap" the interest payments on their debt. World Bank payed IBM's German and Swiss interest payments, and IBM would pay World Bank's US interest payments.

The Bubble Bursts

In 2007, many home buyers found they could no longer afford their payments after the "teaser" rate expired. Their inability to pay led to foreclosures, which increased the number of homes on the market (this increase in supple decreased home prices).

Why is the expected loss to a bank from a default on a swap less than the expected loss from the default on a loan to the counterparty with the same principal?

In an interest-rate swap a financial institution's exposure depends on the difference between a fixed-rate of interest and a floating-rate of interest. It has no exposure to the notional principal. In a loan the whole principal can be lost.

Which of the following describes the way a LIBOR-in-arrears swap differs from a plain vanilla interest rate swap? A. Interest is paid at the beginning of the accrual period in a LIBOR-in-arrears swap. B. Interest is paid at the end of the accrual period in a LIBOR-in-arrears swap. C. No floating, interest is paid until the end of the life of the swap in a LIBOR-in-arrears swap, but fixed payments are made throughout the life of the swap. D. Neither floating nor fixed payments are made until the end of the life of the swap.

Interest is paid at the beginning of the accrual period in a LIBOR-in-arrears swap.

What are teaser rates? A. Interest rates that appear lower than they are. B. Interest rates that depend on LIBOR. C. Interest rates on mortgages with a very long amortization period. D. Interest rates that apply only for the first two or three years.

Interest rates that apply only for the first two or three years.

What went wrong?

Investors often assumed that a BBB-rated MBS tranche could be equated with a BBB-rated corporate bond in terms of risk. However, thinly sliced tranches of a MBS (1% or 2% of total principle) have a high probability of experiencing no loss or complete loss. Losses on a BBB-rated bond portfolio are unlikely to exceed 25%, but losses of 100% were very possible for thin BBB-rated MBS tranches.

How were the risks in ABS CDOs misjudged by the market?

Investors underestimated how high the default correlations between mortgages would be in stressed market conditions. Investors also did not always realize that the tranches underlying ABS CDOs were usually quite thin so that they were either totally wiped out or untouched. There was an unfortunate tendency to assume that a tranche with a particular rating could be considered to be the same as a bond with that rating. This assumption is not valid for the reasons just mentioned.

AIG lost money because: A. It bought tranches created from mortgages. B. It invested heavily in real estate. C. It invested heavily in the stock market. D. It insured AAA tranches of ABS CDOs.

It insured AAA tranches of ABS CDOs.

NINJA Loans

Loans that were made to people with no income, no jobs, and no assets.

Which of the following survived the crisis without declaring bankruptcy or being taken over by another financial institution? A. Bear Stearns B. Morgan Stanley C. Lehman Brothers D. Merrill Lynch

Morgan Stanley

100% Mortgages

Mortgages that require no money down.

The mortgage crisis featured a number of instances of potentially worrisome incentive structures:

Originators - Generate "acceptable" mortgages. Appraisers - Overvalue homes. MBS Creators - Game published rating criteria. MBS Raters - Understate riskiness. Traders - Create short-term profits.

Which of the following is true as the correlation between mortgage defaults increases? A. Equity tranches are almost certain to incur losses. B. Senior tranches become more likely to incur losses. C. The expected number of defaults increases. D. Equity tranches are unaffected.

Senior tranches become more likely to incur losses.

Why did mortgage lenders frequently not check on information provided by potential borrowers on mortgage application forms during the 2000 to 2007 period?

Subprime mortgages were frequently securitized. The only information that was retained during the securitization process was the applicant's FICO score and the loan-to-value ratio of the mortgage.

Which of the following describes the five-year swap rate? A. The fixed rate of interest which a swap market maker is prepared to pay in exchange for LIBOR on a 5-year swap. B. The fixed rate of interest which a swap market maker is prepared to receive in exchange for LIBOR on a 5-year swap. C. The average of A and B. D. The higher of A and B.

The average of A and B.

A bank finds that its assets are not matched with its liabilities. It is taking floating-rate deposits and making fixed-rate loans. How can swaps be used to offset the risk?

The bank is paying a floating-rate on the deposits and receiving a fixed-rate on the loans. It can offset its risk by entering into interest rate swaps (with other financial institutions or corporations) in which it contracts to pay fixed and receiving floating.

The reference entity in a credit default swap is: A. The buyer of protection. B. The seller of protection. C. The company or country whose default is being insured against. D. None of the above.

The company or country whose default is being insured against.

Which of the following describes a subprime mortgage? A. The rate of interest is less than the prime rate of interest. B. The loan-to-value ratio is below average. C. The life of the mortgage is less than 25 years. D. The credit risk is high.

The credit risk is high.

Which of the following is true for the party paying fixed in a newly negotiated interest rate swap when the yield curve is upward sloping? A. The early forward contracts underlying the swap have a positive value and the later ones have a negative value. B. The early forward contracts underlying the swap have a negative value and the later ones have a positive value. C. The swap is designed so that all forward rates have zero value. D. Sometimes A is true and sometimes B is true.

The early forward contracts underlying the swap have a negative value and the later ones have a positive value.

Explain why the end-of-year bonus is sometimes referred to as "short-term compensation".

The end-of-year bonus usually reflects performance during the year. This type of compensation tends to lead traders and other employees of banks to focus on their next bonus and therefore have a short-term time horizon for their decision making.

Which of the following is true of a non-recourse mortgage? A. The house buyer, if unable to make payments, can lose all his or her possessions. B. The house buyer has an American-style put option on the house. C. The house buyer has a European-style put option on the house. D. The lender is less likely to lose money on the mortgage.

The house buyer has an American-style put option on the house.

Why do you think the increase in house prices during the 2000 to 2007 period is referred to as a bubble?

The increase in the price of houses was caused by the unsustainable factors.

What is a mezzanine tranche?

The mezzanine tranche of an ABS or ABS CDO is a tranche that is in the middle as far as seniority goes. It is ranked below the senior tranches and therefore absorbs losses before they do. It ranks above the equity tranche (so that the equity tranche absorbs losses before it does).

Which of the following is true? A. Principals are not usually exchanged in a currency swap. B. The principal amounts usually flow in the opposite direction to interest payments at the beginning of a currency swap and in the same direction as interest payments at the end of the swap. C. The principal amounts usually flow in the same direction as interest payments at the beginning of a currency swap and in the opposite direction to interest payments at the end of the swap. D. Principals are not usually specified in a currency swap.

The principal amounts usually flow in the opposite direction to interest payments at the beginning of a currency swap and in the same direction as interest payments at the end of the swap.

Which of the following describes the five-year swap rate? A. The rate on a five-year loan to an AA-rated company. B. The rate on a five-year loan to an A-rated company. C. The rate than can be earned over five years from a series of short-term loans to AA-rated companies. D. The rate that can be earned over five years from a series of short-term loans to A-rated companies.

The rate that can be earned over five years from a series of short-term loans to AA-rated companies.

When LIBOR is used as the discount rate: A. The value of a swap is worth zero immediately after a payment date. B. The value of a swap is worth zero immediately before the payment date. C. The value of the floating rate bond underlying a swap is worth par immediately after a payment date. D. The value of the floating rate bond underlying a swap is worth par immediately before a payment date.

The value of the floating rate bond underlying a swap is worth par immediately after a payment date.

A company enters into an interest rate swap where it is paying fixed and receiving LIBOR. When interest rates increase, which of the following is true? A. The value of the swap to the company increases. B. The value of the swap to the company decreases. C. The value of the swap can either increase or decrease. D. The value of the swap does not change providing the swap rate remains the same.

The value of the swap to the company increases.

What is the waterfall in a securitization?

The waterfall defines how the cash flows from the underlying assets are allocated to the tranches. In a typical arrangement, cash flows are first used to pay the senior tranches their promised return. The cash flows (if any) that are left over are used to provide the mezzanine tranches with their promised returns. The cash flows (if any) that are left over are then used to provide the equity tranches with their promised returns. Any residual cash flows are used to pay down the principal on the senior tranches.

What is an originator?

They are the businesses that made the initial loan.

How was an ABS CDO created? What was the motivation to create ABS CDOs?

Typically an ABS CDO is created from the BBB-rated tranches of an ABS. This is because it is difficult to find investors in a direct way for the BBB-rated tranches of an ABS.