5360- Money and Capital Markets Chapter 9

Compare the secondary market activity for mortgages to the activity for other capital market instruments (such as stocks and bonds). Provide a general explanation for the difference in the activity level. The prices of 1. (stocks and bonds/mortgages) sold on the secondary market are more transparent, while the prices of 2. (stocks and bonds/mortgages) aren't. However, the secondary market for 3.(stocks and bonds/mortgages) has been enhanced because of securitization.

1. Stocks and bonds 2. Mortgages 3. Mortgages

Explain how a mortgage company's degree of exposure to interest rate risk differs from other financial institutions. Mortgage companies concentrate on 1. (servicing/investing in) mortgages, thus, they 2. (are/are not) as concerned about hedging mortgages over the long run. Mortgage companies' exposure to interest rate risk exists 1. (during the whole lifecycle of the mortgage/before the mortgage is sold/before the mortgage is originated) .

1. Servicing 2. Are not 3. Before the mortgage is sold

Which of the following contributed to the rapid increase in home prices beginning in 2003? Check all that apply. A. Interest rates were high. B. Economic conditions were favorable. C. Economic conditions were unfavorable. D. Interest rates were low.

B. Economic conditions were favorable. D. Interest rates were low.

The type of mortgage that modifies the borrower's interest rate over the life of the mortgage. Determine which type of mortgage loan represents this example/definition. A. Shared-Appreciation B. Growing- Equity C. Adjustable-Rate D. Balloon-Payment E. Fixed-Rate F. Graduated-Payment G. Second

C. Adjustable-Rate

Which of the following contributed to the increase in mortgage defaults in 2006? Check all that apply. A. A decrease in interest rates made mortgage payments significantly lower for home owners with fixed-rate mortgages. B. A decrease in interest rates made mortgage payments significantly lower for home owners with adjustable-rate mortgages. C. An increase in interest rates made mortgage payments significantly higher for home owners with adjustable-rate mortgages. D. Mortgage companies offered extremely low interest rates for the first few years of the mortgage to incentivize people to purchase homes; however, the significant increase in interest rates made homeowners' mortgage payments increase significantly just a few years into the mortgage.

C. An increase in interest rates made mortgage payments significantly higher for home owners with adjustable-rate mortgages. D. Mortgage companies offered extremely low interest rates for the first few years of the mortgage to incentivize people to purchase homes; however, the significant increase in interest rates made homeowners' mortgage payments increase significantly just a few years into the mortgage.

At a given point in time, the price of a credit default swap contract should be ________ related to the default risk of the securities covered by the contract. For a given set of securities that are covered by a credit default swap, the price of the contract should be _______ related to the default risk as it changes over time. a. positively; positively b. positively; inversely c. inversely; positively d. inversely; inversely

a. positively; positively

The ____ market for mortgages is where mortgages are originated. a. primary b. secondary c. money d. none of the above

a. primary

The type of mortgage a company might want if they need financing to build a manufacturing facility, want a low interest rate, and plan to use the profits from manufacturing at the new facility to pay the loan off with one large payment in just a few years. Determine which type of mortgage loan represents this example/definition. A. Shared-Appreciation B. Growing- Equity C. Adjustable-Rate D. Balloon-Payment E. Fixed-Rate F. Graduated-Payment G. Second

D. Balloon-Payment

Sell shares and use the proceeds to create portfolios consisting of mortgage-backed securities. What type of financial institution engages in this mortgage market activity? A. Commercial Savings banks and savings institutions B. Credit Unions and Finance companies C. Mortgage companies D. Mutual Funds E. Securities Firms F. Insurance Companies

D. Mutual Funds

Midway through 2008, approximately what percentage of prime and subprime mortgages in the United States had late payments of at least 30 days? A. Prime mortgages - 20 percent; subprime mortgages - 20 percent B.. Prime mortgages - 30 percent; subprime mortgages - 20 percent C. Prime mortgages - 30 percent; subprime mortgages - 5 percent D. Prime mortgages - 5 percent; subprime mortgages - 30 percent

D. Prime mortgages - 5 percent; subprime mortgages - 30 percent

Offer instruments to help institutions that invest in mortgages hedge (protect themselves) against large fluctuations in interest rates. What type of financial institution engages in this mortgage market activity? A. Commercial Savings banks and savings institutions B. Credit Unions and Finance companies C. Mortgage companies D. Mutual Funds E. Securities Firms F. Insurance Companies

E. Securities Firms

The type of mortgage that is given out when there is already a mortgage on a home and that typically has a higher interest rate than the initial mortgage. Determine which type of mortgage loan represents this example/definition. A. Shared-Appreciation B. Growing- Equity C. Adjustable-Rate D. Balloon-Payment E. Fixed-Rate F. Graduated-Payment G. Second

G. Second

Is the interest rate risk to the financial institution higher for a 15-year or a 30-year mortgage? Why? The interest rate risk is lower for a 1. (15-year/30-year) mortgage because it has 2. (shorter/longer) mortgage period.

1. 15-year 2. shorter

Explain collateralized debt obligations (CDOs). 1. A CDO represents a package of debt securities backed by collateral that is sold to investors. 2. A CDO is a package of debt securities that are usually separated into tranches based on their initial price. 3. CDOs are packages that contain only mortgage types of debt securities.

1. A CDO represents a package of debt securities backed by collateral that is sold to investors

Explain the use of a balloon-payment mortgage. 1. A balloon mortgage payment requires interest payments for a three- to five-year period and full payment at the end of the period. 2. A balloon mortgage payment allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years and then they level off after this period. 3. A balloon mortgage payment requires continual increasing mortgage payments throughout the life of the mortgage. 4. A balloon mortgage payment allows a home purchaser to obtain a mortgage at an interest rate below market rates, while in return the lender will share in the price appreciation of the home.

1. A balloon mortgage payment requires interest payments for a three- to five-year period and full payment at the end of the period.

Explain how caps on ARMs can affect a financial institution's exposure to interest rate risk. If interest rates move 1. (beyond/outside) the boundaries implied by the caps, the exposure to interest rate risk will be adversely affected as the mortgage rates may not fully offset the increased cost of funds.

1. Beyond

What type of financial institution finances the majority of commercial mortgages? 1. Commercial banks 2. Credit unions 3. Securities firms

1. Commercial banks

Explain how the maturity on mortgage-backed securities can be affected by interest rate movements. When interest rates rise, prepayments on mortgages 1. (occur/don't occur) because 2. (some none of) homeowners refinance with a new mortgage with a 3. (lower/higher) interest rate.

1. Don't Occur 2. None of 3. Higher

Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate against interest rate movements. Lenders of 1. (adjustable-rate/fixed-rate) mortgages can be adversely affected by rising interest rates, because their cost of financing the mortgages would 2. (increase/decrease/remain unchanged) while the interest revenues received on mortgages would 3. (increase/decrease/unchanged) . They could reduce their exposure to interest rate risk by offering 4.(adjustable-rate/fixed-rate) mortgages.

1. Fixed-rate 2. Increase 3. Unchanged 4. Adjustable-Rate

How did the repayment of subprime mortgages compare to that of prime mortgages during the credit crisis? In 2008, the number of all outstanding subprime mortgages with late payments of at least 30 days was 1. (higher/lower) than the number of prime mortgages with the same characteristics. The number of prime mortgages that were subject to foreclosure was 2. (higher/lower) than the number of such subprime mortgages.

1. Higher 2. Lower

Explain short sales in the mortgage markets. 1. In a short sale transaction, the lender allows homeowners to sell the home for less than what is owed on the existing mortgage. 2. A short sale transaction is the permission given to some homeowners close to the default to keep their existing homes. This allows to reduce the excess supply of homes for sale in the market and stabilize home prices. 3. In a short sale transaction, the lender forgives a portion of the previous mortgage loan (in average about 25-50%) and at the same time creates a new mortgage with a lower interest rate.

1. In a short sale transaction, the lender allows homeowners to sell the home for less than what is owed on the existing mortgage.

Why might a financial institution prefer to offer this type of mortgage? Financial institutions may desire balloon mortgages because the interest rate risk is lower than for 1. (longer/shorter) term, fixed-rate mortgages.

1. Longer

Distinguish between FHA and conventional mortgages. 1. The Federal Housing Administration protects FHA mortgages against the possibility of default by the borrower, while conventional mortgages doesn't. 2. To qualify for conventional mortgages borrowers must meet various specified requirements, while for FHA mortgages mustn't. 3. The maximum FHA mortgage amount isn't limited, while conventional mortgage amount is federally regulated.

1. The Federal Housing Administration protects FHA mortgages against the possibility of default by the borrower, while conventional mortgages doesn't.

Describe the graduated-payment mortgage. 1. The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years and then they level off after this period. 2. The graduated payment mortgage requires interest payments for a three- to five-year period and full payment at the end of the period. 3. The graduated payment mortgage requires continual increasing mortgage payments throughout the life of the mortgage. 4. The graduated payment mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates, while in return the lender will share in the price appreciation of the home.

1. The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years and then they level off after this period.

Why is the 15-year mortgage attractive to homeowners? The 15-year mortgage is popular because of the potential reduction in 1. (monthly payments/total interest expenses paid) on a mortgage with a shorter lifetime.

1. Total interest expenses paid

How does the growing-equity mortgage differ from a graduated-payment mortgage? The growing-equity mortgage lifetime 1. (is/isn't) reduced, whereas a GPM's life 2. (is/isn't) reduced.

1. is 2. isn't

What type of homeowners would prefer this type of mortgage? Homeowners whose incomes will 1. (rise/fall/remain stable) over time may desire this type of a mortgage.

1. rise

Why are second mortgages offered by some home sellers? 1. A second mortgage is often used when the borrower can not repay the first mortgage on time and use the second mortgage to refinance the first one. 2. A second mortgage is often used when a first mortgage does not fully cover the amount of funds the borrower needs and complements the first mortgage. 3. A second mortgage is often used when financial institutions need liquidity and sell their mortgages on a secondary market with a lower interest rate.

2. A second mortgage is often used when a first mortgage does not fully cover the amount of funds the borrower needs and complements the first mortgage.

Describe the shared-appreciation mortgage. 1. A shared-appreciation mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years and then they level off after this period. 2. A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates, while in return the lender will share in the price appreciation of the home. 3. A shared-appreciation mortgage requires interest payments for a three- to five-year period and full payment at the end of the period. 4. A shared-appreciation mortgage requires continual increasing mortgage payments throughout the life of the mortgage.

2. A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates, while in return the lender will share in the price appreciation of the home.

How does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why? 1. An adjustable rate mortgage typically offers a higher initial rate than a fixed-rate mortgage to compensate lower interest rate in the future. 2. An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk. 3. Both an adjustable rate mortgage and a fixed-rate mortgage offer similar initial rate to attract borrowers.

2. An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk.

Describe how collateralized mortgage obligations (CMOs) are used and why they have been popular. 1. Collateralized mortgage obligations are mortgage-backed securities that guarantee timely payment of principal and interest to investors who purchase these securities. The institutional investors do not have to worry about credit risk. 2. Collateralized mortgage obligations are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors can choose a class that fits their maturity preferences. 3. Collateralized mortgage obligations are long-term mortgage-backed securities that are issued to institutional investors. These mortgage obligations are highly rated securities.

2. Collateralized mortgage obligations are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors can choose a class that fits their maturity preferences.

Explain the role of credit rating agencies in facilitating the flow of funds from investors into the mortgage market (through mortgage-backed securities). 1. Credit rating agencies make the flow of funds slower as investors should wait before the mortgage-backed securities are rated and only then purchase or sell them. 2. Credit rating agencies rate the tranches of mortgage-backed securities based on the mortgages they represent. 3. Credit rating agencies and their activity play little practical role in the market as the risk of mortgage-backed securities cannot be evaluated correctly and investors usually pay very little attention to these ratings.

2. Credit rating agencies rate the tranches of mortgage-backed securities based on the mortgages they represent.

The government intervened in order to resolve problems in the mortgage markets during the credit crisis. Summarize the advantages and disadvantages of the government intervention during the credit crisis. 1. The government intervention helped to stabilize the market for mortgage-backed securities. But in order to prevent the market from the future credit crises U.S. government took control of all financial institutions with annual earnings greater than $1 billion. 2. The government intervention stabilized the market for mortgage-backed securities, and therefore helped the financial institutions and homeowners. However, the government budget deficit increased due to the intervention. 3. The government intervention only resulted in the increase of the government budget deficit and taking over the management of the financial institutions that were on the verge of bankruptcy.

2. The government intervention stabilized the market for mortgage-backed securities, and therefore helped the financial institutions and homeowners. However, the government budget deficit increased due to the intervention.

Describe the growing-equity mortgage. 1. A growing-equity mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years and then they level off after this period. 2. A growing-equity mortgage requires interest payments for a three- to five-year period and full payment at the end of the period. 3. A growing-equity mortgage requires continual increasing mortgage payments throughout the life of the mortgage. 4. A growing-equity mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates, while in return the lender will share in the price appreciation of the home.

3. A growing-equity mortgage requires continual increasing mortgage payments throughout the life of the mortgage.

What types of financial institutions finance residential mortgages? 1. Credit unions and brokerage firms 2. U.S. Treasury and securities firms 3. Commercial banks and savings and loan associations

3. Commercial banks and savings and loan associations

Why some financial institutions prefer to sell the mortgages they originate? 1. Financial institutions may sell their mortgages if they expect interest rate to decrease. 2. Financial institutions may sell their mortgages if the borrower's creditworthiness improves. 3. Financial institutions may sell their mortgages if they do not have sufficient funds to maintain all the mortgages they originate.

3. Financial institutions may sell their mortgages if they do not have sufficient funds to maintain all the mortgages they originate.

Explain subprime mortgages. Why were mortgage companies aggressively offering subprime mortgages? 1. Subprime mortgages are mortgages that are offered to borrowers that have strong creditworthiness. Many financial institutions were aggressively offering subprime mortgages because it gave them tax discounts on interests received. 2. Subprime mortgages are mortgages issued by companies with a low credit rating. Many financial institutions were aggressively offering subprime mortgages because these mortgages were the only kind of mortgages allowed to be issued by such financial institutions. 3. Subprime mortgages are a type of mortgage that are offered to borrowers who do not qualify for prime loans. Many financial institutions were aggressively offering subprime mortgages to expand their business.

3. Subprime mortgages are a type of mortgage that are offered to borrowers who do not qualify for prime loans. Many financial institutions were aggressively offering subprime mortgages to expand their business.

Explain the problems in valuing MBS. 1. Centralized reporting system that reports the trading of MBS in the secondary market has a time lag, because of which prices in the market of MBS do not reflect the real situation. 2. Rating agencies do not assign ratings to the MBS, therefore, it's difficult to evaluate the risk of investing in MBS. 3. The only participants who know the price of MBS that was traded is the buyer and the seller.

3. The only participants who know the price of MBS that was traded is the buyer and the seller.

Why do you think it is difficult for investors to assess the financial condition of a financial institution that has purchased a large amount of mortgage-backed securities? 1. The price of mortgage-backed securities is highly dependent on interest rates and demand for houses that cannot be assessed accurately. 2. Mortgage-backed securities are rated based on an assessment of the most risky underlying mortgage. Therefore, all mortgage-backed securities are undergraded by credit rating agencies. 3. The risk of mortgage-backed securities is dependent on the underlying mortgages and the details of the mortgages are not disclosed in financial statements.

3. The risk of mortgage-backed securities is dependent on the underlying mortgages and the details of the mortgages are not disclosed in financial statements.

What is the general relationship between mortgage rates and long-term government security rates? 1. There is no correlation between mortgage rates and long-term government security rates. 2. There is a high negative correlation between mortgage rates and long-term government security rates. 3. There is a high positive correlation between mortgage rates and long-term government security rates.

3. There is a high positive correlation between mortgage rates and long-term government security rates.

Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what? 1. When interest rates decline, a large proportion of mortgages are paid out, as profits on deposits decrease. 2. When interest rates decline, the cost of obtaining funds for lenders increases, so the benefits from lower interest rate are off-set by higher cost of funds. 3. When interest rates decline, a large proportion of mortgages are refinanced and the benefits are limited.

3. When interest rates decline, a large proportion of mortgages are refinanced and the benefits are limited.

Originate mortgages by working with borrowers to create loans where the real estate or property is used as collateral for the loan. What type of financial institution engages in this mortgage market activity? A. Commercial Savings banks and savings institutions B. Credit Unions and Finance companies C. Mortgage companies D. Mutual Funds E. Securities Firms F. Insurance Companies

A. Commercial Savings banks and savings institutions B. Credit Unions and Finance companies C. Mortgage companies

Purchase mortgages and mortgage-backed securities in the secondary market. What type of financial institution engages in this mortgage market activity? A. Commercial Savings banks and savings institutions B. Credit Unions and Finance companies C. Mortgage companies D. Mutual Funds E. Securities Firms F. Insurance Companies

A. Commercial Savings banks and savings institutions F. Insurance Companies

Which of the following was a result of the rapid increase in home prices beginning in 2003? Check all that apply. A. Investors began to invest more in mortgages. B. Investors began requiring more equity investment than was typically required for an individual to purchase a home. C. Home builders began constructing fewer new homes. D. Investors began requiring less equity investment than was typically required for an individual to purchase a home.

A. Investors began to invest more in mortgages. D. Investors began requiring less equity investment than was typically required for an individual to purchase a home

Suppose an investment bank is trying to sell BBB rated mortgage-backed securities, with a 10% yield, to two classes of investors: (1) pension fund managers and (2) hedge fund managers. However, neither class of investors wants to purchase the securities. Pension fund managers think the securities are too risky for their low-risk portfolios, and hedge fund managers are willing to take the risk on the securities, but they feel that the yield is too low for their portfolios. What is one way that the investment bank could sell the securities to both classes of investors? A. Sell the securities as collateralized debt obligations B. Sell the securities as participation certificates C. Decrease the yield on the securities to 6% D. Increase the yield on the securities to 13%

A. Sell the securities as collateralized debt obligations

Suppose Caroline is planning to purchase a home and in her mortgage application, she declares that she plans to put a 4.5 percent down payment on the home. Additionally, Caroline's debt-to-income ratio and credit score are 40 percent and 590, respectively. The lender Caroline is using is FHA approved, and if the loan is approved, it will be backed by the FHA. Assuming that Caroline's mortgage application is accepted by the lender, how would her mortgage likely be classified? A. Conventional mortgage B. Federally insured mortgage C. Fixed-rate mortgage D. Prime mortgage

B. Federally insured mortgage

The type of mortgage that allows borrowers to make small payments at the beginning of the mortgage's life and larger payments that continue to grow over the life of the loan. Determine which type of mortgage loan represents this example/definition. A. Shared-Appreciation B. Growing- Equity C. Adjustable-Rate D. Balloon-Payment E. Fixed-Rate F. Graduated-Payment G. Second

B. Growing- Equity

Which of the following types of securities are backed by conventional mortgages that are insured through private insurance companies? A. Government National Mortgage Association (Ginnie Mae) mortgage-backed securities B. Private-label pass-through securities C. Federal National Mortgage Association (Fannie Mae) mortgage-backed securities D. Federal Home Loan Mortgage Association (Freddie Mac) participation certificates

B. Private-label pass-through securities

Explain how the credit crisis adversely affected many other people beyond homeowners and mortgage companies. 1. Several financial institutions went bankrupt, and many employees of financial institutions lost their jobs. 2. Credit rating agencies were unable to effectively rate securities, therefore, many companies abandoned to hire credit rating agencies to assign ratings. As a result, credit rating agencies went bankrupt. 3. Mortgage insurers incurred expenses from foreclosures of the property they insured.

Both 1 and 3 1. Several financial institutions went bankrupt, and many employees of financial institutions lost their jobs. 3. Mortgage insurers incurred expenses from foreclosures of the property they insured.

Explain how the Dodd-Frank Act of 2010 attempted to prevent biased ratings of mortgage-backed securities by credit rating agencies. 1. One of the main goals of the Dodd-Frank Act is to ensure stability in the financial system by issuing mortgages only less than $300,000. 2. The Dodd-Frank Act requires that credit rating agencies publicly disclose data on assumptions used to derive each credit rating. 3. The Dodd-Frank Act requires the credit rating agencies to provide an annual report about their internal controls used to ensure an unbiased process of rating securities.

Both 2 and 3 2. The Dodd-Frank Act requires that credit rating agencies publicly disclose data on assumptions used to derive each credit rating. 3. The Dodd-Frank Act requires the credit rating agencies to provide an annual report about their internal controls used to ensure an unbiased process of rating securities.

Which of the following contributed to the decrease in home prices in 2006? Check all that apply. A. The drastic increase in home prices from 2003 to 2006 caused a shortage of housing inventory in the market. B. The drastic increase in home prices from 2003 to 2006 did not affect the level of housing inventory in the market. C. The drastic increase in home prices from 2003 to 2006 caused buyers to be less willing to purchase homes. D. The drastic increase in home prices from 2003 to 2006 caused a surplus of housing inventory in the market.

C. The drastic increase in home prices from 2003 to 2006 caused buyers to be less willing to purchase homes. D. The drastic increase in home prices from 2003 to 2006 caused a surplus of housing inventory in the market.

____ are backed by conventional mortgages. a. Ginnie Mae mortgage-backed securities b. Federal Reserve mortgage-backed securities c. Private-label pass-through securities d. Shared-appreciation pass-through securities

c. Private-label pass-through securities

A __________ allows the borrower to initially make small payments on the mortgage. The payments then increase over the first 5 to 10 years and then level off. a. second mortgage b. growing-equity mortgage c. graduated-payment mortgage d. shared-appreciation mortgage

c. graduated-payment mortgage

The credit risk to a financial institution from investing in mortgage-backed securities representing subprime mortgages is ____ that of mortgage-backed securities representing prime mortgages. a. equal to b. slightly less than c. more than d. substantially less than

c. more than

Collateralized mortgage obligations (CMOs) are generally perceived to have a. no prepayment risk but some default risk. b. no prepayment risk and no default risk. c. the same interest rate risk as money market securities. d. a high degree of prepayment risk.

d. a high degree of prepayment risk.

An institution that originates and holds a fixed-rate mortgage is adversely affected by ____ interest rates; the borrower who was provided the mortgage is adversely affected by ____ interest rates. a. stable; decreasing b. increasing; stable c. decreasing; increasing d. increasing; decreasing

d. increasing; decreasing

Bear Stearns commonly used __________ as collateral when borrowing short-term funds, but its funding was cut off because prospective creditors questioned the quality of the collateral. a. commercial paper b. corporate bonds c. its stock d. mortgages

d. mortgages

American International Group (AIG) experienced financial problems during the credit crisis because it focused heavily on a. purchasing mortgage-backed securities. b. selling mortgage-backed securities. c. purchasing credit default swaps. d. selling credit default swaps.

d. selling credit default swaps.

Federally insured mortgages are intended to protect a. the borrower by providing a backup fund that can be accessed by the borrower. b. against interest rate risk by providing a backup fund to cover any increase in interest rates. c. the federal government in case the home owner does not pay real estate taxes owed on the property. d. the loan repayment to lending institution.

d. the loan repayment to lending institution.