Reading 45. Intro to ABS

When the collateral manager fails pre- specified risk tests, a CDO is: A deleveraged by reducing the senior bond class. B restructured to reduce its most expensive funding source. C liquidated by paying off the bond classes in order of seniority

A is correct. When the collateral manager fails pre- specified tests, a provision is triggered that requires the payoff of the principal to the senior class until the tests are satisfied. This reduction of the senior class effectively deleverages the CDO because the CDO's cheapest funding source is reduced

A commercial mortgage- backed security (CMBS) does not meet the debt- toservice coverage at the loan level necessary to achieve a desired credit rating. Which of the following features would most likely improve the credit rating of the CMBS? A Subordination B Call protection C Balloon payments

A commercial mortgage- backed security (CMBS) does not meet the debt- toservice coverage at the loan level necessary to achieve a desired credit rating. Which of the following features would most likely improve the credit rating of the CMBS? A Subordination B Call protection C Balloon payments

A ba1lloon payment equal to a mortgage's original loan amount is a characteristic of a: A bullet mortgage. B fully amortizing mortgage. C partially amortizing mortgage

A is correct. A bullet mortgage is a special type of interest- only mortgage in which there are no scheduled principal repayments over the entire life of the loan. At maturity, a balloon payment is required equal to the original loan amount. B is incorrect because with a fully amortizing mortgage, the sum of all the scheduled principal repayments during the mortgage's life is such that when the last mortgage payment is made, the loan is fully repaid, with no balloon payment required. C is incorrect because with a partially amortizing mortgage, the sum of all the scheduled principal repayments is less than the amount borrowed, resulting in a balloon payment equal to the unpaid mortgage balance (rather than the original loan amount).

An excess spread account incorporated into a securitization is designed to limit: A credit risk. B extension risk. C contraction risk

A is correct. An excess spread account, sometimes called excess interest cash flow, is a form of internal credit enhancement that limits credit risk. It is an amount that can be retained and deposited into a reserve account and that can serve as a first line of protection against losses. An excess spread account does not limit prepayment risk, extension, or contraction.

Fran Martin obtains a non- recourse mortgage loan for $500,000. One year later, when the outstanding balance of the mortgage is $490,000, Martin cannot make his mortgage payments and defaults on the loan. The lender forecloses on the loan and sells the house for $315,000. What amount is the lender entitled to claim from Martin? A $0. B $175,000. ] C $185,000.

A is correct. Because the loan has a non- recourse feature, the lender can only look to the underlying property to recover the outstanding mortgage balance and has no further claim against the borrower. The lender is simply entitled to foreclose on the home and sell it.

Credit risk is an important consideration for commercial mortgage- backed securities (CMBS) if the CMBS are backed by mortgage loans that: A are non- recourse. B have call protection. C haveprepayment penalty points

A is correct. If commercial mortgage loans are non- recourse loans, the lender can only look to the income- producing property backing the loan for interest and principal repayment. If there is a default, the lender looks to the proceeds from the sale of the property for repayment and has no recourse against the borrower for any unpaid mortgage loan balance. Call protection and prepayment penalty points protect against prepayment risk.

Which of the following characteristics of a residential mortgage loan would best protect the lender from a strategic default by the borrower? A Recourse B A prepayment option C Interest- only payments

A is correct. In a recourse loan, the lender has a claim against the borrower for the shortfall between the amount of the mortgage balance outstanding and the proceeds received from the sale of the property. A prepayment option is a benefit to the borrower and would thus not offer protection to the lender. An interest- only mortgage requires no principal repayment for a number of years and will not protect the lender from strategic default by the borrower.

In a securitization, the special purpose entity (SPE) is responsible for the: A issuance of the asset- backed securities. B collection of payments from the borrowers. C recovery of underlying assets from delinquent borrowers.

A is correct. In a securitization, the special purpose entity (SPE) is the special legal entity responsible for the issuance of the asset- backed securities. The servicer, not the SPE, is responsible for both the collection of payments from the borrowers and the recovery of underlying assets if the borrowers default on their loans

In auto loan ABSs, the form of credit enhancement that most likely serves as the first line of loss protection is the: A excess spread account. B sequential pay structure. C proceeds from repossession sales

A is correct. In addition to a senior/subordinated (sequential pay) structure, many auto loan ABSs are structured with additional credit enhancement in the form of overcollateralization and a reserve account, often an excess spread account. The excess spread is an amount that can be retained and deposited into a reserve account that can serve as a first line of protection against losses. B is incorrect because in an auto loan ABS, losses are typically applied against the excess spread account and the amount of overcollateralization before the waterfall loss absorption of the sequential pay structure. C is incorrect because in auto loan ABSs, proceeds from the repossession and resale of autos are prepayment cash flows rather than a form of credit enhancement for loss protection.

In a securitization, time tranching provides investors with the ability to choose between: A extension and contraction risks. B senior and subordinated bond classes. C fully amortizing and partially amortizing loans

A is correct. Time tranching is the process in which a set of bond classes or tranches is created that allow investors a choice in the type of prepayment risk, extension or contraction, that they prefer to bear. Senior and subordinated bond classes are used in credit tranching. Credit tranching structures allow investors to choose the amount of credit risk that they prefer to bear. Fully and partially amortizing loans are two types of amortizing loans.

Which of the following statements is correct concerning mortgage loan defaults? A A non- recourse jurisdiction poses higher default risks for lenders. B In a non- recourse jurisdiction, strategic default will not affect the defaulting borrower's future access to credit. C When a recourse loan defaults, the mortgaged property is the lender's sole source for recovery of the outstanding mortgage balance.

A is correct. In non- recourse loan jurisdictions, the borrower may have an incentive to default on an underwater mortgage and allow the lender to foreclose on the property because the lender has no claim against the borrower for the shortfall. For this reason, such defaults, known as strategic defaults, are more likely in non- recourse jurisdictions and less likely in recourse jurisdictions, where the lender does have a claim against the borrower for the shortfall. B is incorrect because strategic defaults in non- recourse jurisdictions do have negative consequences for the defaulting borrowers in the form of a lower credit score and a reduced ability to borrow in the future. These negative consequences can be a deterrent in the incidence of underwater mortgage defaults. C is incorrect because when a recourse loan defaults, the lender can look to both the property and the borrower to recover the outstanding mortgage balance. In a recourse loan, the lender has a claim against the borrower for the shortfall between the amount of the outstanding mortgage balance and the proceeds received from the sale of the property.

Which of the following describes a typical feature of a non- agency residential mortgage- backed security (RMBS)? A Senior/subordinated structure B A pool of conforming mortgages as collateral C A guarantee by a government- sponsored enterprise

A is correct. Non- agency RMBS are credit enhanced, either internally or externally, to make the securities more attractive to investors. The most common forms of internal credit enhancements are senior/subordinated structures, reserve accounts, and overcollateralization. Conforming mortgages are used as collateral for agency (not non- agency) mortgage pass- through securities. An agency RMBS, rather than a non- agency RMBS, issued by a GSE (government sponsored enterprise), is guaranteed by the respective GSE.

The tranches in a collateralized mortgage obligation (CMO) that are most likely to provide protection for investors against both extension and contraction risk are: A planned amortization class (PAC) tranches. B support tranches. C sequential- pay tranches

A is correct. PAC tranches have limited (but not complete) protection against both extension risk and contraction risk. This protection is provided by the support tranches. A sequential- pay tranche can protect against either extension risk or contraction risk but not both of these risks. The CMO structure with sequential- pay tranches allows investors concerned about extension risk to invest in shorter- term tranches and those concerned about contraction risk to invest in the longer- term tranches.

Securitization benefits investors by: A providing more direct access to a wider range of assets. B reducing the inherent credit risk of pools of loans and receivables. C eliminating cash flow timing risks of an ABS, such as contraction and extension risks.

A is correct. Securitization allows investors to achieve more direct legal claims on loans and portfolios of receivables. As a result, investors can add to their portfolios exposure to the risk-return characteristics provided by a wider range of assets. B is incorrect because securitization does not reduce credit risk but, rather, provides a structure to mitigate and redistribute the inherent credit risks of pools of loans and receivables. C is incorrect because securitization does not eliminate the timing risks associated with ABS cash flows but, rather, provides a structure to mitigate and redistribute those risks, such as contraction risk and extension risk.

Compared with the weighted average coupon rate of its underlying pool of mortgages, the pass- through rate on a mortgage pass- through security is: A lower. B the same. C higher.

A is correct. The coupon rate of a mortgage pass- through security is called the pass- through rate, whereas the mortgage rate on the underlying pool of mortgages is calculated as a weighted average coupon rate (WAC). The pass- through rate is lower than the WAC by an amount equal to the servicing fee and other administrative fees.

A goal of securitization is to: A separate the seller's collateral from its credit ratings. B uphold the absolute priority rule in bankruptcy reorganizations. C account for collateral's primary influence on corporate bond credit spreads.

A is correct. The legal implication of a special purpose entity (SPE), a prerequisite for securitization, is that investors contemplating the purchase of bond classes backed by the assets of the SPE will evaluate the credit risk of those assets independently from the credit rating of the entity that sold the assets to the SPE. This separation of the seller's collateral from its credit rating provides the opportunity for the SPE to access a lower aggregate funding cost than what the seller might otherwise obtain. B is incorrect because the absolute priority rule, under which senior creditors are paid in full before subordinated creditors, has not always been upheld in bankruptcy reorganizations. There is no assurance that if a corporate bond has collateral, the rights of the bondholders will be respected. It is this uncertainty that creates the dominant influence of credit ratings over collateral in credit spreads. C is incorrect because corporate bond credit spreads will reflect the seller's credit rating primarily and the collateral slightly. Securitization separates the seller's collateral from its credit rating, effectively altering the influence of collateral on the credit spread.

Which of the following statements related to securitization is correct? A Time tranching addresses the uncertainty of a decline in interest rates. B Securitizations are rarely structured to include both credit tranching and time tranching. C Junior and senior bond classes differ in that junior classes can only be paid off at the bond's set maturity

A is correct. Time tranching is the creation of bond classes that possess different expected maturities so that prepayment risk can be redistributed among bond classes. When loan agreements provide borrowers the ability to alter payments, in the case of declining interest rates, this prepayment risk increases because borrowers tend to pay off part or all of their loans and refinance at lower interest rates. B is incorrect because it is possible, and quite common, for a securitization to have structures with both credit tranching and time tranching. C is incorrect because the subordinated structures of junior and senior bond classes differ as to how they will share any losses relative to defaults of the borrowers whose loans are in the collateral pool. Junior classes offer protection for senior classes, with losses first realized by the former. The classes are not distinguished by scheduled repayment terms but, rather, by a loss sharing hierarchy in the event of borrower default.

Which commercial mortgage- backed security (CMBS) characteristic causes a CMBS to trade more like a corporate bond than a residential mortgage- backed security (RMBS)? A Call protection B Internal credit enhancement C Debt- service coverage ratio level

A is correct. With CMBS, investors have considerable call protection. An investor in a RMBS is exposed to considerable prepayment risk, but with CMBS, call protection is available to the investor at the structure and loan level. The call protection results in CMBS trading in the market more like a corporate bond than a RMBS. Both internal credit enhancement and the debt- service- coverage (DSC) ratio address credit risk, not prepayment risk.

Which of the following investments is least subject to prepayment risk? A Auto loan receivable-backed securities B Commercial mortgage- backed securities (CMBSs) C Non- agency residential mortgage- backed securities (RMBSs)

B is correct. A critical feature that differentiates CMBSs from RMBSs is the call protection provided to investors. An investor in a RMBS is exposed to considerable prepayment risk because the borrower has the right to prepay the loan before maturity. CMBSs provide investors with considerable call protection that comes either at the structure level or at the loan level.

William Marolf obtains a 5 million EUR mortgage loan from Bank Nederlandse. A year later the principal on the loan is 4 million EUR and Marolf defaults on the loan. Bank Nederlandse forecloses, sells the property for 2.5 million EUR, and is entitled to collect the 1.5 million EUR shortfall, from Marolf. Marolf most likely had a: A bullet loan. B recourse loan. C non- recourse loan

B is correct. Bank Nederlandse has a claim against Marolf for 1.5 million EUR, the shortfall between the amount of the mortgage balance outstanding and the proceeds received from the sale of the property. This indicates that the mortgage loan is a recourse loan. The recourse/non- recourse feature indicates the rights of a lender in foreclosure. If Marolf had a non- recourse loan, the bank would have only been entitled to the proceeds from the sale of the underlying property, or 2.5 million EUR. A bullet loan is a special type of interest- only mortgage for which there are no scheduled principal payments over the entire term of the loan. Since the unpaid balance is less than the original mortgage loan, it is unlikely that Marolf has an interest only mortgage.

Collateralized mortgage obligations (CMOs) are designed to: A eliminate contraction risk in support tranches. B distribute prepayment risk to various tranches. C eliminate extension risk in planned amortization tranches.

B is correct. CMOs are designed to redistribute cash flows of mortgage- related products to different bond classes or tranches through securitization. Although CMOs do not eliminate prepayment risk, they distribute prepayment risk among various classes of bondholders.

In the context of mortgage- backed securities, a conditional prepayment rate (CPR) of 8% means that approximately 8% of the outstanding mortgage pool balance at the beginning of the year is expected to be prepaid: A in the current month. B by the end of the year. C over the life of the mortgages.

B is correct. CPR is an annualized rate, which indicates the percentage of the outstanding mortgage pool balance at the beginning of the year that is expected to be prepaid by the end of the year

If a mortgage borrower makes prepayments without penalty to take advantage of falling interest rates, the lender will most likely experience: A extension risk. B contraction risk. C yield maintenance.

B is correct. Contraction risk is the risk that when interest rates decline, actual prepayments will be higher than forecasted. Extension risk is the risk that when interest rates rise, prepayments will be lower than forecasted. Yield maintenance results from prepayment penalties; the lender is protected from loss in yield by the imposition of prepayment penalties.

The creation of bond classes with a waterfall structure for sharing losses is referred to as: A time tranching. B credit tranching. C overcollateralization

B is correct. Credit tranching is a form of credit enhancement called subordination in which bond classes or tranches differ as to how they will share losses resulting from defaults of the borrowers whose loans are part of the collateral. This type of protection is commonly referred to as a waterfall structure because of the cascading flow of payments between bond classes in the event of default. A is incorrect because time tranching involves the creation of bond classes that possess different expected maturities rather than bond classes that differ as to how credit losses will be shared. Time tranching involves the redistribution of prepayment risk, whereas credit tranching involves the redistribution of credit risk. C is incorrect because although overcollateralization is a form of internal credit enhancement similar to subordination, it is the amount by which the principal amount of the pool of collateral exceeds the principal balance of the securities issued and backed by the collateral pool. Losses are absorbed first by the amount of overcollateralization and then according to the credit tranching structure.

If interest rates increase, an investor who owns a mortgage pass- through security is most likely affected by: A credit risk. B extension risk. C contraction risk.

B is correct. Extension risk is the risk that when interest rate rise, fewer prepayments will occur. Homeowners will be reluctant to give up the benefit of a contractual interest rate that is lower. As a result, the mortgage pass- through security becomes longer in maturity than anticipated at the time of purchase

If a default occurs in a non- recourse commercial mortgage- backed security (CMBS), the lender will most likely: A recover prepayment penalty points paid by the borrower to offset losses. B use only the proceeds received from the sale of the property to recover losses. C initiate a claim against the borrower for any shortfall resulting from the sale of the property

B is correct. In a non- recourse CMBS, the lender can look only to the incomeproducing property backing the loan for interest and principal repayment. If a default occurs, the lender can use only the proceeds from the sale of the property for repayment and has no recourse to the borrower for any unpaid balance

In a securitization, the collateral is initially sold by the: A issuer. B depositor. C underwriter.

B is correct. In a securitization, the loans or receivables are initially sold by the depositor to the special purpose entity (SPE) that uses them as collateral to issue the ABS. A is incorrect because the SPE, often referred to as the issuer, is the purchaser of the collateral rather than the seller of the collateral. C is incorrect because the underwriter neither sells nor purchases the collateral in a securitization. The underwriter performs the same functions in a securitization as it does in a standard bond offering.

Securitization is beneficial for banks because it: A repackages bank loans into simpler structures. B increases the funds available for banks to lend. C allows banks to maintain ownership of their securitized assets.

B is correct. Securitization increases the funds available for banks to lend because it allows banks to remove loans from their balance sheets and issue bonds that are backed by those loans. Securitization repackages relatively simple debt obligations, such as bank loans, into more complex, not simpler, structures. Securitization involves transferring ownership of assets from the original owner—in this case, the banks—into a special legal entity. As a result, banks do not maintain ownership of the securitized assets.

The single monthly mortality rate (SMM) most likely: A increases as extension risk rises. B decreases as contraction risk falls. C stays fixed over time when the standard prepayment model remains at 100 PSA

B is correct. The SMM is a monthly measure of the prepayment rate or prepayment speed. Contraction risk is the risk that when interest rates decline, actual prepayments will be higher than forecast. So if contraction risk falls, prepayments are likely to be lower than forecast, which would imply a decrease in the SMM. A is incorrect because the SMM is a monthly measure of the prepayment rate or prepayment speed. Extension risk is the risk that when interest rates rise, actual prepayments will be lower than forecast. So if extension risk rises, prepayments are likely to be lower than forecast, which would imply a decrease, not an increase, in the SMM. C is incorrect because at 100 PSA, investors can expect prepayments to follow the PSA prepayment benchmark. Based on historical patterns, the PSA standard model assumes that prepayment rates are low for newly initiated mortgages and then speed up as mortgages season. Thus, 100 PSA does not imply that the SMM remains the same but, rather, implies that it will vary over the life of the mortgage.

Which type of asset- backed security is not affected by prepayment risk? A Auto loan ABSs B Residential MBSs C Credit card receivable ABSs

C is correct. Because credit card receivable ABSs are backed by non- amortizing loans that do not involve scheduled principal repayments, they are not affected by prepayment risk.A is incorrect because auto loan ABSs are affected by prepayment risk since they are backed by amortizing loans involving scheduled principal repayments. B is incorrect because residential MBSs are affected by prepayment risk since they are backed by amortizing loans involving scheduled principal repayments.

Securitization benefits financial markets by: A increasing the role of intermediaries. B establishing a barrier between investors and originating borrowers. C allowing investors to tailor credit risk and interest rate risk exposures to meet their individual needs.

C is correct. By removing the wall between ultimate investors and originating borrowers, investors can achieve better legal claims on the underlying mortgages and portfolios of receivables. This transparency allows investors to tailor interest rate risk and credit risk to their specific needs.

Which of the following best describes the cash flow that owners of credit card receivable asset- backed securities receive during the lockout period? A No cash flow B Only principal payments collected C Only finance charges collected and fees

C is correct. During the lockout period, the cash flow that is paid out to owners of credit card receivable asset- backed securities is based only on finance charges collected and fees.

The longest- term tranche of a sequential- pay CMO is most likely to have the lowest: A average life. B extension risk. C contraction risk

C is correct. For a CMO with multiple sequential- pay tranches, the longestterm tranche will have the lowest contraction (prepayments greater than forecasted) risk because of the protection against this risk offered by the other tranches. The longest- term tranche is likely to have the highest average life and extension risk because it is the last tranche repaid in a sequential- pay tranche.

The last payment in a partially amortizing residential mortgage loan is best referred to as a: A waterfall. B principal repayment. C balloon payment.

C is correct. In a partially amortizing loan, the sum of all the scheduled principal repayments is less than the amount borrowed. The last payment is for the remaining unpaid mortgage balance and is called the "balloon payment."

In credit card receivable ABSs, principal cash flows can be altered only when the: A lockout period expires. B excess spread account is depleted. C early amortization provision is triggered.

C is correct. In credit card receivable ABSs, the only way the principal cash flows can be altered is by triggering the early amortization provision. Such provisions are included in the ABS structure to safeguard the credit quality of the issue. A is incorrect because expiration of the lockout period does not result in the alteration of principal cash flows but instead defines when principal repayments are distributed to the ABS investors. During the lockout period, principal repayments by cardholders are reinvested. When the lockout period expires, principal repayments by cardholders are distributed to investors. B is incorrect because the excess spread account is a credit enhancement for loss absorption. When the excess spread account is depleted, losses are applied against the overcollateralization amount followed by the senior/subordinated structure. The only way principal cash flows can be altered is by triggering the early amortization provision.

A benefit of securitization is the: A reduction in disintermediation. B simplification of debt obligations. C creation of tradable securities with greater liquidity than the original loans.

C is correct. Securitization allows for the creation of tradable securities with greater liquidity than the original loans on a bank's balance sheet. Securitization results in lessening the roles of intermediaries, which increases disintermediation. Securitization is a process in which relatively simple debt obligations, such as loans, are repackaged into more complex structures.

A special purpose entity issues asset- backed securities in the following structure. Bond Class Par Value (€ millions) A (senior) 200 B (subordinated) 20 C (subordinated) 5 At which of the following amounts of default in par value would Bond Class A experience a loss? A €20 million B €25 million C €26 million

C is correct. The first €25 (€5 + €20) million in default are absorbed by the subordinated classes (C and B). The senior Class A bonds will only experience a loss when defaults exceed €25 million.

Support tranches are most appropriate for investors who are: A concerned about their exposure to extension risk. B concerned about their exposure to concentration risk. C willing to accept prepayment risk in exchange for higher returns

C is correct. The greater predictability of cash flows provided in the planned amortization class (PAC) tranches comes at the expense of support tranches. As a result, investors in support tranches are exposed to higher extension risk and contraction risk than investors in PAC tranches. Investors will be compensated for bearing this risk because support tranches have a higher expected return than PAC tranches.

The key to a CDO's viability is the creation of a structure with a competitive return for the: A senior tranche. B mezzanine tranche. C subordinated tranche

C is correct. The key to whether a CDO is viable is whether a structure can be created that offers a competitive return for the subordinated tranche (often referred to as the residual or equity tranche). Investors in a subordinated tranche typically use borrowed funds (the bond classes issued) to generate a return above the funding cost. A is incorrect because the viability of a CDO depends on a structure that offers a competitive return for the subordinated tranche rather than the senior tranche. B is incorrect because the viability of a CDO depends on a structure that offers a competitive return for the subordinated tranche rather than the mezzanine tranche.

The CDO tranche with a credit rating status between senior and subordinated bond classes is called the: A equity tranche. B residual tranche. C mezzanine tranche

C is correct. The mezzanine tranche consists of bond classes with credit ratings between senior and subordinated bond classes. A is incorrect because the equity tranche falls within and carries the credit rating applicable to the subordinated bond classes. B is incorrect because the residual tranche falls within and carries the credit ratings applicable to the subordinated bond classes.

Which of the following is most likely an advantage of collateralized mortgage obligations (CMOs)? CMOs can A eliminate prepayment risk. B be created directly from a pool of mortgage loans. C meet the asset/liability requirements of institutional investors.

C is correct. Using CMOs, securities can be created to closely satisfy the asset/ liability needs of institutional investors. The creation of a CMO cannot eliminate prepayment risk; it can only distribute the various forms of this risk among various classes of bondholders. The collateral of CMOs are mortgage- related products, not the mortgages themselves.

For a mortgage pass- through security, which of the following risks most likely increases as interest rates decline? A Balloon B Extension C Contraction

C is correct. When interest rates decline, a mortgage pass- through security is subject to contraction risk. Contraction risk is the risk that when interest rates decline, actual prepayments will be higher than forecasted because borrowers will refinance at now- available lower interest rates. Thus, a security backed by mortgages will have a shorter maturity than was anticipated when the security was purchased