6.6 MBS Instrument and Market Features

Question 1

The debt-to-income ratio (DTI)

Answer 1

used to measure a borrower’s credit quality

calculated as a monthly mortgage payment as a percentage of a borrower’s gross pre-tax income

Question 2

Prime loans

Answer 2

have been granted to borrowers with high credit quality. They have good credit history and sufficient income to service their mortgage obligations

Question 3

Subprime loans

Answer 3

borrowers with low credit quality, or the loan is not the first lien on the property.

Question 4

Residential mortgage-backed securities (RMBS)

Answer 4

securitized home mortgage loans.

based on pools of home mortgage loans. Investors receive cash flows in the form of interest, scheduled principal payments, and prepayments. RMBS are commonly structured as either mortgage pass-through securities or collateralized mortgage obligations.

Question 5

A prepayment option

Answer 5

allows a borrower to repay some or all of the outstanding principal

Question 6

To mitigate this prepayment risk and achieve more certainty over the timing of incoming cash flows

Answer 6

lenders impose penalties on early retirement of mortgage principal.

These penalties are more common in Europe, but relatively rare in the United States.

Question 7

A mortgage is described as being “underwater”

Answer 7

if the value of the property is less than the amount of outstanding principal (i.e., the LTV ratio is greater than 1).

f a borrower defaults on an underwater mortgage, the lender may not be able to recoup the full amount of the outstanding loan from a foreclosure sale

Question 8

contraction risk

Answer 8

When prepayments come in earlier than scheduled due to a decrease in interest rates

a type of prepayment risk that is also a significant concern for MBS investors.

Not only do prepayments leave investors with cash to reinvest in a low interest rate environment, they also reduce the duration of an MBS and limit its potential price appreciation.

Question 9

extension risk

Answer 9

the opposite of contraction risk

If interest rates increase, homeowners will not be motivated to prepay mortgages with relatively low rates.

Investors will have less cash than anticipated to be reinvested in this higher interest rate environment.

Expected cash flows have a lower present value because they will take longer to receive and they are being discounted at a higher rate.

Question 10

time tranching

Answer 10

the allocation of incoming cash flows to different tranches according to timing rules.

For example, tranches can be prioritized in terms of the order in which they receive principal repayments.

This ensures that certain classes of bonds will absorb prepayments before other classes are affected.

Effectively, time tranching creates bond classes with different expected maturities, allowing investors to choose their preferred level of prepayment risk exposure.

Question 11

Mortgage Pass-Through Securities

Answer 11

shares that represent a claim to the cash flows from an underlying pool of mortgages, but without rules to allocate cash flows differently among tranches.

In other words, cash flows simply pass through to all investors in the same way

The amount of cash flow received by investors is reduced by the servicing and administrative fees that issuers and third parties charge for activities such as collecting payments, sending payment notices, maintaining records, and providing tax information.

The pass-through rate earned by investors is the net interest rate on the underlying mortgages after accounting for the deduction of administrative fees.

Question 12

Collateralized Mortgage Obligations

The key difference between collateralized mortgage obligations (CMOs) and mortgage pass-through securities

Answer 12

CMOs redistribute cash flows among multiple tranches.

This does not eliminate or even reduce overall prepayment risk and credit risk, but it does allow investors to choose their desired levels of exposure.

Question 13

Sequential-Pay CMO Structures

Answer 13

each class (or tranche) is retired sequentially, allowing investors to choose the class that corresponds to their desired maturity.

the sequential-pay tranching structure does not eliminate all uncertainty about the timing of cash flows.

The average life of each tranche will vary depending on the actual prepayment rate.

Question 14

In a basic sequential-pay CMO structure

Answer 14

each tranche receives the same coupon rate, but all scheduled principal payments and prepayments are directed to one tranche until its full par value is repaid. After that, principal payments are directed to the next tranche. This is done until all tranches are completely paid off.

Question 15

Z-Tranches (also known as accretion bonds or accrual bonds)

Answer 15

an example of time tranching

CMBS investors receive no payment until the end of an initial accrual period, during which the principal value of the tranche is credited at the stated coupon rate.

Once the accrual period ends, investors start receiving payments that include both principal and accrued interest.

Including a Z-tranche in a CMO benefits other investors by freeing up cash flows to be distributed to other tranches.

Z-tranches have very long average lives, which eliminates contraction risk but also makes them very difficult to value.

Question 16

Principal-only (PO) tranches

Answer 16

receive only the principal repayments (including prepayments) from the underlying pool of mortgages

Their value is very sensitive to interest rates, increasing when prepayments increase due to falling rates. PO tranches can be used in both pass-through structures and CMOs.

Question 17

Interest-only (IO) tranches

Answer 17

complement PO tranches by receiving only interest payments from the pool.

Unlike PO tranches, these have no par value.

Cash flows to IO tranches are decreased in low interest rate environments due to the increase in principal prepayments.

Investors use IO tranches as a tool to hedge their exposure to interest rate risk.

Question 18

Floating-rate tranches

Answer 18

can be created in CMO, even one that is based on a pool of exclusively fixed-rate mortgages.

This is accomplished by creating an inverse floating-rate tranche to offset the floating rate tranche.

When interest rates increase, the floating-rate tranche will pay more and the inverse floating tranche will pay less (and vice versa when interest rates fall).

Payments are linked to a reference rate and are often subject to both a cap and a floor rate.

Like IO tranches, these can be used to hedge interest rate risk exposure.

Question 19

Residual tranches

Answer 19

receive only the cash flows that remain after obligations to all other tranches have been met. They are attractive to investors with higher levels of risk tolerance, such as hedge funds.

Question 20

Planned amortization class (PAC) tranches

Answer 20

give investors even more protection against prepayment risk than sequential-pay CMOs. This is accomplished by having a support tranche to absorb all principal payments in excess of what is required to satisfy the schedule of the PAC tranches. If the actual prepayment rate stays within an expected range, each PAC tranche will be repaid on schedule. PAC tranches will only absorb prepayments after the support tranche has been repaid. The greater predictability provided by PACs also reduces extension risk. Of course, the average life of the support tranche is highly volatile, even if the prepayment rate remains within the defined range. Investors willing to tolerate this volatility can benefit from high expected returns.

Question 21

Commercial Mortgage-Backed Securities (CMBS)

Answer 21

redistribute cash flows from a pool of mortgages on commercial properties (e.g., apartment buildings, offices, warehouses).

Like residential CMOs, CMBS are structured in tranches. A residual tranche, also known as an equity tranche, absorbs the first default losses from the underlying pool of mortgages.

Using a subordinated structure reduces the credit risk of more senior tranches.

Question 22

Structural call protection at the CMBS level

Answer 22

achieved with sequential payments based on each tranche’s credit rating.

The highest-rated tranches are repaid before those with lower ratings and default losses are absorbed by the lowest-rated tranches.

Question 23

Loan-level call protection comes from the following mechanisms:

Answer 23

Lockout periods during which prepayments are prohibited

Prepayment penalty points that borrowers must pay the SPE to refinance, such as 1% of the outstanding loan balance

Defeasance provisions that require the borrower to purchase a portfolio of government securities that replicate the future cash flows that the lender would receive in the absence of prepayments

Question 24

For a CMO that includes Planned Amortization Class (PAC) tranches, if the prepayment rate is within the anticipated range, which of the following tranches most likely protects investors from prepayment risk?

a) PAC tranche

b) Senior tranche

c) Support tranche

Answer 24

c) Support tranche

If the prepayment rate is within the specified range, all prepayment risk is absorbed by the support tranche. This provides greater predictability of the size and timing of cash flows paid to investors in the PAC tranches.

Question 25

Which of the following provides call protection for CMBS investors at the structural level?

a) Defeasance

b) Prepayment lockout

c) Sequential-pay tranches

Answer 25

c) Sequential-pay tranches

Structural call protection is achieved through sequential-pay tranches in the CMBS as a lower-rated tranche cannot be paid down until the higher-rated tranche is completely retired

Question 26

An investment vehicle based on cash flows from an underlying pool of mortgages offering tranches that carry a high level of prepayment risk is most likely a:

A
mortgage pass-through security.

B
collateralized mortgage obligation.

C
commercial mortgage-backed security.

Answer 26

B
collateralized mortgage obligation.

Collateralized mortgage obligations (CMOs) are a form of mortgage-backed security (MBS) that redistributes cash flows among tranches, which give investors the ability to choose their desired level of cash flow risk.

Note that, because of how a CMO is structured, prepayment risk cannot be reduced or eliminated - only redistributed.

Question 27

The role of a special purpose vehicle (SPV) in the securitization process is most likely to:

A
originate the loans.

B
issue asset-backed securities to investors.

C
collect principal and interest payments from borrowers.

Answer 27

B
issue asset-backed securities to investors.

Question 28

Upon a bankruptcy affecting a covered bond, the first available safeguards to protect against potential losses are the:

A
ringfenced loans.

B
unencumbered assets of the issuer.

C
assets added by the collateral manager during ramp-up.

Answer 28

A
ringfenced loans.

Question 29

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.

Answer 29

A
providing more direct access to a wider range of assets.

Question 30

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.

Answer 30

A
A non-recourse jurisdiction poses higher default risks for lenders.

Question 31

Which of the following statements is most accurate? Unlike other types of asset-backed securities, a collateralized debt obligation (CDO):

A
has a collateral manager.

B
does not have an equity tranche.

C
does not require the creation of a special purpose entity.

Answer 31

A
has a collateral manager.

A CDO issues debt through a special purpose entity and uses the proceeds to purchase assets that are expected to generate a portfolio return in excess of the cost of debt. The portfolio of assets is created and overseen by a CDO manager, also known as a collateral manager. The CDO structure involves several different types of tranches that offer different levels of expected returns. The most senior tranches are relatively low-risk, low-return, while the residual (equity) tranche offers the highest expected return for investors with higher levels of risk tolerance.

Question 32

f a default occurs in a non-recourse commercial mortgage-backed security, 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.

Answer 32

B
use only the proceeds received from the sale of the property to recover losses.

in a non-recourse CMBS, the lender can look only to the income-producing 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.

Question 33

In a securitization, the party that sells the collateral is most likely referred to as the:

A
issuer.

B
servicer.

C
depositor.

Answer 33

C
depositor.

In a securitization, the depositor (or seller) is the party that sells the collateral to the special purpose entity (SPE), which issues the securities.

Question 34

An action affecting the cash flow received by a credit card ABS holder during its revolving period is the:

A
early repayment of principal by cardholders.

B
card’s floating-rate cap exceeding the periodic rate.

C
triggering of an ABS rapid amortization provision.

Answer 34

C
triggering of an ABS rapid amortization provision.

Question 35

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.

Answer 35

C
contraction risk.

For a CMO with multiple sequential-pay tranches, the longest-term tranche will have the lowest contraction (prepayments greater than forecasted) risk because of the protection against this risk offered by the other tranches

Question 36

Which of the following statements related to securitization is correct?

A
Time tranching addresses the uncertainty of a change 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 be paid off only at the bond’s set maturity.

Answer 36

A
Time tranching addresses the uncertainty of a change in interest rates.

Question 37

Which of the following statements about securitization is incorrect?

A
The ABS that are created by securitization have characteristics similar to those of equity investments.

B
Buying securitized debt helps investors increase exposure to the risk–return characteristics of a wider range of underlying assets.

C
Securitization transactions allow issuers to create risk–return characteristics to satisfy the risk tolerance of different investors.

Answer 37

A
The ABS that are created by securitization have characteristics similar to those of equity investments.

The ABS that are created by pooling loans and receivables have characteristics similar to those of a standard bond.

Question 38

n 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.

Answer 38

A
issuance of the asset-backed securities.

Question 39

n credit card receivable ABS, 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.

Answer 39

C
early amortization provision is triggered.

In credit card receivable ABS, 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.