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WQU - MFE > Financial Markets Liquidity and Regulation: C1M5 > Flashcards

Financial Markets Liquidity and Regulation: C1M5 Flashcards

1
Q

What is a derivative?

A

A financial instrument whose value depends on the value of some underlying asset(s) and has a finite lifetime.

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2
Q

What is a mortgage-backed security (MBS)?

A

A type of derivative security that is backed by a bundle of home loans.

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3
Q

Define mortgage origination.

A

The creation of the mortgage loan itself, involving a bank entering a mortgage contract and lending money.

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4
Q

What is securitization?

A

The creation of new securities that are collateralized by assets such as mortgages.

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5
Q

What is credit risk?

A

The risk that the lender does not receive the money that is owed to them in full and on time.

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6
Q

What are the typical terms for most traditional mortgages?

A

15 to 30 years with monthly payments due at the beginning of each month.

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7
Q

What does fully amortizing mean in terms of mortgages?

A

Regular payment amount stays the same, but different proportions of principal vs. interest are paid over the life of the loan.

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8
Q

What happens if a borrower cannot make timely payments on a mortgage?

A

The lender can take control over the property through a legal process called foreclosure.

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9
Q

What are subprime mortgages?

A

Mortgages offered to borrowers with low credit ratings, often involving adjustable rates to compensate for additional risk.

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10
Q

What is a jumbo loan?

A

A mortgage used to finance properties that exceed conventional mortgage limits set by the Federal Housing Finance Agency (FHFA).

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11
Q

What is the maximum value for a conventional mortgage as of 2024?

A

$766,550 in most counties.

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12
Q

What are the 5 Cs of credit analysis?

A
  • Capacity
  • Capital
  • Character
  • Collateral
  • Conditions
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13
Q

What does ‘capacity’ refer to in credit analysis?

A

The ability of the borrower to repay a loan, considering revenues and expenses.

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14
Q

How is ‘capital’ defined in the context of credit analysis?

A

The net worth of an individual or company, calculated as total assets minus total liabilities.

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15
Q

What does ‘character’ indicate in credit analysis?

A

The borrower’s history of repayment and responsibility in managing debt.

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16
Q

Define collateral.

A

Assets that a borrower can put up as security for a loan.

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17
Q

What do ‘conditions’ refer to in the context of loans?

A

Contractual terms of the loan, including principal amount, repayment period, interest rate, and the purpose of the loan.

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18
Q

What is the risk associated with underwater mortgages?

A

The borrower owes more than the home is worth, leading to potential default.

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19
Q

True or False: All mortgages have the same risk profile.

A

False.

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20
Q

Fill in the blank: A bank that provides a mortgage is said to _______.

A

[originate a mortgage]

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21
Q

What is the debt-to-income ratio (DTI)?

A

A metric comparing all outstanding debt to a person’s earnings; lower DTI indicates higher likelihood of timely payments.

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22
Q

What significant event occurred during the housing bubble from 2004-2007?

A

Over $3 trillion worth of jumbo loans were originated with overly lenient terms.

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23
Q

What does a borrower typically need for a down payment in the U.S.?

A

20% of the home price.

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24
Q

What might lenders consider when assessing a borrower’s capacity?

A

Employment status, income, and existing debt obligations.

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25
Q

What is the collateral for a mortgage loan?

A

The house itself

The mortgage loan is secured by the property being purchased.

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26
Q

What percentage of the house price did Jacob afford as a down payment?

A

20%

Jacob’s down payment was $100,000 on a $500,000 house.

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27
Q

How much is Jacob’s mortgage loan amount?

A

$400,000

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28
Q

What is liquidity risk?

A

The risk of not being able to sell an asset at all or having to sell an asset at a steep discount.

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29
Q

What is concentration risk in banking?

A

Too much risk is concentrated in a single borrower.

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30
Q

What is the role of an investment bank in mortgage securitization?

A

To move mortgages into a special purpose entity (SPE) rather than holding them.

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31
Q

True or False: Investment banks store the mortgages they buy.

A

False

Investment banks sell the mortgages into an SPE.

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32
Q

What is a mortgage-backed security (MBS)?

A

A security backed or collateralized by many individual mortgages.

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33
Q

What does LTV stand for and what does it indicate?

A

Loan to Value; it indicates the ratio of the loan amount to the value of the property.

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34
Q

What is the DTI ratio and what does it signify?

A

Debt to Income; it signifies the percentage of a borrower’s income that goes towards debt payments.

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35
Q

What does a high FICO score indicate?

A

A creditworthy borrower who is likely to repay their debts.

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36
Q

What are the five Cs of credit?

A

Capacity, Capital, Character, Collateral, Conditions.

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37
Q

What is the difference between senior and subordinated bond classes in securitization?

A

Senior classes are less risky and have priority in cash flows; subordinated classes absorb losses first.

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38
Q

What is prepayment risk?

A

The risk that a loan’s principal is paid back earlier than agreed.

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39
Q

Fill in the blank: The process of creating different bond classes in securitization is called _______.

A

credit tranching.

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40
Q

What does time tranching address?

A

The uncertainty of cash flows due to prepayment risk.

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41
Q

What is the purpose of a special purpose entity (SPE) in securitization?

A

To issue bonds backed by specific collateral and to protect against issuer bankruptcy.

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42
Q

How does an SPE affect the rating of the bonds?

A

The SPE can receive a different rating from that of the issuing company.

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43
Q

What happens to mortgage payments from borrowers in the securitization process?

A

They are pooled and distributed to MBS investors.

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44
Q

What is the significance of having diversified underlying assets in an MBS?

A

It reduces concentration risk associated with individual borrowers.

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45
Q

What is the relationship between yield and risk in bond classes?

A

Higher risk classes typically have higher yields.

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46
Q

What happens when defaults exceed the capacity of the subordinated tranches?

A

The senior tranches incur losses.

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47
Q

Why might a bank face reinvestment risk after receiving early loan repayments?

A

They may have to reinvest the returned principal at lower interest rates.

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48
Q

What type of loans would be preferable from a collateral perspective?

A

Loans with a lower average LTV ratio.

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49
Q

What might be a preferable condition for loans in terms of interest rates?

A

Higher interest rates are preferable for better returns.

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50
Q

What are the 5 Cs of credit analysis?

A

The 5 Cs of credit analysis are Character, Capacity, Collateral, Conditions, and Capital.

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51
Q

What credit characteristics indicate a subprime mortgagor?

A
  1. Two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months.
  2. Judgment, foreclosure, repossession, or charge-off in the prior 24 months.
  3. Bankruptcy in the last 5 years.
  4. High default probability indicated by a credit bureau risk score (FICO) of 660 or below.
  5. Debt service-to-income ratio of 50 percent or greater.
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52
Q

How does a high LTV ratio affect mortgage default probability?

A

A high LTV ratio, especially as it approaches 100, suggests a higher probability of default.

53
Q

What is the significance of first-lien loans compared to second-lien loans?

A

First-lien loans have priority over second-lien loans, meaning the first-lien lender is repaid first in case of default.

54
Q

What is a cash-out refinance?

A

A cash-out refinance allows a borrower to withdraw principal they have repaid on an existing mortgage, often for other uses.

55
Q

What are NINJA loans?

A

NINJA loans are loans where the borrower provides no income, no job, and no assets information to the lender.

56
Q

What is asymmetric information in the context of mortgages?

A

Asymmetric information occurs when one party, typically the borrower, has more information about their financial situation than the lender.

57
Q

What is moral hazard?

A

Moral hazard describes a situation where one party takes excessive risks because they do not bear the full consequences of those risks.

58
Q

What are ‘liar loans’?

A

‘Liar loans’ refer to no-doc or low-doc loans where borrowers can exaggerate their income and assets without providing proof.

59
Q

How does the non-recourse nature of mortgages affect borrower behavior?

A

The non-recourse nature allows borrowers to walk away from their loans without losing other assets, potentially leading to higher default rates.

60
Q

What happens if a borrower defaults on a non-recourse mortgage?

A

The borrower can walk away without further financial obligation.

61
Q

What is a moral hazard in the context of mortgages?

A

A situation where borrowers may choose to default if real estate prices decline significantly.

62
Q

What does the reading ‘Understanding the Securitization of Subprime Mortgage Credit’ discuss?

A

It discusses informational frictions and moral hazards in the mortgage and MBS markets that contributed to the credit crisis.

63
Q

What is a conflict of interest?

A

A situation where a party has multiple interests that are in conflict, affecting their decision-making.

64
Q

Why should you avoid relying on Nushi’s information about her watch’s value?

A

Nushi has a conflict of interest in providing accurate information about the watch’s value.

65
Q

Why are rating agencies considered to have conflicts of interest?

A

They are paid by the issuers of the debt they are rating, which may bias their assessments.

66
Q

What does the aphorism ‘All models are wrong but some are useful’ imply?

A

No model is perfect, but judicious use of models can provide useful insights.

67
Q

What does Probability of Default (PD) measure?

A

The likelihood that a borrower will default on their debt obligations within a specific time frame.

68
Q

What is Loss Given Default (LGD)?

A

The estimated amount a financial institution loses when a borrower defaults, expressed as a percentage of total exposure.

69
Q

What is Exposure at Default (EAD)?

A

The total value of a loan that a bank is exposed to when a borrower defaults.

70
Q

What is the default recovery rate (RR)?

A

The percentage of each dollar invested that is expected to be recovered in case of a default.

71
Q

What is model risk?

A

The risk of model failure due to inappropriate assumptions or inputs.

72
Q

What did the Dodd-Frank Act address?

A

It aimed to regulate conflicts of interest in rating agencies and improve transparency in financial markets.

73
Q

What is the main risk in the credit market?

A

Credit risk, or the probability of default.

74
Q

What is liquidity risk?

A

The risk that an asset cannot be sold quickly enough in the market to prevent a loss.

75
Q

What is the relationship between credit spread and probability of default?

A

The credit spread reflects the credit risk associated with the probability of default.

76
Q

What is the significance of credit scores in the U.S.?

A

They capture the credit quality of individuals, influencing lending decisions.

77
Q

What are the 5 Cs of credit analysis?

A

The 5 Cs of credit analysis are not explicitly listed in the text, but they are commonly known as Character, Capacity, Capital, Collateral, and Conditions.

78
Q

What is the relationship between a mortgage and derivatives?

A

A mortgage exhibits nonlinearity, similar to other derivatives such as call and put options.

79
Q

What contributed to the Great Financial Crisis?

A

Model risk contributed to the Great Financial Crisis.

80
Q

What are moral hazards in the context of credit markets?

A

Moral hazards include information asymmetry and conflict of interest in the mortgage and bond markets.

81
Q

What regulation was introduced in response to issues in the credit markets?

A

The Dodd-Frank Act was introduced in the U.S. in response to issues in the credit markets.

82
Q

What does the credit market include?

A

The credit market includes securities that involve borrowing or debt, synonymous with the debt market.

83
Q

How does the bond market compare to the equity market?

A

The bond market is vast compared to the global equity market, with significantly higher annual issuance.

84
Q

What was the bond issuance ratio in 2020 compared to equity issuance?

A

Bond issuance in 2020 was 1.5 times larger than equity issuance.

85
Q

Which countries had the largest values of bonds outstanding in 2020?

A

The five largest countries by bond value outstanding in 2020 were the United States, European Union, China, Japan, and the United Kingdom.

86
Q

What is liquidity risk?

A

Liquidity risk is the risk that investors won’t find a market for the bond, preventing them from buying or selling when they want.

87
Q

What is the significance of liquidity in bond markets?

A

Investors looking for low liquidity risk should consider large bond markets, as they are more likely to find liquid bonds.

88
Q

What is a credit spread?

A

A credit spread is the difference in yield between a particular bond and the risk-free rate for the same maturity.

89
Q

How is the probability of default calculated?

A

The probability of default (PD) can be calculated using the formula PD = CS / (1 - RR), where CS is the credit spread and RR is the recovery rate.

90
Q

What is a credit default swap (CDS)?

A

A CDS is a financial derivative that allows an investor to ‘swap’ or transfer the credit risk of a bond to another party.

91
Q

How do CDSs commodify credit risk?

A

CDSs allow for the easy buying and selling of credit risk, packaging and pricing it as a commodity.

92
Q

What are the implications of higher probability of default on credit spread?

A

Higher probability of default implies a higher credit spread.

93
Q

What defines investment grade bonds?

A

Investment grade refers to bonds rated BBB or better, while bonds rated below BBB are called ‘junk’ or ‘high yield.’

94
Q

What does a AAA bond rating indicate?

A

A AAA bond rating indicates almost no risk of default, meaning the probability of default (PD) is at or very near zero.

95
Q

What is meant by ‘investment grade’ bonds?

A

‘Investment grade’ refers to bonds rated BBB or better.

96
Q

What are bonds rated below BBB called?

A

Bonds rated below BBB are called ‘junk’ or ‘high yield.’

97
Q

How do credit ratings relate to probabilities of default?

A

Credit ratings are based on the PDs calculated by rating agencies; a low PD is associated with a high rating.

98
Q

What happens to credit spreads as ratings worsen?

A

Credit spreads increase as ratings worsen, e.g., from BBB to BB+ or from B+ to B-.

99
Q

How does time to maturity affect credit spreads?

A

Credit spreads increase as you move to longer-term bonds, compensating investors for additional default risk.

100
Q

What is the correlation between credit spread and rating?

A

Credit spread and rating are negatively correlated; as the rating improves, the credit spread decreases.

101
Q

What is a major issue with rating agencies?

A

Rating agencies often lag in updating ratings, leading to a reactive rather than proactive assessment of credit quality.

102
Q

What is liquidity risk?

A

Liquidity risk refers to the risk that investors won’t find a market for the bond, preventing them from buying or selling when desired.

103
Q

How is liquidity defined?

A

Liquidity is defined as the closeness of market value and selling price; the more liquid an asset, the closer these values are.

104
Q

What is the bid-ask spread?

A

The bid-ask spread is the difference between current offer prices to sell and bid prices to buy for a security.

105
Q

How does transaction volume relate to liquidity?

A

Lower transaction volumes imply less liquidity; higher volumes correlate with more liquid markets.

106
Q

What is fungibility in the context of liquidity?

A

Fungibility refers to how easily an asset can be interchanged with another of the same type; stocks are fungible, while houses are not.

107
Q

What is the relationship between credit spread and probability of default?

A

Credit spread and probability of default are positively correlated; higher spreads indicate higher probabilities of default.

108
Q

What is the conclusion of the lesson?

A

The lesson covered credit market sizing, calculating credit spreads, the role of CDS, and the complexities of liquidity risk.

109
Q

What does leverage lead to a discussion of?

A

Leverage leads to a discussion of its risks and the need for regulation.

110
Q

What is one approach to calculating the Probability of Default (PD)?

A

Using the credit spread is one approach to calculating the PD.

This is why there is a probability of default and not the probability of default.

111
Q

What is model risk?

A

Model risk is the risk of not using the most appropriate model for calculations.

112
Q

What is the relationship between bond yield and probability of default?

A

As bond yield increases, the probability of default is expected to increase as well.

113
Q

What are CDS and credit ratings indicators of?

A

They are indicators of credit risk in terms of probability of default.

114
Q

What is correlation?

A

Correlation measures the strength and direction of a linear relationship between two variables.

115
Q

What correlation method is used in this lesson?

A

Pearson correlation is used, which assumes the data have particular distributions.

116
Q

What are the two ways to understand the relationship between stock and real estate markets discussed by Yuksel?

A

The wealth effect and the credit-price effect.

117
Q

What is the wealth effect?

A

Changes in a consumer’s wealth cause changes in consumption amounts and distribution.

118
Q

What is the psychological component of perceived wealth?

A

Consumers may feel richer due to increases in the assessed value of their assets, even if their purchasing power remains unchanged.

119
Q

How did housing wealth effects impact the economy in the early 2000s?

A

They played an important role in the boom and subsequent recession, significantly affecting the business cycle.

120
Q

According to the wealth effect, is it a good time to buy or sell a house in a rising stock market?

A

It’s a good time to sell because increased demand leads to better prices; it’s a bad time to buy due to rising prices.

121
Q

What does the credit-price effect suggest about rising real estate prices?

A

They should help the stock market by allowing companies to borrow more at cheaper rates.

122
Q

What is leverage risk?

A

It refers to the additional risks associated with borrowing to invest, such as real estate price risk.

123
Q

What are closed-end funds (CEFs) and exchange-traded funds (ETFs)?

A

Distinct investment types that can entail leverage and allow buying and selling shares on an exchange.

124
Q

What is the relationship between borrowing and leverage?

A

Borrowing can amplify both potential gains and risks, particularly in housing markets.

125
Q

What is moral hazard?

A

It occurs when market participants take excessive risks because they do not bear the consequences of their actions.

126
Q

Why was extensive regulation needed after the Great Financial Crisis?

A

To address the large-scale moral hazard that the market could not manage on its own.

127
Q

What is the argument against centralized regulation according to Taleb?

A

He argues that it releases people from responsibility and can lead to unethical behavior.

128
Q

What is the conclusion of the lesson?

A

Leverage can be both helpful and dangerous, necessitating new regulations to combat moral hazard.

WQU - MFE (6 decks)

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