Module 45.2: Prepayment Risk and Non-Mortgage Backed ABS Flashcards

1
Q

What is extension risk vs. contraction risk?

A

extension - the risk that prepayments will be slower than expected

contraction - the risk that prepayments will be more rapid than expected

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2
Q

What is the conditional prepayment rate?

A

an annualized measure of prepayments. depends on weighted average coupon, current interest rates, and prior prepayments of principal

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3
Q

Will the average life of an MBS be the greater than the weighted average maturity?

A

no, because of prepayments.

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4
Q

What is a CMO? What is the benefit?

A

collateralizaed mortgage obligations, securities that are collateralized by residential mortgage backed securities.

Different investors have different preferences of prepayment risk. Goal of the CMO is align the risk of investors with the underlying RMBS. Increases the potential market for securitized mortgages and could reduce funding costs.

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5
Q

What do primary CMO structures include in terms of tranches?

A

1) sequential pay tranches
2) planned amortization class tranches (PAC)
3) Support tranches
4) floating rate tranches

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6
Q

What does sequential tranching of a CMO do?

A

provides a tranche A and a tranche B, tranche A gets paid first and tranche B gets paid last, therefore, investors who prefer protection on extension risk can go for tranche A and vice versa.

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7
Q

Hoow does planned amortization class deal with prepayment risk?

A

PAC tranches have predictable amortization. any exceess prepayment goes to the support tranches, or if there’s less, the suppor tranches get less.

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8
Q

What is the initial PAC collar?

A

the upper and lower bounds on actual prepayment rates that the support tranche can aborb prepayments.

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9
Q

What happens to the PAC tranche when the PSA is within the initial collar?

A

the average life of the PAC remains constant

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10
Q

What is a shifting interest mechanism?

A

credit enhancement mechanism that shuts off interest and principal to the subordinated tranches until the credit worthiness of the senior tranches is restored.

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11
Q

What is a key difference between RMBS and CMBS?

A

the obligations of the borrowers of the underlying loans. RMBS are repaid by homeowners, CMBS, are repaid by companies. Therefore, the CMBS focuses more on the credit risk of the property rather than the borrower.

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12
Q

What is the debt to service coverage ratio?

A

basic cash flow coverage ratio of the amount of cash flow from a commercial property available to repay debt.

net operating income / debt service

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13
Q

What is the loan to value ratio for CMBS?

A

current mortgage amount / current appraised value

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14
Q

What are the four ways to create loan-level call protection for CMBS?

A

1) prepayment lockout - borrower is prohibited from prepaying the mortgage loan
2) defeasance - using prepaid principal to purchase gov securities sufficient to make the remaining payments
3) prepayment penalty points - penalty fee
4) yield maintenance margins - the borrower is charged for lost interst “make whole payment”

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15
Q

What is the best way to create CMBS level call protection?

A

segregate tranches with specific sequence of repayment.

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