Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

Financial Markets and Institutions > Mortgage Lending and Securitisation P2 > Flashcards

Mortgage Lending and Securitisation P2 Flashcards

1
Q

What are the 6 points covered on this side of the course?

A
  • Mortgage lending & Securitisation
  • Investment banks and Pension funds
  • Commercial banks
  • Mutual funds, Hedge funds; Does the financial system work?
  • Ethics Case Studies
  • Ethics
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What is covered in terms of Mortgages?

A
  • Types of Mortgage
  • Prepayment & Default risk
  • Principles of Securitisation
  • What went wrong
  • Mortgage backed securities (Pass through)
  • Financial engineering: CMOs, IOs and POs
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What is a mortgage, in terms of a House-Buyer?

A

A mortgage is a pledge of property to secure payment of a debt.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What are 2 broad categories of mortgages?

A

Residential and Non-Residential

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Who is the Mortgagor?

A

The Person who bought the Property and pays off the loan (borrower).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Who is the mortgagee?

A

Simply the Lender, usually a Financial Institution.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What are Fixed Rate mortgages?

A

Mortgages where interest payments are constant. The FI accepts the risk that other interest rates may risk. If interests fluctuate upward, for example, the FI may lose out.

Typically funded with short-term floating rate eg. Deposits or Money Market Borrowing.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Who carries the risk of Interest rate fluctuation, in the mortgage agreement?

A

This is dependant on whether the issued mortgage rate is varied or fixed. If the rate is varied, then the mortgagor takes on the risk of fluctuations, and vice versa.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What are Adjustable rate mortgages?

A

aka ARM “Floating Rate Mortgage”

This allows the Interest Rate to change. The borrower thus faces the interest rate risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

What are examples of Mortgage variants?

A
  • Mortgage with an initial fixed rate which moves to floating.
  • Convertible ARM which can be converted to fixed rate.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What is Amortization?

A

Creating a Loan that provides constant payments to the bank, by raising principal payments as interest payments fall.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

What is a mortgage in terms of an investor?

A

A mortgage is a stream of defined future payments, so its present value can be evaluated like a bond.

The NPV method is commonly used to value a mortgage.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What factors make mortgage cash-flows uncertain?

A

Interest rate shifts affecting ARMs
Default risk
Prepayment risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What is Negative Equity?

A

This is the occurrence of when the value of collateral (such as a house) becomes less than the actual value of the loan.

If you walk away from such a situation …
In US, due to non-recourse lending, you will not be pursued.
In UK, you will still be liable for what you owed and will be sued.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What are the 3 key underlying risks to making mortgage loans?

A

Interest rate risk —> If fixed
Default risk (Credit risk)
Prepayment risk —> For lender

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What is the standard process for giving a mortgage?

A

The Originator (Financial Institution) assesses the creditworthiness of a borrower and makes a loan. The property then acts as collateral for the loan.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

Why is the occurrence Negative Equity not equal to certain Default in the UK?

A

This is because if one were to walk away from Neg. Equity in the UK, not only will they lose their house but they will also be liable to getting sued.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

How do Originators limit default risk?

A

Lending to Borrowers with a good credit history.

Lending at a low Loan to Income ratio (% of monthly income to go into mortgage payments).

Lending at a low Loan to Value ratio (LTV: the ratio of the loan to the value of the property).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

What kind of Borrower would Originators prefer?

A

The Borrower:

Higher Deposit
Good Credit
Lower Multiple for LTI Ratio (eg. 3.5x mortgage)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

What is the Prepayment Risk defined as?

A

The Risk that a Loan/Mortgage will be paid before maturity.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

What are the sources of Prepayment risk?

A

Refinancing

Moving Home

Property Destroyed

Property Repossessed and Sold

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

How is the US State involved in Property?

A

In the US, federal agencies may also act as guarantors of the loan.

Or … mortgage can be privately insured by a FI, with the premium usually passed to the borrower in the form of higher mortgage payments.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

What does the US government want in the mortgage market? Why?

A

To widen access to mortgage lending and allow money to move more easily from state to state. This may be for Political reasons.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

How does Borrowers generally react to Interest Rate fluctuautions?

A

Increase:
Keep the Mortgage.

Decrease:
Refinance the Mortgage.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

Why is ‘Refinancing’ dangerous/worrying to lenders?

A

Falling interest rates give Borrowers an incentive to pay off their old mortgages and refinance at lower rates.

This causes a sharp rise in Prepayment Risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

Which are the firms that insure the risk on most US residential mortgages? What do they do?

A

Government National Mortgage Association (Ginnie Mae)
Federal National Mortgage Association (Fannie Mae)
Federal Home Loan Mortgage Corporation (Freddie Mac)

They encourage banks to lend to people by guaranteeing their loans.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

Why did Fannie Mae and Freddie Mac cause scandals?

A

Were caught using irregular accounting practices, to smooth out their earnings and conceal the levels of risk in their lending.

28
Q

What is the Origination fee charged for?

A

(% of borrowed funds)

Application and Processing fees.

Facilitates in selling a mortgage at a higher than it originally cost.

29
Q

What is the Servicing fee charged for?

A

Collecting monthly payments,
Sending payment notices,
Notifying overdue payments,
Maintaining records etc.

30
Q

How did Financial Institutions traditionally deal with a mortgage?

A

Traditionally, FIs would originate a mortgage, service it, and hold it on their balance sheets until it was paid off.

… This was before the secondary market however …

31
Q

What does the new secondary market for mortgages allow FI’s and Investors to do?

A

FI’s can originate the mortgages and then sell them on. They still earn the origination and servicing fees.

Investors who couldn’t originate mortgages can now buy them in the secondary market. This allows them to diversify into a new and liquid market.

32
Q

What is the purpose of Securitisation?

A

Mortgages used to be entirely illiquid asset for FI’s, but securitisation makes them liquid.

33
Q

What does securitisation of a mortgage allow?

A

FI’s can get asset off their balance sheet.

Investors get a new and liquid asset class (meaning cheaper finance for borrowers)

Structure of securitised assets can be manipulated to give the type of properties which investors want, through financial engineering.

Due to the aforementioned FE, it was thought risks are spread more widely across different lenders. But this is not the case, due to reputation and legal repurcussions.

34
Q

What are Bond markets famous for?

A

Very high liquidity.

35
Q

What caused the spread of the originate-and-sell model?

A

Fees form instant profit/revenue
Remembering that mortgage-lending is restricted and Gearing is risky;
Selling relieves gearing and creates space for more originating.
Thus running the Originate-and-Sell cycle while harvesting all the fees.

36
Q

What advantage does securitisation have for the Issuer?

A

Risk attached to these loans is passed on, and the profit locked in by the issuer. (Though not always)

37
Q

What made the Originate-and-Sell model dangerous?

A

Originators lost interest in the credit rating of Debtors, as this did not affect them. Credit Ratings did not see this. Money was made simply on volumes sold, not on the quality.

As long as there was confidence that that security would sell, quality is irrelevant.

38
Q

What factors led to the decline in mortgage quality control?

A

FI’s did not have reason to care, as they themselves (supposedly) owned none of the debt, but distributed them all.

Investors didn’t notice, as they relied on the ratings agencies who gave assets excellent ratings.

Ratings agencies didn’t notice.

39
Q

Why didn’t Ratings agencies see the fall in Mortgage quality?

A

They were paid by the originators
Their models were backward-looking
The Agencies were socially inferior to Wall Street
The Agencies themselves had very little hard data

40
Q

What was the FI’s assumption that may have caused the Credit crunch?

A

They assumed that securitisation took all the risk away from them.

41
Q

What kind of loans did FI’s hold before the Credit crunch?

A

Loans which had not yet been securitised and sold (Pipeline risk)

Loans which were difficult to sell, formed of the least attractive tranches.

42
Q

How did FI’s take on risk from SPV’s?

A

They took on the liabilities of their SPV’s because of the legal and reputational risks.

Some found that other parts of their own organisation had invested in sub-prime exposure.

43
Q

Why were mortgage failings a shock to the whole system?

A

There was no knowledge of the Mortgage bondholders and the Risk holders. They may have been institutions. This often led to banks suspicions on others leading to the Credit Crunch.

44
Q

Why was there difficulty in finding the loser in the Credit crunch?

A

The trading of underlying mortgage assets as securitised assets, and the use of credit derivatives (Like Credit Default Swaps) meant that it was hard to identify who had suffered these losses.

Banks started to fear that any of their trading partners might now default.

45
Q

Which banks were most likely to fail in the face of the Credit crunch?

A

The banks which were most highly geared, and had made the greatest losses, were the first to fail.

46
Q

What are 3 types of Securitisation?

A

Mortgage Backed Securities (MBS’s)
Pass-through strips (IO’s and PO’s)
Collateralised Mortgage Obligations (CMO)

47
Q

What is a SPV?

A

Institutions separate from their parent firm.
Fully-Financed by mortgage bonds;
- SPV pays coupons from FI to bondholders
- SPV pays profit to FI
—–> Assets are (packaged) mortgages.

48
Q

What are MBS’s?

A

Defined as pass-through securities. A large group of mortgages are pooled together. All monthly interest and principal payments from these borrowers then flow to an SPV, which then passes them on to the owners of the MBS.

FI earns a fee for this service, which it extracts from the interest paid to the MBS owners.

49
Q

What are the roles of GNMA, FNMA and FHLMC in the formation of MBS’s?

A

GNMA guarantees interest and principal to investors who purchase MBS.
FNMA and FHLMC purchase mortgages from other FI’s and sell MBS.

50
Q

What is PIPS?

A

Publicly Issued Pass-through Securities

PIPS - insured through private insurance companies

51
Q

What are CMO’s?

A 
Collateralised Mortgage Obligations
A multi-class pass-through with a number of different bondholder tranches. Issuing a CMO is equivalent to double securitisation.
- Mortgages are packaged and a GNMA pass-through is issued.
- An IB buys this issue, places them as collateral with an SPV, and issues different classes of bond.
52
Q

How are payments carried out for a CMO?

A

Principal payments initially all go to the first tranche. When these are fully repaid, repayments all go to the second tranche. This process continues until principal payments are made to the owners of the last class.

53
Q

How did the CC affect SPV in a way that caused loss for FI’s?

A

The Assets of SPV were wiped as house prices collapsed and borrowers defaulted.
The parent FI’s were sued for negligence, in turn their reputation was also affected. Some banks even held in-house SPV’s.

54
Q

What are the features of the highest and lowest CMO tranches?

A

Last loss
First returns
Lowest interest paid

First loss
Last returns
Highest interest paid

55
Q

What did tranching allow?

A

The reallocation of risk into specific parts (Tranches). This makes investors happy, as they (supposedly) can choose their risk exposure.

This earns FI’s much more profits.

56
Q

How do IO and PO instruments work?

A 
Assets can be split into two types.
Interest Only (IO): [ Prepayment Unfavourable ]
The investor only earns the interest from the asset, and receives nothing on maturity.
Principal Only (PO): [ Prepayment Favourable ]
The investor only earns the principle that is paid on maturity by the borrower.
57
Q

What is the difference between Aganecy and Non-Agency CMO’s?

A

Agency CMO’s have a government guarantee against default. They just re-distribute prepayment risk.

Non-Agency CMO’s have no guarantee, so they are generally created with some kind of credit enhancement.

58
Q

What are the different types of Credit Enhancement techniques?

A

Credit tranching
Excess spread
Excess collateral
Insurance from an insurer

59
Q

How could we describe the credit tranching technique?

A

This is a technique for redistributing credit risk, in the same way that other CMO’s use tranching to redistribute prepayment risk.

These tranches are given separate credit ratings by ratings agencies. Many senior tranches of sub-prime CMO’s were given AAA ratings.

60
Q

What is CMO squared?

A

When the B-rate tranches of a certain class is re-tranched into varying risk levels. This creates even more low-risk assets and further returns.

61
Q

How does Prepayment risk affect the value of IO strips and PO strips?

A

The ‘Pass-through strips’ are a piece of engineering that creates new assets which investors want as it provides them with control over their exposure to Prepayment risk.

  • Ppmt reduces value of IO strips (interest payments cease earlier)
  • Ppmt increases value of PO strips (Principal repaid earlier)
62
Q

Why are underlying assumptions so vital to CMO’s?

A

A small miscalculation of assumptions can have disastrous effects on even the higher tranches (like 2nd tranche)

63
Q

What are other types of assets that have been turned into Asset Backed Securities? Why?

A

Junk bunds
Automobile loans
Credit card receivables
Commercial and Industrial loans

More Asset classes are favourable due to diversification opportunities.

64
Q

What are advantages that securitisation brings to mortgages?

A

Securitisation makes these assets liquid. This allows risk to be spread more widely.

65
Q

How is Financial Engineering (like securitisation) used in the mortgage market?

A

Mortgage lending is a huge market, though it is inherently risky.

Financial Engineering can be used to give CMO’s a range of properties which will appeal to different types of investor.

66
Q

What chapters are we expected to analyse or ‘Mortgages’?

A

Madura Ch. 9
Valdez/Molyneux Ch. 9 (Securitisation)
Howells/Bain 13.4

Financial Markets and Institutions (7 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions