Reading 58: LOS f ～ Q1- 5

1.Identify three risks associated with investing in mortgage backed securities (MBS). Risks associated with investing in MBS are:

A)   interest rate risk, default risk, and prepayment risk.

B)   extension risk, credit risk, and downgrade risk.

C)   servicing fee risk, downgrade risk, and prepayment risk.

D)   interest rate risk, contraction risk, and servicing fee risk.

The correct answer was A)

A mortgage is a loan that is collateralized with a specific piece of real property, either residential or commercial. The borrower must make a series of mortgage payments over the life of the loan, and the lender has the right to “foreclose” or lay claim against the real estate in the event of a loan default. A mortgage backed security represents a claim against a pool of mortgages. The cash flows from the pool are distributed amongst the holders of all the MBS as per the terms of the issue. 

Risks associated with investment in MBS: 

a. Interest rate risk: changes in the value of the MBS as interest rates change (usually inverse).

b. Default risk: risk that some or all of the borrowers default and the collateral is not enough to cover the entire mortgage. 

c. Prepayment risk: risk that the borrowers prepay as interest rates decline.

2.Prepayments or curtailments:

A)   will increase the amount of interest the lender receives over the life of the loan.

B)   have no impact on the amount of interest the lender receives over the life of the loan.

C)   cause the duration of the original mortgage to lengthen or increase.

D)   will reduce the amount of interest the lender receives over the life of the loan.

The correct answer was D)

Prepayments or curtailments will reduce the amount of interest the lender receives over the life of the loan.

3.Which of the following most accurately describes prepayments?

A)   A payment that pays the mortgage in full prior to maturity.

B)   Prepayment occurs if both interest and principal are paid before the end of the mortgage term.

C)   A payment made in excess of the monthly mortgage payment.

D)   A scheduled mortgage payment that includes scheduled amortization and interest.

The correct answer was C)

It is possible for a mortgage borrower to pay an amount in excess of the required payment or even to pay off the loan entirely. Payments in excess of the required monthly amount are called prepayments.

4.Prepayments cause the timing and amount of cash flows from mortgage loans and mortgage-backed securities (MBS) to be uncertain. Thus:

A)   the analyst must make specific assumptions about the rate at which prepayments of the pooled mortgages occurs when valuing the passthrough securities.

B)   the rate of prepayments is important to valuing the passthrough securities but is impossible to estimate.

C)   industry conventions need to be adopted as benchmarks for prepayment risk but have not been at this point.

D)   regulators mandate the convention firms must use when estimating prepayment rates.

The correct answer was A)

The analyst must make specific assumptions about the rate at which prepayments of the pooled mortgages occur when valuing the passthrough securities.

5.Payments in excess of the required monthly payment amount are called:

A)   passthroughs.

B)   prepayments.

C)   mega-payments.

D)   CMOs.

The correct answer was B)

Payments in excess of the required monthly payment amount are called prepayments.