[2008] Topic 55: Understanding the Securitization of Subprime Mortgage Credit identified, mortgage, following

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AIM 2: List and discuss the seven key frictions in the subprime mortgage securitization that the authors identified and how they have affected the process.

1、Which of the following frictions are NOT considered adverse selection problems?

A) Originator and arranger.

B) Servicer and credit rating agencies.

C) Asset manager and arranger.

D) Mortgagor and regulators.

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The correct answer is B

Servicer and credit rating agencies face a moral hazard problem since the servicer may take actions that enhance their cash flow position but negatively impact the reputation of the credit rating agency.

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2、Which of the following frictions is NOT discussed in Ashcraft and Schuermann?

A) Adverse selection between originator and arranger.

B) Adverse selection between borrower and appraiser.

C) Moral hazard between asset manager and investor.

D) Moral hazard between servicer and investor.

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The correct answer is B

The relationship between the borrower and appraiser is not discussed in the reading.

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3、Which of the following demonstrates potential adverse selection?

A) Arranger does not perform adequate due diligence on the asset manager.

B) Originator has better information than the borrower.

C) Investors do not understand the investment strategy of the asset manager.

D) Arranger securitizes the lower quality mortgages.

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The correct answer is D

The arranger has better information about the individual mortgages and may retain the higher quality mortgages and pool the lower quality ones. The asset manager performs the due diligence on the arranger. The borrower has better information than the originator. Investors not understanding the investment strategy of the asset manager describe a moral hazard problem.

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4、Which of the following does NOT represent moral hazard?

A) Investor can observe the asset manager effort level.

B) In default, borrowers may not perform maintenance on the property.

C) Servicer prefers to modify loan terms rather than foreclose to generate additional fees.

D) Servicer is responsible for insurance and taxes in delinquency so servicer may exaggerate fees and expenses.

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The correct answer is A

Moral hazard occurs if the investors cannot observe the effort level of asset managers. All other choices are correct.

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AIM 4: Discuss the characteristics of the subprime mortgage market, including the creditworthiness of the typical borrower, the features and performance of subprime loan.

1、Mr. Benjamin Wong is the senior loan officer for Big Apple Bank and is reviewing the Woodfields mortgage application. He has collected the following financial information about the couple:

Average gross salary last 3 years ($100,000)

Debt service ratio of 55%

2 charge offs on consumer credit

No bankruptcy filings in the last 7 years

Individual FICO scores of 670 and 620

How should Mr. Wong best characterize the Woodfields?

A) Prime borrowers.

B) Alt-A borrowers.

C) First-lien borrowers.

D) Sub-prime borrowers.

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The correct answer is D

High debt to service ratio, charge offs and low average FICO scores are indicative of sub-prime borrowers. Sub-prime borrowers may have had previous bankruptcies but it is not required.