There are several types of external credit enhancements. All of the following are examples of external credit enhancements EXCEPT:
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Setting aside reserve funds is an example of internal, not external credit enhancement.
The investment policy committee of Worthy, Drummond, Bakerslee & Corrier has decided to devote this month’s overview meeting to a review of the firm’s asset-backed securities (ABS) investments. Worthy Drummond runs several billion dollars of fixed income securities in a variety of portfolios, and the members of the investment policy committee are becoming concerned about the impact of economic weakness on credit quality.
Jamison Bakerslee has recently led a project to review the guarantees on some of the firm’s ABS. He reports to the policy committee that one of the main guarantors of Worthy Drummond’s ABS portfolio, First Credit Systems, Inc., is the subject of rumors about a credit downgrade. Bakerslee points out, “If First Credit is downgraded, that means many of the issues we hold may be downgraded as well, since they have ratings that are already as high as First Credit’s current rating.” Lucinda Corrier agrees that a First Credit downgrade would be a potential problem, since “First Credit’s guarantee protects us against losses before the internal credit enhancements are used.”
Internal credit enhancements are of primary interest to Worthy Drummond because many of the securities the firm holds are in subordinated tranches. The policy committee is particularly concerned about its investments in a pool of boat loans that are not subject to any third-party guarantees. The pool consists of three tranches:
Senior tranche $460 million
Subordinated tranche A 90 million
Subordinated tranche B 50 million
The collateral for the pool of boat loans is $657 million.
Corrier, however, is more concerned about prepayment risk across the portfolio if economic weakness causes interest rates to decline. She reminds the investment policy committee, “Our auto loan-backed securities face the same prepayment risk that our collateralized mortgage obligations (CMOs) do.” Bakerslee points out that the firm’s investments in credit card receivable backed securities will still be in the lockout period for another two years, “so we don’t have to worry about prepayment of principal on those right now.”
What is the amount of overcollateralization on the pool of boat loans?
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The pool of boat loans totals ($460 + 90 + 50 = ) $600 million dollars, and has collateral of $657 million. Overcollateralization = $657 million - $600 million = $57 million. (Study Session 15, LOS 56.d)
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If the pool of boat loans suffers $154 million in losses, the losses will be first absorbed by the $57 million in overcollateralization. That leaves ($154 – 57 = ) $97 million in losses to be distributed among the tranches. Subordinated tranche B will lose $50 million, leaving ($97 – 50 = ) $47 million in losses for holders of subordinated tranche A. (Study Session 15, LOS 56.d)
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The guarantee of a third party cannot provide a credit rating higher than the credit rating of the third party itself. Thus, if Worthy Drummond’s securities already have credit ratings as high as First Credit’s own rating and First Credit’s rating is downgraded; the credit ratings on the guaranteed securities will likely be downgraded. Bakerslee’s comment is correct. Third party guarantees (an external credit enhancement) protect against losses before internal credit enhancements are used. Corrier’s statement is also correct. (Study Session 15, LOS 56.d)
Statement 1:
Corporate guarantees, bond insurance and cash reserve funds are all examples of external credit enhancements.
Statement 2:
The effectiveness of default protection offered by excess servicing spread funds can diminish if defaults are below initial projections.
Statement 3:
Third-party guarantees impose a limit on the guarantor’s liability for losses at a specified level.
Statement 4:
Cash reserve funds come from issuance proceeds.
Which of the following regarding Taylor’s statements is most accurate?
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Cash reserve funds are internal, not external, credit enhancements, therefore Statement 1 is incorrect. The effectiveness of default protection offered by excess servicing spread funds can diminish if defaults exceed certain projections. Defaults that are below projections would be a positive occurrence and would not cause protection provided by the servicing spread to decline – Statement 2 is incorrect. Statements 3 and 4 are both correct statements. (Study Session 15, LOS 56.d)
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No principal is paid to the ABS holders during the lockout period, so there can be no prepayment risk at that time. Bakerslee’s statement is correct. The prepayments from a pool of auto loans are much more predictable and much less dependent on interest rate changes than prepayments on mortgage loans. Corrier’s statement is incorrect. (Study Session 15, LOS 56.b)
Point 1:
Under a bullet payment structure, investors receive the total principal amount in a single payment.
Point 2:
Prepayment risk applies to individual non-amortizing loans.
Which of the following regarding Drummond’s points is most accurate?
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Point 1 is correct – under a bullet payment structure, investors receive the total principal amount in a single sum. Point 2 is incorrect - prepayment risk does not apply to individual non-amortizing loans because they have no scheduled principal payments. (Study Session 15, LOS 56.e)
Which of the following are least likely examples of internal credit enhancements?
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Third party guarantees are external credit enhancements, not internal enhancements.
Which of the following is NOT a form of internal credit enhancement?
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A sequential-pay structure is not a credit enhancement. External credit enhancements are financial guarantees from third parties that generally support the performance of the bond. Internal credit enhancements do not rely on a third-party guarantee. They commonly include setting aside reserve funds and structures that contain senior and subordinated debt.
External credit enhancement least likely includes:
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External enhancements include corporate guarantees and bond insurance. A revenue fund is not an external enhancement it is an internal enhancement.
Which of the following is least likely an example of internal credit enhancement?
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Bond insurance is an example of external, not internal, credit enhancement.
Which of the following is a general problem associated with external credit enhancements? External credit enhancements:
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According to the “weak link” philosophy adopted by rating agencies, the credit quality of an issue can not be higher than the credit rating of the third-party guarantor. Along these lines, if the guarantor is downgraded, the issue itself could be subject to downgrade even if the structure is performing as expected.
Which of the following is a disadvantage of bond insurance as an external credit enhancement?
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Bond insurance provides for protection against losses when bonds default and includes both principal and interest payments. Issuers must weigh the costs of insurance against the decrease in required yield.
Which of the following is the best description of excess servicing spread accounts as an internal credit enhancement? Excess servicing spread accounts involve the allocation of:
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All excess cash is paid into the excess servicing spread account in order to be used to pay for possible future losses.
Which of the following is least likely a common form of external credit enhancement?
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External credit enhancements are financial guarantees from third parties that generally support the performance of the bond. Portfolio insurance is not a third party guarantee.
Which of the following is the best description of cash reserve funds as an internal credit enhancement? Cash reserve funds are investments in:
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Cash reserve funds are cash deposits that come from issuance proceeds. This excess cash provides for the establishment of a reserve account to pay for future losses. Cash reserve funds are usually used along with external credit enhancements.
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