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Which of the following statements regarding securities backed by closed-end home equity loans is CORRECT?

A)	Prepayments are not allowed.

B)	The prepayment benchmark is issuer specific.

C)	The securities in those deals are typically floating-rate tranches.

In a passthrough structure, the principal cash flow from the credit card accounts are:

A)	paid to security holders on a pro rata basis.

B)	amoritized without penalty.

C)	never paid due to interest rate charges.

Financial consultant George Price advises high-net-worth individuals on income investments. His firm, Price Enterprises, specializes in asset-backed securities (ABS). Price’s son-in-law, Roger Camby, also works for the firm. Price and Camby do not get along well, and they often engage in heated arguments in the office.

On a certain morning, Price and Camby are arguing about which asset-backed securities (ABS) to purchase. Over the last two weeks, Price Enterprises signed up a half-dozen new clients and received several million in new funds from existing clients, and the company needs some new ideas for the portfolios.

Camby is excited about a new ABS issued by a large retailer, Glendo’s. The ABS reflects a bundle of nonamortizing consumer credit accounts. As usual, Price prefers a different option, in this case a new collateralized mortgage obligation (CMO) issued by Trident Mortgage. Both securities offer similar total return potential and seem reasonably valued. Both Camby and Price believe the other analyst’s preferred securities are too risky.

Unable to come to an agreement about which ABS to purchase, Camby and Price return to an old topic of discussion, the merits of collateralized debt obligations, (CDOs). Both analysts agree on the benefits of CDOs, which allow investors to profit off the spread between return on collateral and the cost of funding. But they disagree on the best strategy for constructing a CDO. Price prefers a simple cash CDO and criticizes Camby for his preference for more complicated synthetic securities. Camby argues that synthetic CDOs offer several advantages over cash CDOs:

Bindle Bonds, a consultancy that sets up payment structures for entities that wish to issue asset-backed securities, has a referral relationship with Price Enterprises. Just before lunch, Bindle sales director Marty Malkin calls Price to offer him a piece of a new ABS comprised of thousands of home-improvement loans. Price likes the interest rates and the senior/subordinated structure that contains several junior tranches and senior tranches. But during his analysis of the default and prepayment projections, Price becomes concerned that Bindle is underestimating the risks. In response to Price’s concerns, Malkin explains that the ABS has a shifting-interest mechanism designed to limit risk for the senior tranches.

After Price agrees to invest in the new Bindle ABS, he and Camby go to lunch. As they wait for their food, they discuss an investment a colleague pitched to Camby that morning. The ABS issuer used a conditional prepayment rate to estimate prepayment risks. According to the issuer’s model, prepayment risks are modest, in part because refinancing is not a major concern with the underlying securities. The underlying securities are fixed-rate loans, and their default risk is fairly high. One benefit of the securities is the fact that principal payments are immediately passed on to investors.

Immediately after Price and Camby return from lunch, Kay Peterson, a longtime client of Price Enterprises, comes into the office with questions about investing in the mortgage securities market. Price and Camby agree that this is an excellent time for Peterson to enter the MBS market, but disagree which mortgage securities would be best. Price believes Peterson’s best alternative would be a commercial MBS. Price makes the following arguments for CMBS:

Camby, however, disagrees with his father-in-law. He suggests that Peterson should invest in residential MBS, citing the following reasons:

What affect will the shifting-interest mechanism connected to the ABS backed by home-improvement loans have on the senior tranches?

Shifting-interest mechanisms reduce the proportional share of the outstanding loan balance in junior tranches as prepayments occur. This has the effect of reducing credit risk for the senior tranches but increasing their prepayment risk. (Study Session 15, LOS 56.d)

A)	Small Business Administration (SBA) loans.

B)	auto loans.

C)	home-equity loans.

The low prepayment risk eliminates home-equity loans, which have a high prepayment risk. The fact that the loans have a fixed interest rate suggests they are not SBA loans, most of which have a variable rate. That leaves auto loans, and the characteristics of the ABS presented in the vignette can all apply to auto-loan-backed securities. (Study Session 15, LOS 56.e)

A)	Only the senior section must be funded.

B)	A bank can use a synthetic CDO to take debt off the balance sheet without the consent of borrowers.

C)	It is cheaper to purchase exposure to an asset through a swap than to purchase the asset directly.

We have little information about the Glendo’s and Trident bonds. All we know is that the Glendo’s ABS is backed by consumer credit accounts, while the Trident securities are backed by mortgage loans. Most consumer-credit accounts are nonrevolving, meaning that during the lockout period, any prepayments will be invested in new loans. As such, the Glendo’s ABS probably has less prepayment risk than the Trident ABS. We don’t know enough about the loans to conclude anything about their credit or interest-rate risk. But the difference in prepayment risk is apparent. Camby’s preference for Glendo’s suggest he wants to avoid prepayment risk. (Study Session 15, LOS 56.b)

A)	only one statement is correct.

B)	both statements are correct.

C)	both statements are incorrect.

Only one of Price’s statements is correct regarding commercial MBS. He is correct that contraction risk on a CMBS can be lowered by adding prepayment lock out periods and yield maintenance charges, as well as other loan-level call protections such as defeasance and prepayment penalty points. Price is incorrect to state that a low debt-to-service coverage ratio makes a CMBS attractive. A high debt-to-service coverage ratio and low loan-to-value ratio are better for lenders. (Study Session 15, LOS 55.l)

A)	both statements are correct.

B)	both statements are incorrect.

C)	only one statement is correct.

Camby is incorrect in stating residential MBS have more certain cash flows than a CMBS because you can rely on their government-backed guarantee. Although it is true that government agency issued MBS do come with a pseudo-governmental guarantee, many residential MBS are non-agency issued, meaning they are issued by private entities and do not come with a government guarantee.

Camby’s statement regarding a CMBS defeasance clause is incorrect. If the borrower makes early payments on the mortgage loan, the mortgage loan can be defeased, which means the loan proceeds are received by the loan servicer and invested in U.S. Treasury securities, essentially creating cash collateral against the loan. Treasuries provide higher-quality collateral than the underlying real estate, so loans structured with defeasance increase the credit quality of a CMBS loan pool. (Study Session 15, LOS 55.l)

The measure of prepayments associated with securities backed by auto loans is called:

A)	auto-backed prepayments.

B)	collateralized prepayment speed.

C)	absolute prepayment speed.

Relative to mortgage-backed securities and home equity loan-backed assets, prepayments for manufactured housing-backed securities are:

A)	more significant because the underlying loans are more sensitive to refinancing.

B)	less significant because the underlying loans are not as sensitive to refinancing.

C)	equally as significant.

Relative to mortgage-backed securities and home equity loan-backed assets, prepayments for manufactured housing-backed securities are less significant because the underlying loans are not as sensitive to refinancing.

How is the principal retired when an early amortization provision is triggered? It is retired by:

A)	maturing credit card receivable-backed securities immediately.

B)	paying credit card borrowers' principal payments directly to investors without using them to purchase more receivables.

C)	reinvesting credit card borrowers' principal payments in receivables.

When early amortization occurs, the credit card tranches are retired sequentially. This is accomplished by paying prepayments to investors instead of using them to purchase more receivables.

A closed-end home equity loan (HEL) is a secondary mortgage that is structured like:

A)	a variable rate, amortizing loan.

B)	a standard, fixed-rate, fully amortizing loan.

C)	a standard balloon payment loan.

Prepayments are more stable for manufactured housing-backed securities (HBS) because:

A)	borrowers are not sensitive to refinancing since they have few alternative financing sources.

B)	manufactured housing securities have very high interest rates.

C)	manufactured housing loans are too large to be marketed separately.

Prepayments for manufactured housing-backed securities are less significant because the underlying loans are not as sensitive to refinancing. This is correct for all of the following reasons EXCEPT:

A)	Loan balances are usually small, reducing the savings resulting from refinancing.

B)	Often borrowers are using Federal Housing Administration (FHA) and Veterans Administration (VA) loans, which prohibit refinancing.

C)	Depreciation of mobile homes in the early years can cause the loan outstanding to be greater than the value of the asset.

Borrowers are not necessarily borrowing through the FHA or VA, and even if they were, they would not be prohibited from refinancing.

A home equity loan (HEL) is a loan backed by residential property. Which of the following generally does NOT describe a HEL?

A)	It is frequently a first lien on property owned by a borrower with an excellent credit history.

B)	The loan often does not meet agency requirements for a qualified loan.

C)	It is frequently a first lien on property owned by a borrower with a marginal credit history.

Which of the following statements concerning the early amortization trigger for a credit card receivable-backed security is CORRECT? An early amortization trigger leads to:

A)	partial default.

B)	the principal payments made by credit card holders being reinvested in receivables.

C)	credit card tranches being retired sequentially.

The most frequent trigger is when the 3-month average excess spread earned on the receivables falls to zero or less. When this happens, prepayments are used to retire credit card tranches sequentially, instead of using them to purchase more receivables.

Which of the following is referred to as principal-amortization period for a credit card receivable-backed security? The principal-amortization period is the period during which the:

A)	principal is reinvested.

B)	principal is no longer reinvested, but paid to investors.

C)	interest is reinvested.

Since credit card balances are revolving, principal is not amortized. As such, interest on credit card ABSs is paid periodically and the principal is placed under a “lockout period,” during which time no principal is paid to the ABS holders. Principal payments made during the lockout period are used to purchase additional underlying assets or receivables. Once the lockout period ends, principal payments are passed on to the security holders. This post-lockout period is known as the “principal amortization period.”

Which of the following statements regarding credit card receivable-backed securities is least accurate?

A)	Credit card receivable-backed securities use a master trust structure.

B)	The cash flow to the pool of credit card receivables consists of finance charges, fees, and principal repayment.

C)	Credit card receivable-backed securities pay principal and interest each payment just like a mortgage-backed security.

Credit card receivable-backed securities do not pay principal and interest each payment just like a mortgage-backed security. Interest is paid periodically and principal is placed under a lockout period.

Which of the following statements regarding Small Business Administration (SBA) loan-backed securities is least accurate?

A)	Loan payments are based on the reference rate at the beginning of each period.

B)	The interest rate on SBA loans is reset monthly or quarterly.

C)	Pooled SBA loans are fairly heterogeneous.

Pooled Small Business Administration (SBA) loans must have similar terms and features. SBA loan payments are based on the reference rate at the beginning of each period.

Which of the following statements regarding Small Business Administration (SBA) loan-backed securities is least accurate?

A)	SBA loans are backed by the credit of the U.S. government.

B)	Prepayments on SBA loans are not passed through.

C)	Most SBA loans are based on the prime rate.

SBA loans are backed by the credit of the U.S. government. Most SBA loans are variable rate, where the rate is based on prime and reset monthly or quarterly. The investor receives three cash flows: interest, principal repayment and principal prepayments.

Which of the following statements regarding student loan asset-backed securities (SLABs) is least accurate?

A)	Interest accrues on the loan during the deferment period.

B)	Loan repayments are based on a reference rate plus a margin.

C)	Prepayments occur when government guarantees are paid in the case of defaults.

In student loan asset-backed securities (SLABs), there are three periods. During the deferment period, the borrower makes no payments and the loan accrues no interest. During the loan repayment period, the borrower makes principal and interest payments based on a reference rate plus margin. Prepayments may occur because government guarantees are paid when there are defaults.

Which of the following regarding student loan asset-backed securities (SLABs) is least accurate?

A)	Federal Family Education Loan Program (FFELP) loans are guaranteed up to 98% of principal and accrued interest.

B)	The borrower makes no payment during the deferment period and no interest accrues.

C)	Alternative loans are securitized and guaranteed by the U.S. government.

With U.S. government FFELP loans, the government guarantees of up to 98% of principal and accrued interest. Alternative loans (student loans not in the FFELP) are securitized, but not guaranteed by the U.S. government. In general, there are three periods with SLABs. During the deferment period, the borrower makes no payments and the loan accrues no interest. During the grace period, the borrower makes no payments but the loan accrues interest. During the loan repayment period, the borrower makes principal and interest payments based on a reference rate plus margin.