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.

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.

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.

The correct answer is B

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

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.

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.

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.

The correct answer is A

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

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.

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.

2、Which of the following is the typical way an asset manager employs interest rate swaps in subprime securitized pools?

A) Short-term, pay fixed swap.

B) Long-term, pay fixed swap.

C) Short-term, receive fixed swap.

D) Long-term, receive fixed swap.

The correct answer is D

First, the fixed portion of subprime hybrid loans are short-term, typically 2 to 3 years. The floating portion is long-term. Second, the bank reduces its exposure to a floating rate inflow (asset) by entering into a pay-floating, receive-fixed swap.

AIM 5: Explain the structure of the securitization process of the subprime mortgage loans.

1、Investors in subprime securitized mortgage pools are protected from losses by all of the following methods EXCEPT:

A) Subordination of senior tranche.

B) Excess spread.

C) Performance triggers.

D) Interest rate swaps.

The correct answer is A

Subordination of equity tranches provides protection to investors by absorbing first losses.

2、Risk and return of subprime securitized tranches is best characterized by:

      Claim            Risk

A) Senior             Moderate

B) Mezzanine         Moderate

C) Equity             Low

D) Mezzanine         High

The correct answer is B

Mezzanine investors are behind senior but ahead of equity investors.

3、John Diego is reviewing two RMBS investments for his firm, First Light Capital, LLC. He has identified a senior tranche from a subprime securitized pool with a AA rating and a senior tranche from a conforming mortgage pool also with a AA rating. How should Mr. Diego rank the investments?

A) Conforming senior tranche is undervalued relative to the subprime senior tranche.

B) Conforming senior tranche is overvalued relative to the subprime senior tranche.

C) Neither is overvalued relative to the other.

D) Subprime senior tranche is overvalued relative to the conforming senior tranche.

The correct answer is C

Ratings assigned by credit rating agencies are supposed to summarize the total risk in the security so that any bond issue of the same rating offers the same risk-return rewards.

4、Which of the following is NOT true about the excess spread?

A) Excess spread is the net difference between weighted average mortgage rates and investor coupons.

B) Excess spread maybe negative.

C) Excess spread, when positive, is paid to senior tranche investors.

D) Excess spread protects all investors.

The correct answer is C

The excess spread is paid to equity tranche investors.

5、Which of the following factors is least likely to impact the analysis of excess spread?

A) Modeling potential interest rate paths.

B) Servicer quality.

C) Involuntary prepayments.

D) Voluntary prepayments.

The correct answer is B

Modeling potential interest rates paths and involuntary and voluntary prepayments have a direct impact on cash flow analysis and hence excess spread. The effect of servicer quality has a much less important effect.

AIM 6: Discuss the credit ratings process in the subprime mortgage backed securities.

1、Which of the following is NOT true about credit ratings of subprime securitized assets?

A) Rating agencies are compensated by the arrangers.

B) Rating agencies face an inherent moral hazard problem with servicers.

C) Ratings should rate “through the cycle”.

D) Ratings are based upon the originator.

The correct answer is D

Ratings are based upon the collateral in the pool, not the originator.

2、The Newest City Financial Corp has securitized a pool of subprime mortgages. The credit rating agency was not able to provide as a credit rating on the senior tranche as Newest City Financial Corp was expected. How could Newest City restructure the tranches to receive the higher credit rating?

A) Increase the size of the senior tranche and decrease the size of the equity tranche.

B) Increase the size of the senior tranche and increase the size of the equity tranche. 

C) Decrease the size of the senior tranche and increase the size of the equity tranche. 

D) Decrease the size of the senior tranche and decrease the size of the equity tranche.

The correct answer is C

To receive a higher credit rating, the senior tranche needs more protection. By increasing the equity tranche and decreasing the senior tranche size, more potential losses are diverted away from the senior tranche.

3、Suppose the credit rating agencies have recently issued many rating downgrades for securitized subprime mortgages. The mortgages were previously issued during stronger economic times and received high initial ratings. Which of the following statements is most accurate?

A) The agencies rated “through the cycle” since the pools are now more likely to default as the economy weakens.

B) The agencies rated “through the cycle” because the initial pools were highly rated.

C) The agencies did not rate “through the cycle” because the initial pools were highly rated.

D) The agencies did not rate “through the cycle” since the pools are now more likely to default as the economy weakens.

The correct answer is D

Rating agencies goal is to rate “through the cycle” where there are not excessive upgrades or downgrades as market conditions change. It is unreasonable to expect no ratings change but the emphasis is on “excessive” amount.

AIM 7: Discuss the implications credit ratings had on the emergence of subprime related mortgage backed securities and why the credit ratings fell short in this process.

1、Which of the following statements is TRUE about securitized mortgage pools and corporate credit ratings?

A) MBS ratings are based upon dynamic asset pools.

B) Both corporate and MBS bonds can infuse additional capital.

C) MBS pools exhibit greater variation in losses.

D) Degree of correlation between assets is more important for corporate bond ratings.

The correct answer is C

MBS ratings are based upon static pools. Only corporate bonds can infuse more capital into the firm. Degree of correlation is more important for MBS investors because the security is backed by a pool of assets.

AIM 11: Discuss the difference between predatory lending and borrowing.

1、Which of the following best illustrates predatory borrowing?

A) Jumbo loan with high LTV.

B) Conforming loan with high LTV.

C) Jumbo loan with low LTV.

D) Conforming loan with low LTV.

The correct answer is A

The riskiest borrower would be one who borrows a large amount with relatively little downpayment. Jumbo loans are above the conforming limit for GSE securitization and high LTV indicates low downpayment.

2、Which of the following best illustrates predatory lending?

A) Issuing sophisticated borrowers adjustable rate mortgages.

B) Issuing unsophisticated borrowers adjustable rate mortgages.

C) Issuing unsophisticated borrowers fixed rate mortgages.

D) Issuing sophisticated borrowers fixed rate mortgages.

The correct answer is B

Unsophisticated borrowers are most likely to underestimate the likelihood and magnitude of changes in payments from adjustable rate mortgages.

3、Predatory borrowing is most likely to occur under which economic environment?

A) Rapid home appreciation in high price real estate markets.

B) Rapid home appreciation in moderate price real estate markets.

C) Moderate home appreciation in high price markets.

D) Moderate home appreciation in moderate price markets.

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The correct answer is A

During rapid real estate markets, the borrowers are worried that the longer they wait to buy a home the higher the price. This is exacerbated in markets with high home prices. Therefore borrowers may overstate or falsify their creditworthiness because the risk of waiting is perceived as significant.

4、Helen and Harrison Woodfield are considering have agreed to purchase a new home for US$500,000. The bank requires a 20% downpayment which the Woodfields have in escrow. Recent sales of similar homes have sold for $450,000. Which describes the situation best?

A) Predatory lending.

B) Predatory borrowing.

C) Moral hazard between originator and investor.

D) Adverse selection between borrower and lender.

The correct answer is B

Based on similar home sales, the Woodfields are overpaying for their home and borrowing too much.

5、Examples of predatory lending include with of the following?

A) Inflating appraisals with cash-outs so the borrower cannot refinance.

B) Actual effective interest rates appear higher than they really are.

C) Lying on the mortgage application to purchase a more expensive home to refinance in the near future as prices appreciate.

D) Steering borrowers away from negative amortizing mortgages.

The correct answer is A

Predatory lending is when actual rates are higher than they seem. Lying on a mortgage application to purchase a more expensive home to later refinance as prices appreciate describes predatory borrowing not lending. Negative amortizing mortgages are very aggressive arrangements where the low teaser-rates do not cover the actual interest expense and the differential accrues as principal.