1.What is curtailment in relation to a mortgage?

A)   Payments that come in slower than expected.

B)   Prepayments of a mortgage for the entire amount.

C)   Prepayments of a mortgage for less than the full amount.

D)   A full default on the mortgage.

2.Which of the following is a characteristic of a mortgage loan?

A)   A very risky loan since it is unsecured.

B)   A loan that can be collateralized by real estate, financial securities, or any other personal asset.

C)   If the borrower defaults on the loan, the lender has the right to seize all assets of the borrower to ensure that the loan is paid off.

D)   If the borrower defaults on the loan, the lender has the right to seize the collateral.

3.Paul Advani, an unemployed telecommunications analyst, is scheduled to interview tomorrow with Manish Preeh, managing partner of the mortgage-banking division of Robust Investors. Since Advani has not worked in mortgage banking and his knowledge of the field is somewhat rusty, he asks to borrow a friend’s Level 2 CFA Study Notes so he can prepare for the interview.

After a brief introduction and a discussion of Advani’s resume, Preeh tells Advani he is concerned about the candidate’s familiarity with the industry. Preeh asks Advani a series of questions to test his knowledge.

Preeh begins with a question about prepayment rates and benchmarks. He asks Advani to name some conventions used as benchmarks for prepayment rates. Advani comes up with four benchmarks:

§ Conditional prepayment rates.

§ Single monthly mortality rates.

§ Nonconforming mortgage rates.

§ Public Securities Association prepayment benchmarks.

Then Preeh asks Advani to describe the use of excess servicing spreads as internal credit enhancements.

Preeh’s next question requires Advani to discuss reasons for using the stated maturity of a mortgage passthrough security versus using the average life measure. Advani responds that the security’s maturity is less valuable to bond analysis than is the average life measure.

Then Preeh turns the questions to Advani’s product knowledge. Preeh gives Advani four characteristics that allegedly apply to stripped mortgage-backed securities (MBS), then asks him which one of the characteristics is accurate. The characteristics are as follows:

§ Principal and interest are not allocated on a pro-rata basis.

§ Owners of these securities benefit from quick prepayments.

§ They pay significantly lower yields than their "whole" counterparts.

§ They are less volatile than the passthrough from which they were stripped.

Preeh proceeds to ask Advani how planned amortization class (PAC) bonds are protected against prepayment risk to create products that provide better asset and liability matching for institutional investors.

The interview ends with a question using the following data:

§ The single-monthly mortality rate (SMM) is equal to 0.003.

§ The mortgage balance for March is $250 million.

§ The scheduled principal payment is $3 million in March, and $3 million in April.

Which of the following characteristics best describes stripped mortgage-backed securities?

A)   Owners of these securities benefit from quick prepayments.

B)   They pay significantly lower yields than traditional MBS.

C)   Principal and interest are not allocated on a pro-rata basis.

D)   They are less volatile than the passthrough from which they were stripped.

4.Which of the following choices best completes the following sentence about excess servicing spreads? Excess servicing spread accounts involve the allocation of:

A)   surplus cash into a separate reserve account.

B)   the servicing fee into a separate reserve account.

C)   expenses into accounts for senior and subordinate tranches.

D)   cash deposits from issuance proceeds.

5.The estimated April prepayment is closest to:

A)   $732,000.

B)   $738,777.

C)   $729,777.

D)   $741,000.

6.Which of the following is NOT used as a benchmark for prepayment rates?

A)   Conditional prepayment rates.

B)   Nonconforming mortgage rates.

C)   Single monthly mortality rates.

D)   Public Securities Association rates.

7.Which of the following responses to Preeh’s question about PAC bonds is best? They:

A)   structure the PAC tranche so it has more contraction risk but less interest-rate risk than the support tranches.

B)   gain prepayment risk protection as their par value falls relative to that of the support tranche.

C)   accrue the interest for one tranche and redistribute it to the support tranches.

D)   do not attempt to provide a guaranteed principal repayment.

8.Advani’s assertion that the maturity is a less-useful analytical tool than the average life measure of a mortgage passthrough security is:

A)correct because the investor may not know the maturity, but can calculate the average life measure.

B)correct because the maturity does not take into account the assumed prepayment rate.

C)incorrect because the average life measure does not take interest-rate risk into account.

D)incorrect because the average life measure does not reflect the effects of economic cycles.

9.Which of the following is a characteristic of a fixed rate, level payment, fully amortized mortgage loan?

A)   Each payment includes interest on the borrowed amount only.

B)   Throughout the life of the mortgage, the interest portion of each payment increases.

C)   Each payment includes an equal portion of interest and amortized principal.

D)   The payments are such that at the end of the mortgage, the loan has been fully amortized.

10.Regarding a fixed-rate, level payment, and fully amortized mortgage loan, which of the following statements is FALSE?

A)   Principal repayment falls as interest payments rise over the life of the loan.

B)   Interest payments fall as principal payments rise over the life of the loan.

C)   Payments are equal over the life of the loan.

D)   Each payment consists of an interest component and a principal component.

11.Which of the following statements regarding mortgages is FALSE?

A)   Mortgages are collateralized by a piece of real property, either residential or commercial.

B)   The lender has the right to "foreclose" or lay claim against the real estate in the event of a loan default.

C)   Because mortgages are secured loans, mortgage insurance is unnecessary.

D)   In a conventional mortgage, the loan is based on the creditworthiness of the borrower.

12.Which of the following most accurately describes a mortgage loan?

A)   An unsecured loan to enable the borrower to finance a real estate property.

B)   A loan secured by the collateral of some specified real estate property.

C)   A commercial loan secured by the collateral of some specified real estate property.

D)   An unsecured commercial loan to enable the borrower to finance a real estate property.

1.What is curtailment in relation to a mortgage?

A)   Payments that come in slower than expected.

B)   Prepayments of a mortgage for the entire amount.

C)   Prepayments of a mortgage for less than the full amount.

D)   A full default on the mortgage.

The correct answer was C)

Curtailments are prepayments of mortgages for less than the full amount.

2.Which of the following is a characteristic of a mortgage loan?

A)   A very risky loan since it is unsecured.

B)   A loan that can be collateralized by real estate, financial securities, or any other personal asset.

C)   If the borrower defaults on the loan, the lender has the right to seize all assets of the borrower to ensure that the loan is paid off.

D)   If the borrower defaults on the loan, the lender has the right to seize the collateral.

The correct answer was D)

With a mortgage loan, 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 loan default.

A)   Owners of these securities benefit from quick prepayments.

B)   They pay significantly lower yields than traditional MBS.

C)   Principal and interest are not allocated on a pro-rata basis.

D)   They are less volatile than the passthrough from which they were stripped.

The correct answer was C)

Stripped mortgage-backed securities (MBS) differ from conventional MBS in that principal and interest are not allocated on a pro-rata basis, because they come in two flavors, principal-only and interest-only. PO and IO strips have different payment policies. Investors who buy interest-only strips want slow prepayments, as fast prepayments reduce the value of the cash flows. Yield characteristics differ greatly. PO strips can pay very high yields when prepayment rates are high. PO and IO strips are more volatile than the original security with both principal and interest payments.

4.Which of the following choices best completes the following sentence about excess servicing spreads? Excess servicing spread accounts involve the allocation of:

A)   surplus cash into a separate reserve account.

B)   the servicing fee into a separate reserve account.

C)   expenses into accounts for senior and subordinate tranches.

D)   cash deposits from issuance proceeds.

The correct answer was A)

Excess cash is paid into the excess servicing spread account in order to cover possible future losses. Servicing fees pay for services, not reserves against default risk. Excess servicing spreads have nothing to do with tranche structures, and cash deposits from issuance proceeds are called cash reserve funds.

5.The estimated April prepayment is closest to:

A)   $732,000.

B)   $738,777.

C)   $729,777.

D)   $741,000.

The correct answer was C)

The prepayment amount is computed as follows:

Prepayment amount = SMM x (beginning mortgage balance for a month - scheduled principal payment for the month) = For March, the prepayment is 0.003 x ($250 million - $3 million) = $741,000.
For April, the starting mortgage balance is $250 million - $3 million - $741,000 = $246.259 million.
The prepayment is 0.003 x ($246.259 million - $3 million) = $729,777.

6.Which of the following is NOT used as a benchmark for prepayment rates?

A)   Conditional prepayment rates.

B)   Nonconforming mortgage rates.

C)   Single monthly mortality rates.

D)   Public Securities Association rates.

The correct answer was B)

Two industry conventions have been adopted as benchmarks for prepayment rates:

1.   the conditional prepayment rate, which is used to compute single monthly mortality rates (SMM).

2.   the Public Securities Association (PSA) prepayment benchmark.

7.Which of the following responses to Preeh’s question about PAC bonds is best? They:

A)   structure the PAC tranche so it has more contraction risk but less interest-rate risk than the support tranches.

B)   gain prepayment risk protection as their par value falls relative to that of the support tranche.

C)   accrue the interest for one tranche and redistribute it to the support tranches.

D)   do not attempt to provide a guaranteed principal repayment.

The correct answer was B)

The PAC tranche has significant protection against prepayment risk at the expense of the support or companion tranches. The more the support tranche’s par value rises relative to that of the PAC bond, the better the protection against prepayment risk. PAC tranches are designed to deal with prepayment risk, and as such pass the contraction or extension risk onto the support tranches. PAC tranches can siphon interest slated for the support tranches, but do not redistribute it. In fact, PAC tranches are designed to provide a minimum guaranteed principal payment by collecting interest targeted for a support tranche when prepayments are low.

8.Advani’s assertion that the maturity is a less-useful analytical tool than the average life measure of a mortgage passthrough security is:

A)correct because the investor may not know the maturity, but can calculate the average life measure.

B)correct because the maturity does not take into account the assumed prepayment rate.

C)incorrect because the average life measure does not take interest-rate risk into account.

D)incorrect because the average life measure does not reflect the effects of economic cycles.

The correct answer was B)

The stated maturity of a mortgage pass-through security is unlikely to equal its true life because of prepayments. Average life is used because it represents the average time to receipt of both scheduled principal payments and expected prepayments. The average life measure attempts to reflect changes in prepayment rates, and as such takes into account likely changes in interest rates or the economic climate. Because the average life measure is a better analytical tool than the stated maturity, the answers starting with “incorrect” are wrong.

9.Which of the following is a characteristic of a fixed rate, level payment, fully amortized mortgage loan?

A)   Each payment includes interest on the borrowed amount only.

B)   Throughout the life of the mortgage, the interest portion of each payment increases.

C)   Each payment includes an equal portion of interest and amortized principal.

D)   The payments are such that at the end of the mortgage, the loan has been fully amortized.

The correct answer was D)

As time passes, the proportion of the equal monthly mortgage payment that represents interest decreases and the proportion that goes toward the repayment of principal increases. This process continues until the outstanding principal reaches zero and the loan is paid in full (fully amortized).

10.Regarding a fixed-rate, level payment, and fully amortized mortgage loan, which of the following statements is FALSE?

A)   Principal repayment falls as interest payments rise over the life of the loan.

B)   Interest payments fall as principal payments rise over the life of the loan.

C)   Payments are equal over the life of the loan.

D)   Each payment consists of an interest component and a principal component.

The correct answer was A)     

Interest payments fall as principal payments rise over the life of the loan, not the other way around.

11.Which of the following statements regarding mortgages is FALSE?

A)   Mortgages are collateralized by a piece of real property, either residential or commercial.

B)   The lender has the right to "foreclose" or lay claim against the real estate in the event of a loan default.

C)   Because mortgages are secured loans, mortgage insurance is unnecessary.

D)   In a conventional mortgage, the loan is based on the creditworthiness of the borrower.

The correct answer was C)

Mortgage insurance is often required, depending on the creditworthiness of the borrower or the amount of equity in the loan.

12.Which of the following most accurately describes a mortgage loan?

A)   An unsecured loan to enable the borrower to finance a real estate property.

B)   A loan secured by the collateral of some specified real estate property.

C)   A commercial loan secured by the collateral of some specified real estate property.

D)   An unsecured commercial loan to enable the borrower to finance a real estate property.

The correct answer was B)

A mortgage is a loan that is collateralized with a specific piece of real property, either residential or commercial.