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Reading 56: Mortgage-Backed Sector of the Bond Market Los f~Q

 

Q10. Scott Walters is an investment manager who considers an investment in an asset-backed security (ABS) that consists of the loans in Table 1. Table 2 includes the ABS tranches from which he can select.

Table 1
Characteristics of Loan Pool

Loan Group

Amount

Weight in Pool

Gross Coupon

Maturity (Years)

Servicing Fee (bp)

Net Coupon

1

$200,000,000

16.33%

8.25%

25

50

7.50%

2

$250,000,000

20.41%

7.70%

25

7.10%

3

$325,000,000

26.53%

6.90%

25

6.10%

4

$450,000,000

36.73%

9.20%

25

8.20%

Total

$1,225,000,000

100.00%

 

Weighted Average

8.13%

25.00

50.00

7.30%

 

Table 2
ABS Tranches of the Loan Pool

 

Amount

Percent of Total

Senior Tranche

$700,000,000

58.33%

Subordinated Tranche 1

$300,000,000

25.00%

Subordinated Tranche 2

$100,000,000

8.33%

Subordinated Tranche 3

$100,000,000

8.33%

Total

$1,200,000,000

100.00%

Table 3 lists the prepayment percentages of the tranches in Table 2.

Table 3
Prepayment Allocation

Years after Issuance

Senior Tranche

Subordinated Tranche 1

Subordinated Tranche 2

Subordinated Tranche 3

1-5

90.00%

5.00%

3.00%

2.00%

6-10

70.00%

15.00%

10.00%

5.00%

11-15

50.00%

25.00%

15.00%

10.00%

after year 15

30.00%

30.00%

25.00%

15.00%

Walters has long dealt with mortgage-backed securities (MBS) and is trying to understand the terminology in the ABS market. In particular, he is interested in the relationship between an MBS passthrough and collateralized mortgage obligation (CMO) and an ABS paythrough structure.

Walters wonders why the prepayment percentages change over the life of the security. Which of the following best describes the rationale for this property? The prepayment allocations attempt to:

A)   increase the maturity of junior subordinated tranches.

B)   protect the structure in the event that credit losses reduce the subordinated tranches below their minimum value.

C)   limit the extension risk of the senior tranche.

 

Q11. Walters learns that the difference between the net coupons given and the stated 50 bp servicing fee is held as an excess servicing spread. Which of the following is least likely a purpose of the excess servicing spread in Table 1?

A)   Paying for administrative and managerial expenses.

B)   Establishing an account to pay for possible future losses.

C)   Augmenting external credit enhancements.

 

Q12. Which of the following best describes the relationship between the MBS passthrough and CMO and an ABS paythrough? An ABS paythrough structure is:

A)   created from an ABS passthrough structure in the same way a CMO is created from an MBS passthrough.

B)   similar to an MBS passthrough security except when using non-agency-based mortgages as collateral.

C)   created directly from the underlying loans unlike the way a CMO is created from an MBS passthrough.

 

Q13. An older investor with a short time horizon and a strong desire for extra income wishes to purchase a MBS or ABS. Which of the following is the most accurate choice?

A)   Investment-grade bonds with short maturities, rather than ABS or MBSs.

B)   Subordinated tranche 3 from the loan detailed above.

C)   The senior tranche from the loan detailed above.

 

Q14. Suppose all of the securities in Table 1 were backed by auto loans. Which of the following statements most accurately describes the difference, if any, in prepayment characteristics of auto loans versus mortgages? Prepayments on auto loans:

A)   rarely occur, since auto loans traditionally have short maturities and low interest rates.

B)   occur frequently, but are rarely affected by refinancing.

C)   are affected by the same factors as mortgage prepayments.

 

Q15. Based on the information in the tables above, which investment offers the most protection against default?

A)   Loan group 3.

B)   The senior tranche.

C)   Loan group 4.

 

Q16. Which of the following is the best definition of extension risk? The adverse consequences of:

A)   increasing interest rates on passthrough securities.

B)   lower prepayment rates.

C)   declining interest rates on passthrough securities.

 

Q17. Which of the following is the best definition of contraction risk? The adverse consequences of:

A)   declining interest rates on passthrough securities.

B)   lower prepayment rates.

C)   expected prepayment rates.

 

Q18. Which of the following statements is FALSE regarding prepayment risk?

A)   Reinvestment rate risk is a result of rising interest rates.

B)   Contraction risk refers to the shortening of the expected life of the mortgage pool due to falling interest rates.

C)   Investor in mortgage-backed securities must reinvest at lower rates when rates fall and borrowers prepay and are "stuck" with lower rates when rates rise and borrowers hold onto their mortgages.

 

Q19. All of the following are factors that affect prepayments EXCEPT:

A)   seasoning.

B)   the amount of overall mortgage loan activity in the market.

C)   characteristics of underlying mortgage loans.

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