Reading 57: Mortgage-Backed Sector of the Bond Market-LOS f 2011, following, mortgage, factors, likely

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Session 15: Fixed Income: Structured Securities
Reading 57: Mortgage-Backed Sector of the Bond Market

LOS f: Explain the factors that affect prepayments and the types of prepayment risks.

 

 

Which of the following mortgage loan characteristics least likely affects prepayments?

A) reputation of the lender with the agencies (e.g., Fannie Mae, Ginnie Mae).

B) original mortgage rate.

C) type of loan (e.g., 30-year fixed rate, 15-year variable).

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The reputation of the lender does not affect prepayments.

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Which of the following most accurately describes prepayments?

A) A payment made in excess of the monthly mortgage payment.

B) A payment that pays the mortgage in full prior to maturity.

C) Prepayment occurs if both interest and principal are paid before the end of the mortgage term.

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It is possible for a mortgage borrower to pay an amount in excess of the required payment or even to pay off the loan entirely. Payments in excess of the required monthly amount are called prepayments.

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Prepayments or curtailments:

A) cause the duration of the original mortgage to lengthen or increase.

B) will reduce the amount of interest the lender receives over the life of the loan.

C) will increase the amount of interest the lender receives over the life of the loan.

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Prepayments or curtailments will reduce the amount of interest the lender receives over the life of the loan.

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Identify three risks associated with investing in mortgage-backed securities (MBS). Risks associated with investing in MBS are:

A) interest rate risk, default risk, and prepayment risk.

B) interest rate risk, contraction risk, and servicing fee risk.

C) extension risk, credit risk, and downgrade risk.

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A mortgage is a loan that is collateralized with a specific piece of real property, either residential or commercial. 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 a loan default. An MBS represents a claim against a pool of mortgages. The cash flows from the pool are distributed amongst the holders of all the MBS as per the terms of the issue.

Risks associated with investment in MBS:

• Interest rate risk?changes in the value of the MBS as interest rates change (usually inverse).
• Default risk?risk that some or all of the borrowers default and the collateral is not enough to cover the entire mortgage.
• Prepayment risk?risk that the borrowers prepay as interest rates decline.

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Which of the following factors does NOT affect prepayments?

A) Housing turnover.

B) Defeasance.

C) Characteristics of the underlying mortgage pool.

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Defeasance is a type of call protection used in commercial loans.

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Which of the following best describes how a growing economy can affect prepayments? A growing economy:

A) leads to increasing prepayments.

B) does not affect prepayments.

C) leads to decreasing prepayments.

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The reason for this link is as follows: A growing economy leads to a rise in personal income and opportunities for worker migration and mobility. This results in higher housing turnover and therefore increasing prepayment rates.

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Which of the following best describes prepayment risk?

A) The lender's interest rate risk resulting from prepayments.

B) The risk associated with the unknown amount and timing of cash flow's resulting from prepayments.

C) The lender's spread risk resulting from prepayments.

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Mortgage prepayments reduce the amount of interest the lender receives over the life of the loan. The likelihood of this situation actually occurring is very real and is known as prepayment risk.

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Payments in excess of the required monthly payment amount are called:

A) mega-payments.

B) prepayments.

C) passthroughs.

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Payments in excess of the required monthly payment amount are called prepayments.

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Prepayments cause the timing and amount of cash flows from mortgage loans and mortgage-backed securities (MBS) to be uncertain. Thus:

A) the rate of prepayments is important to valuing the passthrough securities but is impossible to estimate.

B) the analyst must make specific assumptions about the rate at which prepayments of the pooled mortgages occurs when valuing the passthrough securities.

C) regulators mandate the convention firms must use when estimating prepayment rates.

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The analyst must make specific assumptions about the rate at which prepayments of the pooled mortgages occur when valuing the passthrough securities.

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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.

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A CMO is a paythrough structure. A pool of passthrough securities serves as collateral for CMO paythrough securities. In the ABS market, once the loans are pooled, either passthrough or paythrough securities may be issued – it is not necessary to first create passthroughs when creating a paythrough structure for an ABS. (Study Session 15, LOS 55.g)

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An investor who wants to avoid extension risk wishes to purchase securities from one of the ABS tranches listed above. Which of the following is the most appropriate choice for inclusion in his portfolio?

A) The senior tranche from the loan detailed above.

B) An equal allocation to the senior tranche and each of the subordinated tranches from the loan detailed above.

C) Subordinated tranche 3 from the loan detailed above.

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Investors with short time horizons and a need for current income wish to avoid extension risk. The senior tranche from the above loan pool offers a chance to collect high prepayments during the first several years (see table 3). The subordinated tranches are protected from contraction risk in the early years, and do not meet the investor’s needs. (Study Session 15, LOS 55.g)

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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.

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Car loans tend to balances that are small enough so that the benefits from refinancing are small. Auto-loan prepayments occur whenever a car is sold, traded in, or wrecked—all of which are relatively frequent occurrences. Consequently, they are not affected by all the same underlying factors as mortgage loans. (Study Session 15, LOS 56.e)

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

A) Loan group 4.

B) Loan group 3.

C) The senior tranche.

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Loan group 4 has the highest excess servicing spread (9.20 ? 8.20 ? 0.50 = 0.50 or 50 bp excess servicing spread), which allows for the largest reserves against losses. The tranches offer protection against expansion or contraction risk, but probably have similar characteristics in terms of default risk. (Study Session 15, LOS 56.d)