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 excided 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:
- It is cheaper to purchase exposure to an asset through a swap than to purchase the asset directly.
- Only the senior section must be funded.
- It takes less time to assemble the portfolio.
- A bank can use a synthetic CDO to take debt off the balance sheet without the consent of borrowers.
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, repayment 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 interested in diversifying her portfolio by purchasing European securities. Price is not a fan of the European market and tries to dissuade Peterson, who he knows prefers MBS. He makes the following arguments:
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The U.S. MBS market has delivered stronger growth than the European market.
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Mortgage loans need not be marked to market in the U.S.
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Standardized credit-scoring systems in the U.S. make it easier for lenders to assess risk.
Camby, however, disagrees with his father-in-law. He suggests that Peterson invest in Europe, citing two advantages:
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Europeans are more likely to own their homes than Americans.
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In Europe, mortgage debt represents a smaller portion of gross domestic product (GDP) than it does in the U.S.
Peterson is not sure which of the men is correct, and she asks for more details about the European market. Price explains that spotty data on mortgage loans hinders growth in the European market, adding that at times data presentation is inconsistent even in different parts of the same country. New valuation models are becoming more sophisticated, Camby added, postulating that as such models come into wider use in Europe, the region will see higher growth.
What affect will the shifting-interest mechanism connected to the ABS backed by home-improvement loans have on the senior tranches?
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Credit Risk? |
Prepayment Risk? |
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 58.d)
The ABS Price and Camby discussion at lunch is most likely backed by:
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A) |
Small Business Administration (SBA) loans. | |
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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 58.e)
With regard to statements made by Price and Camby to Peterson regarding the characteristics of the European and U.S. MBS market:
All of Price’s statements are technically correct, but Camby said Europeans were more likely to own homes than Americans - this is incorrect. (Study Session 15, LOS 57.a)
Which of Camby’s statements about the advantage of synthetic CDOs is least accurate?
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A) |
A bank can use a synthetic CDO to take debt off the balance sheet without the consent of borrowers. | |
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B) |
Only the senior section must be funded. | |
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C) |
It is cheaper to purchase exposure to an asset through a swap than to purchase the asset directly. | |
For a synthetic CDO, only the junior section must be funded. The other statements are accurate. (Study Session 15, LOS 58.f)
Camby’s preference for Glendo’s bonds suggests he is most likely concerned about:
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 58.b)
To further advance his case in favor of the U.S. MBS market relative to the European market, Price’s most accurate argument is:
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how a shortage of mortgage-servicing firms is slowing growth. | |
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B) |
the illiquidity of the market for securitized loans. | |
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the fact that most European mortgage debt is funded through retail deposits. | |
One of the statements are incorrect. The market for securitized loans in Europe is very liquid. The statement about the funding of mortgage debt through retail deposits, although accurate, is not a compelling argument for or against the European market. However, the statement about a lack of mortgage servicers is both accurate and reflective of a weakness in the European market. (Study Session 15, LOS 57.a) | 
发表于 2010-4-21 13:44
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