Reading 62: Overview of Bond Sectors and Instruments LOS e习 likely, security, following, 2010

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LOS e, (Part 1): Describe the types and characteristics of mortgage-backed securities.

Which of the following is least likely a cash flow that results from a mortgage-backed security?

A) Mortgage processing fees and charges.

B) Prepayments.

C) Net interest.

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Mortgage processing fees and charges are deducted before interest and principal payments are passed through.

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When a prepayment is less than the entire outstanding principal amount it is called:

A) prepayment risk.

B) securitized.

C) curtailment.

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Curtailment is when the prepayment is not for the entire amount. Prepayment risk is the risk that relates to the amount and timing of cash flows from a mortgage.

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The risk that relates to the amount and timing of cash flows from a mortgage is known as:

A) liquidity risk.

B) prepayment risk.

C) default risk.

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Default risk is the risk that the borrower will not pay back the amounts borrowed. Liquidity risk deals with the ability to sell a security easily at a fair price.

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If a prepayment of principal is for an amount that is less than the full outstanding balance of the loan, it is know as a(n):

A) curtailment.

B) participation.

C) intermediate payment.

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If a prepayment of principal is for an amount that is less than the full outstanding balance of the loan, it is know as a curtailment.

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Which of the following statements concerning mortgage-backed securities is most accurate?

A) Curtailment of a mortgage is a prepayment of less than the full principal.

B) As rates rise, mortgage-backed security holders face reinvestment risk.

C) Collateralized Mortgage Obligations (CMOs) prioritize the interest payments on mortgages to different sets of investors.

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Curtailment of a mortgage is a prepayment of less than full principal. The other statements are false. Holders of mortgage-backed securities face reinvestment risk as rates decline. Also, CMO’s prioritize the principal payments on mortgages to different sets of investors – all tranches receive interest payments, but each successive tranche does not receive principal payments until the first is paid off.

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Which of the following is the least significant risk faced by a holder of a mortgage-backed security?

A) Reinvestment risk.

B) Interest rate risk.

C) Scheduled principal payment risk.

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Interest rate risk and reinvestment risk are both significant for mortgage-backed securities. There is no risk embedded in a scheduled principal payment.

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Paul Blackburn is describing mortgage backed securities and makes the following statements:

Statement 1: A mortgage passthrough security is formed by pooling a large number of mortgages and issuing certificates that represent ownership shares in the pool. Because each mortgage borrower has the right to prepay the mortgage, the value of a passthrough security behaves as if the security has an embedded put feature.

Statement 2: A collateralized mortgage obligation with sequential tranches is created by pooling mortgage passthrough certificates. Securities are issued in different tranches that have proportionate claims on the cash flows from the passthrough certificates.

With regards to Blackburn’s statements:

A) both are correct.

B) both are incorrect.

C) only one is correct.

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Statement 1 is incorrect. A borrower who prepays a mortgage is in effect exercising a call option, similar to a corporate bond issuer who calls a bond and prepays the principal. Therefore the pool of mortgages and the securities created from it behave as if they had an embedded call feature.

Statement 2 is also incorrect. Sequential tranches issued as a collateralized mortgage obligation do not have proportionate claims on the cash flows from the pool. Instead they have sequential claims. The shortest-term tranche receives principal and interest payments until it is paid off. The cash flows then go to the second tranche until it is paid off, and so on. This structure allows securities with different timing and risk profiles to be issued from the same pool of certificates.

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LOS e, (Part 2): Explain the cash flow, prepayments, and prepayment risk for each type of mortgage-backed security.

A payment made that is in excess of the required monthly mortgage payment is called:

A) prepayment.

B) prepayment risk.

C) curtailment.

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This is the definition of prepayment. Curtailment is when the prepayment is not for the entire amount. Prepayment risk is the risk that relates to the amount and timing of cash flows from a mortgage.