Reading 58: LOS f ～ Q14- 19

14.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 3 lists the prepayment percentages of the tranches in Table 2.

Walters has long dealt with mortgage-backed securities (MBS) and is trying to understand the terminology in the asset-backed securities (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)   limit the extension risk of the senior tranche.

B)   increase the maturity of junior subordinated tranches.

C)   maintain the overcollateralization of the structure.

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

The correct answer was A)

In order to maintain extension protection for the senior tranche at a desirable level, prepayments are allocated to the senior tranche at a relatively higher proportion in the early years.

15.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 NOT a purpose of the excess servicing spread in Table 1?

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

B)   Augmenting external credit enhancements.

C)   Paying for administrative and managerial expenses.

D)   Complementing the cash reserve fund of the structure.

The correct answer was C)

The excess servicing spread is placed in a reserve account called the excess servicing spread account. It will gradually grow over the length of the loan, so that it provides increasing protection against possible future losses. These funds complement the cash reserves and enhance any external arrangements.

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

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

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

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

D)   created from an ABS passthrough structure unlike the way a CMO is created directly from the underlying mortgages.

The correct answer was C)

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.

17.An older investor with a short time horizon and a strong desire for extra income wishes to purchase a mortgage-backed or asset-backed security. Which of the following is the best choice?

A)   The senior tranche from the loan detailed above.

B)   Subordinated tranche 3 from the loan detailed above.

C)   A collateralized mortgage obligation containing a series of mortgage pools like the one above.

D)   Investment-grade bonds with short maturities, rather than asset- or mortgage-backed securities.

The correct answer was A)

Investors with short time horizons and a need for income wish to avoid extension risk. The senior tranche from the above loan pool offers a chance to collect high prepayments during the first few years. The subordinated tranches protect against contraction risk, and do not meet the investor’s needs. A CMO spreads the prepayment risk among many investors, again, not meeting this investor’s needs. Short-maturity corporate bonds will return the principal quickly, but because of fixed coupon payments, will not provide extra income.

18.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 more sensitive to interest-rate changes than mortgage prepayments.

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

The correct answer was B)

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. Auto loans are less sensitive to interest rates than mortgage loans because of the relatively short maturities and smaller principal amounts. Consequently, they are not affected by all the same underlying factors as mortgage loans.

19.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.

D)   Subordinated tranche 3.

The correct answer was A)

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.