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 excited 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, prepayment 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 with questions about investing in the mortgage securities market. Price and Camby agree that this is an excellent time for Peterson to enter the MBS market, but disagree which mortgage securities would be best. Price believes Peterson’s best alternative would be a commercial MBS. Price makes the following arguments for CMBS:
- There are currently plenty of attractive CMBS, evident by their low debt-to-service coverage ratios and low loan-to-value ratios.
- Contraction risk on a CMBS can be substantially lower than on a residential MBS due to prepayment lock out periods and yield maintenance charges.
Camby, however, disagrees with his father-in-law. He suggests that Peterson should invest in residential MBS, citing the following reasons:
- Residential MBS have more certain cash flows than a CMBS because you can rely on their government-backed guarantee.
- Residential MBS have more reliable collateral than CMBS, due to the fact that CMBS are structured with defeasance clauses which act to lower the credit quality of the underlying loan pool.
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 56.d)
The ABS Price and Camby discussed 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 56.e)
Which of Camby’s statements about the advantage of synthetic CDOs is least accurate?
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A) |
Only the senior section must be funded. | |
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B) |
A bank can use a synthetic CDO to take debt off the balance sheet without the consent of borrowers. | |
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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 56.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 56.b)
With regard to statements made by Price concerning the reasons why Peterson should invest in commercial MBS:
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A) |
only one statement is correct. | |
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B) |
both statements are correct. | |
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C) |
both statements are incorrect. | |
Only one of Price’s statements is correct regarding commercial MBS. He is correct that contraction risk on a CMBS can be lowered by adding prepayment lock out periods and yield maintenance charges, as well as other loan-level call protections such as defeasance and prepayment penalty points. Price is incorrect to state that a low debt-to-service coverage ratio makes a CMBS attractive. A high debt-to-service coverage ratio and low loan-to-value ratio are better for lenders. (Study Session 15, LOS 55.l)
With regard to statements made by Camby concerning the reasons why Peterson should invest in residential MBS:
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A) |
both statements are correct. | |
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B) |
both statements are incorrect. | |
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C) |
only one statement is correct. | |
Camby is incorrect in stating residential MBS have more certain cash flows than a CMBS because you can rely on their government-backed guarantee. Although it is true that government agency issued MBS do come with a pseudo-governmental guarantee, many residential MBS are non-agency issued, meaning they are issued by private entities and do not come with a government guarantee.
Camby’s statement regarding a CMBS defeasance clause is incorrect. If the borrower makes early payments on the mortgage loan, the mortgage loan can be defeased, which means the loan proceeds are received by the loan servicer and invested in U.S. Treasury securities, essentially creating cash collateral against the loan. Treasuries provide higher-quality collateral than the underlying real estate, so loans structured with defeasance increase the credit quality of a CMBS loan pool. (Study Session 15, LOS 55.l)
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发表于 2011-3-23 14:47
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