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

Q1. Which of the following is least likely a cash flow that results from a mortgage-backed security?

A)   Prepayments.

B)   Net interest.

C)   Mortgage processing fees and charges.

Q2. 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.

Q3. 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)   only one is correct.

C)   both are incorrect.

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

Q1. Which of the following is least likely a cash flow that results from a mortgage-backed security?

A)   Prepayments.

B)   Net interest.

C)   Mortgage processing fees and charges.

Correct answer is C)

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

Q2. 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.

Correct answer is C)

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

Q3. 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 ffice:smarttags" />Blackburn’s statements:

A)   both are correct.

B)   only one is correct.

C)   both are incorrect.

Correct answer is C)

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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