manchester88

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

A) prepayment risk.

B) prepayment.

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.

manchester88

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.

manchester88

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.

manchester88

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) participation.

B) intermediate payment.

C) curtailment.

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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.

manchester88

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

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

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

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.

manchester88

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 regard to Blackburn’s statements:

A) both are correct.

B) only one is correct.

C) both are incorrect.

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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.

manchester88

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

A) Scheduled principal payment risk.

B) Reinvestment risk.

C) Interest rate 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.

manchester88

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.

manchester88

Which of the following statements about creating a collateralized mortgage obligation (CMO) is NOT correct? A CMO:

A) redistributes the risk between the tranches on a random basis.

B) redistributes the risk between the tranches on an unequal basis.

C) does not affect the overall risk of prepayment.

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Creating a CMO usually redistributes the risk between the tranches on an unequal basis, not on a random basis.

manchester88

A mortgage-backed security has been divided into three classes or tranches as follows:

• Tranche I receives net interest and all the principal payments until it is completely paid off.
• Tranche II receives its share of net interest and starts receiving all the principal repayments after Tranche I has been completely paid off. Prior to that, it only receives interest payments.
• Tranche III receives monthly net interest and starts receiving all principal repayments after Tranches I and II have been completely paid off. Prior to that, it only receives interest payments.

For a relatively small decline in mortgage interest rates, which of the tranches has the least amount of prepayment risk?

A) Prepayment risk is equal for all three tranches.

B) Tranche I.

C) Tranche III.

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Tranche III has the least amount of prepayment risk since it receives the prepayments last.

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For an investor who is interested in long-term gains, in which tranche should s/he invest?

A) Tranche I.

B) Any of the tranches since mortgage-backed securities generally have a long duration.

C) Tranche III.

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Tranche III has the least amount of prepayment risk; therefore, there is a greater chance that the investor will be able to hold on to the investment for a longer time horizon.