cyber21

Prepayments or curtailments:

A) cause the duration of the original mortgage to lengthen or increase.

B) will increase the amount of interest the lender receives over the life of the loan.

C) will reduce the amount of interest the lender receives over the life of the loan.

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Prepayments or curtailments will reduce the amount of interest the lender receives over the life of the loan.

cyber21

Identify three risks associated with investing in mortgage-backed securities (MBS). Risks associated with investing in MBS are:

A) interest rate risk, contraction risk, and servicing fee risk.

B) interest rate risk, default risk, and prepayment risk.

C) extension risk, credit risk, and downgrade risk.

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A mortgage is a loan that is collateralized with a specific piece of real property, either residential or commercial. The borrower must make a series of mortgage payments over the life of the loan, and the lender has the right to “foreclose” or lay claim against the real estate in the event of a loan default. An MBS represents a claim against a pool of mortgages. The cash flows from the pool are distributed amongst the holders of all the MBS as per the terms of the issue.
Risks associated with investment in MBS:

• Interest rate risk−changes in the value of the MBS as interest rates change (usually inverse).
• Default risk−risk that some or all of the borrowers default and the collateral is not enough to cover the entire mortgage.
• Prepayment risk−risk that the borrowers prepay as interest rates decline.

cyber21

Which of the following factors does NOT affect prepayments?

A) Housing turnover.

B) Defeasance.

C) Characteristics of the underlying mortgage pool.

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Defeasance is a type of call protection used in commercial loans.

cyber21

Which of the following best describes how a growing economy can affect prepayments? A growing economy:

A) leads to increasing prepayments.

B) does not affect prepayments.

C) leads to decreasing prepayments.

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The reason for this link is as follows: A growing economy leads to a rise in personal income and opportunities for worker migration and mobility. This results in higher housing turnover and therefore increasing prepayment rates.

cyber21

Which of the following best describes prepayment risk?

A) The lender's interest rate risk resulting from prepayments.

B) The lender's spread risk resulting from prepayments.

C) The risk associated with the unknown amount and timing of cash flow's resulting from prepayments.

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Mortgage prepayments reduce the amount of interest the lender receives over the life of the loan. The likelihood of this situation actually occurring is very real and is known as prepayment risk.

cyber21

Payments in excess of the required monthly payment amount are called:

A) mega-payments.

B) prepayments.

C) passthroughs.

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Payments in excess of the required monthly payment amount are called prepayments.

cyber21

Prepayments cause the timing and amount of cash flows from mortgage loans and mortgage-backed securities (MBS) to be uncertain. Thus:

A) the analyst must make specific assumptions about the rate at which prepayments of the pooled mortgages occurs when valuing the passthrough securities.

B) the rate of prepayments is important to valuing the passthrough securities but is impossible to estimate.

C) regulators mandate the convention firms must use when estimating prepayment rates.

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The analyst must make specific assumptions about the rate at which prepayments of the pooled mortgages occur when valuing the passthrough securities.

cyber21

Which of the following is the best definition of extension risk? The adverse consequences of:

A) increasing interest rates on passthrough securities.

B) lower prepayment rates.

C) declining interest rates on passthrough securities.

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Increasing interest rates will slow prepayments resulting in extending the maturity of the passthrough. This reduces the amount available to be invested at the currently high interest rates.

cyber21

Which of the following is the best definition of contraction risk? The adverse consequences of:

A) lower prepayment rates.

B) declining interest rates on passthrough securities.

C) expected prepayment rates.

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A decrease in interest rates will give borrowers an incentive to prepay the loan and refinance the debt at a lower rate. Therefore, the maturity of the passthrough will contract. The second adverse consequence is that the cash flows resulting from prepayments have to be reinvested at a lower interest rate.

cyber21

Which of the following statements is least accurate regarding prepayment risk?

A) Reinvestment rate risk is a result of rising interest rates.

B) Contraction risk refers to the shortening of the expected life of the mortgage pool due to falling interest rates.

C) Investor in mortgage-backed securities must reinvest at lower rates when rates fall and borrowers prepay and are "stuck" with lower rates when rates rise and borrowers hold onto their mortgages.

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Reinvestment rate risk is a result of falling interest rates, not rising rates.