Deck 23: Mortgage-Backed Securities Market

Question 1

Agency pass-through securities are issued by ________.

A) Ginnie Mae
B) Fannie Mae
C) Freddie Mac
D) All of these

Answer 1

D

Question 2

The agency mortgage-backed security market includes three types of securities: ________.

A) nonagency mortgage pass-through securities, agency CMOs, and agency stripped mortgage-backed securities.
B) agency mortgage pass-through securities, nonagency CMOs, and agency stripped mortgage-backed securities.
C) nonagency mortgage pass-through securities, nonagency CMOs, and nonagency stripped mortgage-backed securities.
D) agency mortgage pass-through securities, agency CMOs, and agency stripped mortgage-backed securities.

Answer 2

D

Question 3

________ is created by redistributing the cash flow (________) to the different tranches based on a set of payment rules.

A) An LBO; prepayment and principal
B) A CMO; interest and principal
C) A WAC; interest and prepayment
D) A PSA; interest and principal

Answer 3

B

Question 4

Although the priority rules for the disbursement of the principal payments are known, the precise amount of the principal in each period ________ known. This will depend on the cash flow and, therefore, on the principal payments of the collateral, which will depend on the ________ of the collateral. An assumed ________ allows the cash flow to be projected.

A) is; actual prepayment rate; PSA speed
B) is not; actual prepayment rate; PSA speed
C) is; projected prepayment rate; CPR speed
D) is not; actual prepayment rate; SMM speed

Question 5

A mortgage pass-through security ________.

A) is a security created when one or more holders of mortgages form a collection (pool) of mortgages and sell shares or participation certificates in the pool.
B) is a security created when one or more holders of mortgages form a collection (pool) of mortgages where the pool consists of at least one hundred mortgages.
C) is considerably less liquid than an individual mortgage.
D) is an agency pass-through security if not issued by Ginnie Mae, Fannie Mae, or Freddie Mac.

Question 6

One of the three key innovations in the CMO market is ________.

A) sequential-pay tranches.
B) accrual tranches.
C) planned amortization class bonds.
D) All of these

Question 7

In regards to Fannie Mae and Freddie Mac, which of the below statements is FALSE?

A) The mortgage-backed securities issued by Fannie Mae and Freddie Mac are commonly referred to as "agency MBS."
B) The mortgage-backed securities issued by Fannie Mae and Freddie Mac are in fact shareholder-owned corporations chartered by Congress to fulfill a public mission.
C) The stocks for Fannie Mae and Freddie Mac largely trade over-the-counter.
D) Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that (in early September 2008) were taken over by the U.S. government because of the financial difficulties it faced as a result of the subprime mortgage crisis.

Question 8

The cash flow of a mortgage pass-through security ________.

A) consists of monthly mortgage payments representing interest and the scheduled repayment of principal, but not on any prepayments.
B) is more than the monthly cash flow of the underlying mortgages by an amount equal to servicing and other fees.
C) depends on the cash flow of the underlying mortgages.
D) All of these

Question 9

The mission of Fannie Mae and Freddie Mac is to support the liquidity and stability of the mortgage market by ________.

A) buying and selling railway trusts.
B) creating pass-through securities that are not guaranteed.
C) selling but not buying mortgage-backed securities.
D) None of these

Question 10

In regards to the conditional prepayment rate (CPR), which of the below statements is FALSE?

A) The CPR assumes that some fraction of the remaining principal in the pool is prepaid each year for the remaining term of the mortgage.
B) The CPR assumed for a pool is based on the characteristics of the pool (including its historical prepayment experience) and the current and expected future economic environment.
C) To estimate monthly prepayments, the CPR must be converted into a monthly prepayment rate, commonly referred to as the single-monthly mortality rate (SMM).
D) A CPR of 5% corresponds to a SMM of 0.005143.

Question 11

In terms of market size, the agency mortgage-backed security market is the ________.

A) smallest sector of the U.S. investment-grade market
B) largest sector of the U.S. investment-grade market
C) smallest sector of the U.S. noninvestment-grade market
D) largest sector of the U.S. noninvestment-grade market

Question 12

Some institutional investors are concerned with extension risk and others with contraction risk when they invest in a pass-through. This problem can be mitigated by redirecting the cash flows of mortgage pass-through securities ________.

A) to similar bond classes.
B) to tranches.
C) so as to create securities that have the same exposure to prepayment risk.
D) so as to create securities that have the same risk/return patterns.

Question 13

Suppose that an investor owns a pass-through in which the remaining mortgage balance at the beginning of some month is $300 million. Assuming that the CPR is 5.00% and the scheduled principal payment is $4 million, what is the estimated prepayment for the month?

A) $1,242,789
B) $1,262,534
C) $1,273,128
D) $1,284,465

Question 14

Suppose that an investor owns a pass-through in which the remaining mortgage balance at the beginning of a month is $200 million. Assuming that the CPR is 4.00% and the scheduled principal payment is $2.5 million, what is the estimated prepayment for this month?

A) $670,681
B) $670,701
C) $670,721
D) $670,741

Question 15

The "private label mortgage market" sector includes loans that ________.

A) conform for a reason other than credit quality or if the loan is not a first lien on the property.
B) do not satisfy the underwriting standards of Ginnie Mae, Fannie Mae, and Freddie Mac (i.e., conforming loans).
C) fail to conform for a reason other than credit quality or if the loan is not a first lien on the property.
D) fail to conform the underwriting standards of Ginnie Mae, Fannie Mae, and Freddie Mac (i.e., conforming loans).

Question 16

The creation of a CMO ________.

A) can eliminate prepayment risk
B) can never distribute the various forms of this risk among different classes of bondholders.
C) cannot broaden the appeal of mortgage-backed products to traditional bond investors.
D) can more closely satisfy the asset/ liability needs of institutional investors.

Question 17

The "subprime mortgage" sector includes loans ________.

A) provided to borrowers with impaired credit rating or where the loan is a second lien.
B) satisfying the underwriting standards of Ginnie Mae, Fannie Mae, and Freddie Mac (i.e., conforming loans).
C) that fail to conform for a reason other than credit quality or if the loan is not a first lien on the property.
D) that are not provided to borrowers with impaired credit rating or where the loan is a second lien.

Question 18

Which of the below statements is TRUE?

A) The pass-through securities issued by Freddie Mac are referred to as Mortgage-Backed Securities; Fannie Mae uses the term Participation Certificate (PC) to describe its pass-through security.
B) An investor who owns pass-through securities knows what the cash flow will be.
C) A mortgage loan effectively grants the borrower the right to call the loan at a discount.
D) The adverse consequence when mortgage rates decline is referred to as contraction risk.

Question 19

In regards to Ginnie Mae, which of the below statements is FALSE?

A) Ginnie Mae, like Fannie Mae and Freddie Mac, was created by Congress to increase the supply of capital to the residential mortgage market and to provide support for an active secondary market.
B) When Ginnie Mae guarantees securities issued by approved lenders, Ginnie Mae permits these lenders to convert illiquid individual loans into liquid securities backed by the U.S. government.
C) Ginnie Mae is a federally related institution and, as a result, the pass-through securities that it guarantees carry the full faith and credit of the U.S. government.
D) Pass-through securities that carry Ginnie Mae's guarantee and bear its name are issued by lenders approved by the federal government and these lenders do not include thrifts.

Question 20

Which of the below statements is TRUE?

A) There is very little variability of the average life for the tranches.
B) The distribution of principal effectively protects a shorter-term tranche against extension risk; this protection comes from the other tranches.
C) There is very little or no protection provided for each tranche against prepayment risk.
D) None of these

Question 21

Which of the below statements is FALSE?

A) In 1987, CMO issuers began issuing bonds with the characteristic that if prepayments are within a specified range, the cash flow pattern is known. The greater predictability of the cash flow for these classes of bonds, referred to as planned amortization class (PAC) bonds, occurs because there is a principal repayment schedule that must be satisfied.
B) PAC bondholders have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral.
C) The greater certainty of the cash flow for the non-PAC bonds comes at the expense of the PAC classes, called the support bonds or companion bonds. It is these bonds that absorb the prepayment risk.
D) Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.

Question 22

The average life of a mortgage-backed security is the average time to receipt of principal payments (scheduled principal payments and projected prepayments), weighted by the amount of principal expected.

Question 23

Traditional corporate bond buyers sought a structure with both the characteristics of a ________ and high credit quality. While CMOs satisfied the ________, they did not satisfy the ________.

A) corporate bond; second condition; first condition
B) government bond; first condition; second condition
C) corporate bond; first condition; second condition
D) government bond; second condition; first condition

Question 24

Which of the below statements is FALSE?

A) A stripped mortgage-backed security is created by distributing the principal and interest from a pool of underlying mortgages on an unequal basis to two classes of securityholders.
B) A stripped mortgage-backed security is another example of a derivative mortgage security.
C) Stripped mortgage-backed securities cannot be used to hedge a portfolio exposed to prepayment risk.
D) There are two types of stripped mortgage-backed securities: partially stripped and IO/PO securities.

Question 25

The stated maturity of a mortgage pass-through security is an appropriate measure of the security's life because of prepayments.

Question 26

A mortgage pass-through security is created when one or more holders of mortgages form a collection (pool) of mortgages and sell shares or PCs in the pool.

Question 27

________ is basically the interest from the collateral that is not being used to satisfy the liabilities (i.e., the interest payments to the tranches in the structure) and the fees (such as mortgage servicing and administrative fees).

A) Excess spread
B) Overcollateralization
C) Monoline insurance
D) Senior-subordinate structure

Question 28

Which of the below statements is FALSE?

A) The PO security is purchased at a substantial discount from par value.
B) A PO is a security whose price would rise when interest rates decline and fall when interest rates rise.
C) In contrast to the PO investor, the IO investor wants prepayments to be slow.
D) A PO has no par value.

Question 29

In early 1987, stripped mortgage-backed securities began to be issued allocating all the interest to one class [called the ________ class] and the entire principal to the other class [called the ________ class].

A) principal-only (PO); interest-only (IO)
B) interest-only (IO); prepayment-only (PO)
C) interest-only (IO); principal-only (PO)
D) stripped-only (SO); payment-only (PO)

Question 30

A ________ security divides the cash flow from the underlying pool of mortgages on a pro rata basis to the securityholders, while a ________ security is created by altering that distribution of principal and interest from a pro rata distribution to an unequal distribution.

A) mortgage pass-through; stripped mortgage-backed
B) hedged pass-through; prepayment mortgage-backed
C) hedged pass-through; stripped mortgage-backed
D) mortgage pass-through; prepayment mortgage-backed

Question 31

Which of the below statements is FALSE?

A) Shorter-term tranches and a longer-term tranche are created by excluding an accrual bond.
B) A reason for the shortening of nonaccrual tranches is that the interest that would be paid to the accrual bond is being allocated to the other tranches.
C) In many sequential-pay CMO structures, at least one tranche does not receive current interest.
D) An accrual tranche, or a Z bond, is similar to a zero-coupon bond.

Question 32

Nonagency MBS are issued by conduits of ________.

A) commercial banks.
B) investment banking firms.
C) entities not associated with either commercial banks or investment banking firms.
D) All of these

Question 33

Which of the below statements is TRUE?

A) When rating agencies assign a rating to the tranches in a nonagency CMO, they look at the prepayment risk associated with a tranche.
B) The process by which the rating agencies determine the amount of credit enhancement needed is referred to as enhancing the transaction.
C) When prime loans are securitized, the credit enhancement mechanisms and therefore the structures are not complicated; however, when subprime loans are securitized, the structures are more complex because of the need for greater credit enhancement.
D) In a senior-subordinate structure, two general categories of tranches are created: an older tranche and younger tranches.

Question 34

The cash flow of a mortgage pass-through security depends on the cash flow of the underlying mortgages, which consists of monthly mortgage payments representing interest, the scheduled repayment of principal, and any prepayments.

Question 35

Market participants often classify subprime mortgage-backed securities as part of the RMBS market and classify agency mortgage-backed securities and private label mortgage-backed securities as part of the market for asset-backed securities.

Question 36

Of all securities that have an investment-grade rating (which includes U.S. Treasury securities), the agency mortgage-backed security market is the largest sector.

Question 37

Which of the below are NOT two forms of credit enhancement?

A) junior-subordinate structure and monoline insurance
B) multiline insurance and overcollateralization
C) undercollateralization and excess spread
D) None of these

Question 38

In ________, the loans are pooled and used to create different bond classes, which we refer to as ________.

A) an agency CMO; branches
B) an agency CMO; tranches
C) a nonagency CMO; debt classes
D) a nonagency CMO; tranches

Question 39

In an agency CMO, there is ________. What is being done in creating the different tranches is the redistribution of ________. In contrast, in ________, there is both credit risk and prepayment risk.

A) no credit risk; prepayment risk; a nonagency CMO
B) credit risk; prepayment risk; a nonagency CMO
C) no credit risk; payment risk; an agency CMO
D) credit risk; payment risk; an agency CMO

Question 40

________ is more commonly used as a form of credit enhancement in subprime deals than in prime deals.

A) Surplus spread
B) Overcollateralization
C) Multiline insurance
D) Junior-subordinate structure

Question 41

What is an IO?

Question 42

Just like a support bond, a CMO reduces the uncertainty concerning the maturity of a tranche, thereby providing a risk/return pattern not available with typical mortgage pass-through securities.

Question 43

A CMO is a security backed by a pool of mortgage pass-through securities or mortgages and is referred to as a derivative security.

Question 44

What does the creation of a CMO accomplish? Briefly explain.

Question 45

A stripped mortgage-backed security is created by distributing the principal and interest from a pool of underlying mortgages on an equal basis to two classes of securityholders.

Question 46

The three major types of pass-through securities are guaranteed by either Freddie Mac (a federally related entity), Fannie Mae (a government-sponsored enterprise), or Ginnie Mae (a government-sponsored enterprise), and are referred to as agency pass-through securities.

Question 47

What does PSA stand for? How is the PSA prepayment benchmark expressed? What does the PSA benchmark assume?

Question 48

An investor in a mortgage pass-through security is exposed to prepayment risk, which is the same as one type of risk: extension risk.

Question 49

There are public issuers of mortgage pass-through securities that are explicitly or implicitly guaranteed by the U.S. government; these securities are called nonagency pass-through securities.

Question 50

Securitization has decreased the supply of credit to homeowners and increased the cost of borrowing.

Question 51

Securitization - the financial framework that allowed Wall Street to package these loans into RMBS - is of enormous benefit to the economy.

Question 52

In a CMO structure, there is one bond class called a branch.

Question 53

What is a PO?

Question 54

Tranche types that have been included in a CMO structure are sequential-pay bonds, accrual bonds (or Z-bonds), PAC bonds, and support bonds.

Question 55

A PAC bond is a class of bonds designed to reduce prepayment risk by specifying a schedule for the amortization of the principal owed to the bondholder; the reduction in the prepayment risk comes at the expense of the support bonds.

Question 56

The cash flow of a mortgage pass-through is projected based on an assumed PSA.

Question 57

The securitization of subprime loans works by dividing pools of credit into classes, or tranches, separated by the amount of risk each class represents.

Question 58

There are two types of stripped mortgage-backed securities: partially stripped and IO/PO securities.

Question 59

Of the mortgage pass-through securities guaranteed by one of the three agencies, only those guaranteed by Ginnie Mae carry the full faith and credit of the U.S. government; nonagency pass-through securities are rated by a commercial rating company, and often they are supported by credit enhancements so that they can obtain a high rating.

Question 60

The residential mortgage market can be divided into two subsectors based on the credit quality of the borrower: private label mortgage market and subprime mortgage market. Describe the loans for these two subsectors.

Question 61

Describe "excess spread" as a from of credit enhancement.