Deck 8: Credit Risk I: Individual Loan Risk

Question 1

Which of the following statements is true?

A)Zero-coupon corporate bonds are bonds without any intervening cash flows between issue and maturity and thus these bonds typically sell at a large discount from face value.
B)Zero-coupon corporate bonds are bonds with semi-annual cash flows between issue and maturity and thus these bonds typically sell at a large discount from face value.
C)Zero-coupon corporate bonds are bonds without any intervening cash flows between issue and maturity and thus these bonds typically sell at a small discount from face value.
D)Zero-coupon corporate bonds are bonds with annual cash flows between issue and maturity and thus these bonds typically sell at a large discount from face value.

Answer 1

A

Question 2

Assignments:

A)are common in loan syndications.
B)do not have buyer restrictions.
C)comprise less than 30 per cent of the US loan sales market.
D)involve extremely high monitoring costs.

Answer 2

A

Question 3

Assumable mortgage is a mortgage contract that is:

A)transferred from the seller to the buyer of a house.
B)assumed to be paid off.
C)transferred from the buyer to the seller of a house.
D)non-transferrable.

Answer 3

A

Question 4

As coupon rates on new mortgages fall:

A)individuals are inclined to sell off their mortgages.
B)there is a decreased incentive for individuals in the pool to pay off old, high-cost mortgages and refinance at lower rates.
C)there is an increased incentive for individuals in the pool to pay off old, high-cost mortgages and refinance at lower rates.
D)there is no effect on mortgage payments.

Question 5

Which of the following is true concerning loans sold with recourse?

A)Most loans are sold in this manner.
B)The buyer cannot put the loan back to the selling FI.
C)The FI has no explicit liability if the loan eventually goes bad.
D)The FI that originated the loan retains a contingent credit risk liability.

Question 6

Which of the following is not true of a loan that is sold without recourse?

A)The loan is removed from the FI's balance sheet.
B)The FI has no explicit liability if the loan eventually goes bad.
C)The FI that originated the loan bears all the credit risk.
D)The buyer can put the loan back to the selling FI.

Question 7

This propensity to prepay means:

A)realised coupons/cash flows on pass-through securities would conform to expected cash flows.
B)realised coupons/cash flows on pass-through securities can often deviate substantially from the stated or expected coupon flows.
C)realised coupons/cash flows on pass-through securities are prepaid.
D)None of the listed options are correct.

Question 8

What are the two basic types of loan sale contracts or mechanisms by which loans can be transferred between seller and buyer?

A)participations and assignments
B)participations and originations
C)syndications and originations
D)transfers and assignments.

Question 9

Besides reducing credit risks, an FI has an incentive to sell loans it originates for all of the following reasons except to:

A)geographically diversify.
B)decrease core deposits.
C)lower reserve requirements.
D)lower capital requirements.

Question 10

In a loan participation the holder (buyer):

A)is not a party to the underlying credit agreement, so the initial contract between the loan seller and the borrower remains in place after the sale
B)is a party to the underlying credit agreement, so the initial contract between the loan seller and the borrower remains in place after the sale.
C)can vote only on material changes to the loan contract such as changes in interest rate or collateral backing.
D)is not a party to the underlying credit agreement, so the initial contract between the loan seller and the borrower remains in place after the sale and the holder (buyer) can vote only on material changes to the loan contract such as changes in interest rate or collateral backing.

Question 11

Loan participations are:

A)riskier than loan assignments.
B)less risky than loan assignments.
C)always sold without recourse.
D)always sold with partial recourse.

Question 12

The move toward market value accounting:

A)increases banks' incentives to sell loans to avoid reporting capital losses.
B)decreases banks' incentives to sell loans to avoid reporting capital losses.
C)increases banks' incentives to sell loans since all assets will automatically be marked to market.
D)decreases banks' incentives to sell loans since all assets will automatically be marked to market.

Question 13

Which of the following observations is not correct?

A)Most loans are sold with recourse.
B)Loan sales are a primitive substitute for securitisation.
C)Selling of a loan creates a secondary market for loans.
D)Ownership of the loan is always transferred to the loan purchaser.

Question 14

Which of the following statements is false?

A)Default risk is the risk that the borrower is willing but unable to fulfil the terms promised under loan contract.
B)Default risk is the risk that the borrower refinances the loan before maturity.
C)Default risk is the risk that the borrower is able but unwilling to fulfil the terms promised under loan contract.
D)Default risk is the risk that the borrower is unable and unwilling to fulfil the terms promised under loan contract.

Question 15

What is NOT true of loan assignments?

A)All rights are transferred on sale.
B)The loan buyer holds a direct claim on the borrower.
C)Ownership rights are generally much clearer in a loan sale by assignment.
D)Contract terms are unrestrictive from the seller's perspective.

Question 16

In Australia, a securitisation program must have:

A)a specifically created SPV, which is resident in Australia and which is not required to provide data to the Australian Prudential Regulation Authority (APRA):
B)a specifically created SPV, which may or may not be resident in Australia and which is not required to provide data to the Australian Securities and Investment Commission (ASIC) under the Financial Statistics (Collection of Data) Act;
C)specifically selected assets (e.g.mortgages, receivables, etc.) backing its liabilities in the form of debt securities.
D)a specifically created SPV, which is resident in Australia, which is not required to provide data to the Australian Prudential Regulation Authority and have Specifically selected assets (e.g.mortgages, receivables, etc.) backing its liabilities in the form of debt securities.

Question 17

Currently, this basic type of loan sale contracts comprises the bulk of loan sales trading.

A)participations
B)originations
C)syndications
D)assignments

Question 18

A loan provided by a group of FIs as opposed to a single lender is called:

A)a joint loan.
B)project finance.
C)a syndicated loan.
D)a multiple loan.

Question 19

Loan participations are typically sold to correspondent banks because:

A)they are insiders and can be trusted.
B)they offer the best prices.
C)the ongoing relationship offers the greatest monitoring opportunities.
D)this is a regulatory requirement.

Question 20

A buyer of a loan participation is exposed to:

A)risk exposure to the original borrower defaulting.
B)risk exposure to the failure of the selling bank.
C)moral hazard problems because the borrower is no longer monitored by the seller.
D)risk exposure to the original borrower defaulting and risk exposure to the failure of the selling bank.

Question 21

Creating mortgage-backed pass-through securities:

A)can largely resolve the duration and illiquidity risk problems for a FI.
B)would not have any effect on the duration and illiquidity risk problems for a FI.
C)can worsen the duration and illiquidity risk problems for a FI.
D)None of the listed options are correct.

Question 22

Correspondent banking is a relationship between:

A)banks in two different countries.
B)a commercial bank and an investment bank in which the investment bank provides a number of deposit, lending and other services.
C)a small bank and a large bank in which the large bank provides a number of deposit, lending and other services.
D)a large bank and non-banking financial institution.

Question 23

Which is of the statements below is true?

A)An FI will earn fees when arranging a large loan, even if it sells part or all of the loan later.
B)Like reserve requirements, the capital adequacy requirements imposed on FIs are a burden as long as required capital exceeds the amount the FI believes to be privately beneficial.
C)In addition to credit risk and interest rate risk, holding loans on the balance sheet can increase the overall illiquidity of an FI's assets.
D)All of the listed options are correct.

Question 24

The ___________ is an accrual class of a CMO that makes a payment to bondholders only when preceding CMO classes have been retired:

A)A Class
B)B Class
C)Z Class
D)R Class

Question 25

Collateralised debt obligation (CDO) is:

A)an asset-backed bond issued in multiple classes or tranches.
B)a mortgage issued in multiple classes or tranches.
C)unsecured notes issued in multiple classes or tranches.
D)commercial paper issued with collateral.

Question 26

Transferable mortgage is:

A)a mortgage contract that allows a change of asset to be sold.
B)a mortgage contract that does not allow a change of asset to be mortgaged.
C)a mortgage contract that allows a change of asset to be mortgaged.
D)None of the listed options are correct.

Question 27

With over $1200 billion in doubtful and troubled loans on their books in the early 2000s, _________ banks presented a huge potential market for the sale of distressed loans.

A)Australian
B)US
C)UK
D)Japanese

Question 28

Pass-throughs, CMOs and mortgage-backed bonds have been used for:

A)car loans.
B)credit card receivables.
C)commercial and industrial loans.
D)All of the listed options are correct.

Question 29

Fully amortised means:

A)periodic repayment on a loan that reflects only principal over the life of the loan.
B)a repayment on a loan with varying amounts, that reflects part interest and part principal over the life of the loan.
C)an equal periodic repayment on a loan that reflects part interest and part principal over the life of the loan.
D)None of the listed options are correct.

Question 30

Z class is:

A)an accrual class of a CMO that makes a payment to bondholders only when preceding CMO classes have been retired.
B)the residual class of a CMO, giving the owner the right to any remaining collateral in the trust after all other bond classes have been retired plus any reinvestment income earned by the trust.
C)a bond that has some prepayment protection and expected durations of five to seven years depending on the level of interest rates.
D)a bond that has the shortest average life with a minimum of prepayment protection.They are, therefore, of no interest to investors seeking short-duration mortgage-backed assets.

Question 31

Choose the correct answer:

A)While pass-throughs and CMOs remain on banks and building societies balance sheets, mortgage-backed bonds (MBBs) remove mortgages from balance sheets as forms of off-balance-sheet securitisation.
B)While pass-throughs and CMOs help banks and building societies remove mortgages from their balance sheets as forms of off-balance-sheet securitisation, mortgage-backed bonds (MBBs) normally remain on the balance sheet.
C)Pass-throughs and CMOs are the same as mortgage-backed bonds (MBBs).
D)None of the listed options are correct.

Question 32

Burn-out factor is the aggregate percentage of the mortgage pool that:

A)has been prepaid prior to the sale of the loan.
B)will be paid after the month under consideration.
C)has been prepaid prior to the month under consideration.
D)has defaulted.

Question 33

Collateralised debt obligations:

A)Can be created either by packaging and securitising whole mortgage loans.
B)by placing existing pass-throughs in a trust off the balance sheet.
C)can be created either by packaging and securitising unsecured loans, or by placing existing pass-throughs in a trust on-balance sheet.
D)can be created either by packaging and securitising whole mortgage loans and by placing existing pass-throughs in a trust off the balance sheet.

Question 34

Which statement is not true with respect to loan sales?

A)Are one way used by FI managers to restructure their balance sheet.
B)Can change the interest rate sensitivity of the FI's balance sheet.
C)Can be used to manage FI's interest rate risk.
D)None of the listed options are correct.

Question 35

Benefits of securitisation include:

A)increased liquidity of bank loans
B)enhanced ability to manage the duration gap.
C)if off-balance-sheet, the issuer saves on reserve requirements, deposit insurance premiums and capital adequacy requirements.
D)All of the listed options are correct.

Question 36

The key feature of a loan assignment is that all rights are:

A)negotiated at the time of sale, meaning the loan buyer can opt to hold a direct claim on the borrower.
B)are transferred on sale, meaning the loan buyer now holds a direct claim on the borrower.
C)are not transferred on sale and can be sold later.
D)None of the listed options are correct.

Question 37

R class is:

A)an accrual class of a CMO that makes a payment to bondholders only when preceding CMO classes have been retired.
B)the residual class of a CMO, giving the owner the right to any remaining collateral in the trust after all other bond classes have been retired plus any reinvestment income earned by the trust.
C)a bond that has some prepayment protection and expected durations of five to seven years depending on the level of interest rates.
D)a bond that has the shortest average life with a minimum of prepayment protection.They are, therefore, of no interest to investors seeking short-duration mortgage-backed assets.

Question 38

The profitability of securitised assets is largely determined by the special purpose vehicle's:

A)debt to equity ratio.
B)credit rating.
C)ownership.
D)timing insurance.

Question 39

The credit rating agency is:

A)a legal party to any of the securitisation arrangements and is usually listed on all documentation.
B)not a legal party to any of the securitisation arrangements and is usually listed on all documentation.
C)a legal party to any of the securitisation arrangements but is usually not listed on all documentation.
D)not a legal party to any of the securitisation arrangements and is usually not listed on all documentation.

Question 40

Choose the correct answer:

A)Regulatory taxes such as reserve requirements create an incentive for banks to remove loans from the balance sheet by selling them without recourse to outside parties.
B)Regulatory taxes such as reserve requirements create an incentive for banks to offer low rate mortgages.
C)Regulatory taxes such as reserve requirements create an incentive for banks limit their lending to large corporates only.
D)None of the listed options are correct.

Question 41

Which of the following is not a factor that may tend to increase loan sales in the future?

A)There is an increased trend to apply credit ratings to loans offered for sale, increasing the attractiveness to secondary market purchasers.
B)Because of their special credit monitoring skills, FIs have a comparative advantage in making loans to below-investment grade companies and then selling the loan.
C)The trend toward marked-to-market accounting for assets makes bank loans more like securities so they may be easier to sell.
D)The risk-based capital requirements of the Bank for International Settlements give banks a strong incentive to sell housing loans to decrease their amount of risky assets.

Question 42

Asset securitisation is where:

A)existing securities are sold to create a pool of funds for investment in income assets.
B)securities are created based on house loans and income payments from the house owners are then paid to the investors.
C)securities are created based on a pool of underlying assets and the value and income payments of the securities are derived from the underlying assets.
D)All of the listed options are correct.

Question 43

Illiquidity is a problem to an FI because while FI:

A)liabilities tend to be highly illiquid; its assets usually are not.
B)assets tend to be highly liquid, its liabilities usually are not.
C)liabilities tend to be highly liquid, its assets usually are not.
D)None of the listed options are correct.

Question 44

One way to boost the capital to assets ratio of an FI is through loan sales.

Question 45

Costs of securitisation include:

A)costs of public/private credit risk insurance and guarantees.
B)costs of over-collateralisation.
C)valuation and packaging costs (the cost of asset heterogeneity).
D)All of the listed options are correct.

Question 46

Which of the following is true concerning loans sold without recourse?

A)The loan sale is technically removed from the balance sheet ..
B)The buyer cannot put the loan back to the selling FI.
C)The FI has no explicit liability if the loan eventually goes bad.

Question 47

A normal bond values fall with interest rate increases but the following bond often has a negative duration and therefore it is potentially attractive to banks and non-bank FIs seeking to hedge their regular bond and fixed-income portfolios.

A)A Class
B)B Class
C)Z Class
D)R Class

Question 48

A bank loan sale occurs when an FI originates a loan and sells the loan with or without recourse to an outside buyer.

Question 49

Collateralised Debt Obligations (CDOs) were responsible for significant damage and disruption to global financial markets as:

A)investors accepted the recommendations of CDO arrangers and rating agencies.
B)many investors were unable to assess the fairness of prices.
C)the securities' cash flow was based on cash flows from other financial securities and not the cash flows from real assets.
D)the CDOs' cash flows were based on cash flows from real assets and not from other financial securities.

Question 50

When a portion of a loan is sold from a large bank to a small bank, it is often called a participation.

Question 51

Interest rate swaps are used to assist in interest rate risk management of the securitised assets.

Question 52

The implementation of BIS capital requirements may be expected to:

A)increase the downward trend in loan sales because of higher required capital levels.
B)increase the downward trend in loan sales because of the use of risk adjusted assets.
C)decrease the downward trend in loan sales because of the use of risk adjusted assets and because of higher required capital
D)decrease the downward trend in loan sales because of the use of risk adjusted assets and because of lower required capital levels.

Question 53

While collateralised mortgage obligation (CMO) is still the primary mechanism for securitisation, the pass-throughs are second and growing vehicle for securitising bank assets.

Question 54

Timing insurance is a liquidity support provided to the special purpose vehicle to cover mismatches of cash flows:

A)from its accounts receivable and accounts payable to all stake holders.
B)from its investment income and current liabilities.
C)between the underlying mortgage pool and those required to be paid on the securitised assets.
D)None of the listed options are correct.

Question 55

Banks have been partially responsible for big corporate collapses such as Enron.

Question 56

Credit card facilities is a revolving loan product.

Question 57

The buyer of a loan participation benefits because the only risk exposure is to the borrower.

Question 58

Securitisation removes assets (such as loans) from the balance sheets of FIs, similar to loan sales.

Question 59

When current mortgage rates fall sufficiently low that the present value savings of refinancing outweigh the cost of prepayment penalties(and other fees and costs), the mortgage holders are said to have a valuable:

A)put option.
B)call option.
C)forward agreement.
D)futures contract.

Question 60

Mortgage-backed bonds (MBB) differ from pass-throughs and collateralised mortgage obligations (CMOs) in which of the following ways?

A)The MBB bondholders have a junior claim to assets of the FI.
B)There is no direct link between the cash flow on the mortgages backing the bond and the interest and principal payments on the MBB.
C)The assets backing a MBB issue are normally removed from the balance sheet of the FI.
D)Tranches of a MBB are treated equally with respect to prepayments on mortgages backing the bond issue.

Question 61

What is prepayment risk? How does prepayment risk affect the cash flow stream on a fully amortised mortgage loan? What are the two primary factors that cause early payment?

Question 62

When an FI sells a loan without recourse, the credit risk of the loan is completely eliminated.

Question 63

Collateralised mortgage obligation (CMO) is a mortgage-backed bond issued in multiple classes or tranches.

Question 64

When a Special Purpose Vehicle (SPV) creates asset-backed securities, the SPV retains ownership of the original assets.

Question 65

What are four reasons why an FI may prefer the use of either pass-through securities or CMOs to the use of MBBs?