Deck 8: Securitization and the Credit Crisis of 2007

Question 1

What are the factors that contributed to the credit crisis in 2007? _ _ _ _ _ _ _ _ _ _ _ _ _ _

Answer 1

low interest rate, lax lending standards, development of adjustable-rate mortgages ARMS), originate-to-distribute OTd model of lending, lack of understanding of the investment risks in mortgage-backed securities and bonus structure that focuses on short-term performance.

Question 2

When a mortgage is non-recourse: choose one)

A) The house buyer can lose all possessions if they are unable to make payments
B) The purchaser has a free American-style put option on the house
C) The purchaser has a free European-style put option on the house
D) The lender is less likely to lose money on the mortgage

Answer 2

B

Question 3

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 75%, mezzanine 20% and equity 5%. An ABS CDO is then created from the mezzanine tranche with the same allocation of principal. Losses on the mortgage portfolio prove to be 16%. What as a per cent of tranche principal) are the losses on:
i) The equity tranche of the ABS? _ _ _ _ _ _
ii) The mezzanine tranche of the ABS? _ _ _ _ _ _
iii) The senior tranche of the ABS? _ _ _ _ _ _
iv) The equity tranche of the ABS CDO? _ _ _ _ _ _
v) The mezzanine tranche of the ABS CDO? _ _ _ _ _ _
vi) The senior tranche of the ABS CDO? _ _ _ _ _ _

Answer 3

i): 100%
ii): 55%
iii): 0%
iv): 100%
v): 100%
vi): 40%

Question 4

Which of the following would tend to lead to an increase in house prices? choose two)

A) A reduction in interest rates
B) Regulators specify a maximum level for the loan-to-value ratio on mortgages
C) Banks reduce the minimum FICO that borrowers are required to have
D) An increase in foreclosures

Question 5

Which of the following is not true? choose one)

A) The bonus structure at banks is liable to lead to short term horizons for decision making.
B) A portfolio of BBB tranches created from mortgages has a loss probability distribution similar to a portfolio of BBB bonds.
C) The term 'agency costs' describes the situation where the incentives of two parties in a business relationship are not perfectly aligned.
D) Correlations tend to increase in stressed market conditions.