Deck 8: Securitization and the Credit Crisis of 2007

Question 1

Which of the following describes regulatory arbitrage?

A)Finding a way of reducing capital requirements without changing the risks being taken
B)Buying products that are not subject to regulation
C)Shorting products that are not subject to regulation
D)Trading with the government

Answer 1

A
Regulatory arbitrage involves organizing trading and accounting so that regulatory capital is reduced without the risks being taken changing.

Question 2

Which of the following describes the S&P/Case-Shiller index?

A)A stock market index
B)An index of interest rates on mortgages
C)An index of house prices
D)An index showing the dollar amount of mortgages granted each month

Answer 2

C
The S&P/Case-Shiller index is an index of house prices

Question 3

Which of the following is true as the correlation between mortgage defaults increases?

A)Equity tranches are almost certain to incur losses
B)Senior tranches become more likely to incur losses
C)The expected number of defaults increases
D)Equity tranches are unaffected

Answer 3

B
If the correlation between mortgage defaults is very low the senior tranche is safe,but as the correlation increases it becomes more likely that it will experience losses.Suppose that the default probability is 2%.When correlation is zero,we expect roughly 2% of mortgages to default each year and there is virtually no chance of the senior tranche bearing losses.In the limit when default correlation between mortgages is perfect,the senior tranche has a 2% chance of bearing losses in any given year.

Question 4

Which of the following describes a subprime mortgage?

A)The rate of interest is less than the prime rate of interest
B)The loan-to-value ratio is below average
C)The life of the mortgage is less than 25 years
D)The credit risk is high

Question 5

What are teaser rates

A)Interest rates that appear lower than they are
B)Interest rates that depend on LIBOR
C)Interest rates on mortgages with a very long amortization period
D)Interest rates that apply only for the first two or three years

Question 6

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 80%,mezzanine 10%,and equity 10%.(The portfolios of subprime mortgages have the same default rates.)An ABS CDO is then created from the mezzanine tranches with the same allocation of principal.Losses on the mortgage portfolio prove to be 16%.What,as a percent of tranche principal,are losses on the senior tranche of the ABS CDO

A)50%
B)60%
C)80%
D)100%

Question 7

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 85%,mezzanine 10%,and equity 5%.(The portfolios of subprime mortgages have the same default rates.)An ABS CDO is then created from the mezzanine tranches with the same allocation of principal.How high can losses on the mortgages be before the mezzanine tranche of the ABD CDO bears losses?

A)5.0%
B)5.5%
C)6.0%
D)6.5%

Question 8

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 80%,mezzanine 10%,and equity 10%.(The portfolios of subprime mortgages have the same default rates.)An ABS CDO is then created from the mezzanine tranches with the same allocation of principal.Losses on the mortgage portfolio prove to be 16%.What,as a percent of tranche principal,are losses on the mezzanine tranche of the ABS CDO

A)50%
B)60%
C)80%
D)100%

Question 9

Which of the following would be described by the term "liar loan"?

A)A situation where the lender concealed information from the borrower
B)A situation where the lender lied to the borrower about the interest rate
C)A situation where the borrower lied about the his or her income
D)None of the above

Question 10

Which of the following is true of a non-recourse mortgage?

A)The house buyer, if unable to make payments, can lose all his or her possessions
B)The house buyer has an American-style put option on the house
C)The house buyer has a European-style put option on the house
D)The lender is less likely to lose money on the mortgage

Question 11

AIG lost money because

A)It bought tranches created from mortgages
B)It invested heavily in real estate
C)It invested heavily in the stock market
D)It insured AAA tranches of ABS CDOs

Question 12

In 2008 the TED spread reached a high of

A)About 150 basis points
B)About 250 basis points
C)About 450 basis points
D)About 550 basis points

Question 13

Which of the following is NOT true

A)The bonus structure at banks can lead to short-term horizons for decision making
B)Securitization involves the transfer of risk
C)The term "agency costs" describes the situation where the incentives of two parties in a business relationship are not perfectly aligned
D)Correlations decrease in stressed market conditions

Question 14

Which of the following were introduced before the credit crisis that started in 2007

A)Basel II
B)Dodd-Frank
C)Basel III
D)Requirements for living wills

Question 15

Which of the following describes the waterfall typically used for mortgages pre-crisis?

A)A distribution of cash flows to tranches with priority given to tranche with the highest rating
B)A distribution of cash flows to tranches in proportion to their outstanding principals
C)A distribution of losses to tranches so that tranches bear losses in proportion to their outstanding principals
D)None of the above

Question 16

Which of the following tends to lead to an increase in house prices?

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

Question 17

Which of the following survived the crisis without declaring bankruptcy or being taken over by another financial institution?

A)Bear Stearns
B)Morgan Stanley
C)Lehman Brothers
D)Merrill Lynch

Question 18

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 85%,mezzanine 10%,and equity 5%.(The portfolios of subprime mortgages have the same default rates.)An ABS CDO is then created from the mezzanine tranches with the same allocation of principal.How high can losses on the mortgages be before the senior tranche of the ABS CDO bears losses?

A)5.5%
B)6.0%
C)6.5%
D)7.0%

Question 19

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 94.5% (rated AAA),mezzanine 0.1% (rated BBB),and equity 5% (rated C).The portfolios of subprime mortgages have the same default rates.An ABS CDO is then created from the mezzanine tranches.Which of the following is true?

A)The ABS CDO tranches should have ratings ranging from AAA to C
B)The ABS CDO tranches should all be rated BBB
C)The ABS CDO tranches should all be rated C
D)The ABS CDO tranches are almost worthless because the mezzanine tranches are so thin

Question 20

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 80%,mezzanine 10%,and equity 10%.(The portfolios of subprime mortgages have the same default rates.)An ABS CDO is then created from the mezzanine tranches with the same allocation of principal.Losses on the mortgage portfolio prove to be 16%.What,as a percent of tranche principal,are losses on the mezzanine tranche of the ABS

A)50%
B)60%
C)80%
D)100%