CFA 2018 Question bank 04 Introduction to Asset Backed Securities Credit Analysis

Introduction to Asset-Backed Securities & Credit Analysis

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Question ID: 463937

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Question ID: 463881

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Question #4 of 131

Question ID: 463941

Test ID: 7441716

Principal-only strips are:

sold at a considerable discount to par. sold at par.

could be sold at a discount or a premium, depending on economic conditions.

Explanation

Principal-only strips are sold at a considerable discount to par.

Prepayments or curtailments:

will reduce the amount of interest the lender receives over the life of the loan. will increase the amount of interest the lender receives over the life of the loan. cause the duration of the original mortgage to lengthen or increase.

Explanation

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

What is the relation between the PSA prepayment benchmark and the conditional prepayment rate (CPR)? The PSA prepayment benchmark is:

not related to the CPR.

expressed as a monthly series of CPR's.

expressed as an annual series of CPR's.

Explanation

The PSA prepayment benchmark is expressed as a monthly series of CPR's that increase over the life of the liabilities.

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Question ID: 463973

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Question ID: 463879

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Question #7 of 131

Question ID: 463860

Compute a weighted debt service coverage ratio (DSC ratio) for the overall portfolio.

Compute the DSC ratio for each property in the CMBS. Both of the answer choices are correct.

Explanation

Financial analysis of the DSC ratio for each property in the CMBS and analysis of the DSC ratio for the overall portfolio are both completed by the underwriter when assessing credit risk for a CMBS.

Which of the following statements concerning the early amortization trigger for a credit card receivable-backed security is CORRECT? An early amortization trigger leads to:

credit card tranches being retired sequentially. partial default.

the principal payments made by credit card holders being reinvested in receivables.

Explanation

The most frequent trigger is when the 3-month average excess spread earned on the receivables falls to zero or less. When this happens, prepayments are used to retire credit card tranches sequentially, instead of using them to purchase more receivables.

Which of the following mortgage loan characteristics leastlikely affects prepayments?

reputation of the lender with the agencies (e.g.,Fannie Mae, Ginnie Mae). type of loan (e.g., 30-yearfixedrate, 15-yearvariable).

original mortgage rate.

Explanation

The reputationof the lenderdoes not affect prepayments.

AlanBarding is a bank analyst currently reviewing data on the credit scores of3 individuals whohave appliedfor a bank loan. The credit scores for the 3 individuals are shownbelow:

Individual Credit score

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B 440

C 350

Whichof the following conclusions is Barding leastlikely todraw?

Individual C is twice as likely to default as individual A. Individual B is less likely todefault than individual C. Individual Ahas a lowercredit risk than individual B.

Explanation

Credit scores are ordinal rankings.Individual C is more likely todefault than individual A, but it cannot be concluded that A is twice as likely.

Which of the following bestdescribes howa growing economycanaffect prepayments? A growing economy:

leads to increasing prepayments. does not affect prepayments.

leads todecreasing prepayments.

Explanation

The reasonfor this linkis as follows: A growing economyleads toarise inpersonalincome andopportunities forworkermigrationand mobility.This results inhigherhousing turnoverand therefore increasing prepayment rates.

Which of the following is least likely an example of external credit enhancements?

Excess spread. Letters of credit. Bank guarantees.

Explanation

Excess spread is an example of internal, not external credit enhancement.

Regarding prepayment rates, which of the following statements is least accurate?

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Questions #11-1

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The conditional prepayment rate (CPR) is the actual rate at which the mortgage pool balance is prepaid.

If the conditional prepayment rate (CPR) is converted into a monthly rate, it is called the single monthly mortality rate (SMM).

Explanation

CPR is the assumed rate at which the mortgage pool balance is prepaid, not the actual rate at which it is prepaid.

Financial consultant George Price advises high-net-worth individuals on income investments. His firm, Price Enterprises, specializes in asset-backed securities (ABS). Price's son-in-law, Roger Camby, also works for the firm. Price and Camby do not get along well, and they often engage in heated arguments in the office.

On a certain morning, Price and Camby are arguing about which asset-backed securities (ABS) to purchase. Over the last two weeks, Price Enterprises signed up a half-dozen new clients and received several million in new funds from existing clients, and the company needs some new ideas for the portfolios.

Camby is excited about a new ABS issued by a large retailer, Glendo's. The ABS reflects a bundle of nonamortizing consumer credit accounts. As usual, Price prefers a different option, in this case a new collateralized mortgage obligation (CMO) issued by Trident Mortgage. Both securities offer similar total return potential and seem reasonably valued. Both Camby and Price believe the other analyst's preferred securities are too risky.

Unable to come to an agreement about which ABS to purchase, Camby and Price return to an old topic of discussion, the merits of collateralized debt obligations, (CDOs). Both analysts agree on the benefits of CDOs, which allow investors to profit off the spread between return on collateral and the cost of funding. But they disagree on the best strategy for constructing a CDO. Price prefers a simple cash CDO and criticizes Camby for his preference for more complicated synthetic securities. Camby argues that synthetic CDOs offer several advantages over cash CDOs:

It is cheaper to purchase exposure to an asset through a swap than to purchase the asset directly. Only the senior section must be funded.

It takes less time to assemble the portfolio.

A bank can use a synthetic CDO to take debt off the balance sheet without the consent of borrowers.

Bindle Bonds, a consultancy that sets up payment structures for entities that wish to issue asset-backed securities, has a referral relationship with Price Enterprises. Just before lunch, Bindle sales director Marty Malkin calls Price to offer him a piece of a new ABS comprised of thousands of home-improvement loans. Price likes the interest rates and the senior/subordinated structure that contains several junior tranches and senior tranches. But during his analysis of the default and prepayment projections, Price becomes concerned that Bindle is underestimating the risks. In response to Price's concerns, Malkin explains that the ABS has a shifting-interest mechanism designed to limit risk for the senior tranches.

After Price agrees to invest in the new Bindle ABS, he and Camby go to lunch. As they wait for their food, they discuss an investment a colleague pitched to Camby that morning. The ABS issuer used a conditional prepayment rate to estimate prepayment risks. According to the issuer's model, prepayment risks are modest, in part because refinancing is not a major concern with the underlying securities. The underlying securities are fixed-rate loans, and their default risk is fairly high. One benefit of the securities is the fact that principal payments are immediately passed on to investors.

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Question ID: 464002

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Question #13 of 131

Question ID: 464003

alternative would be a commercial MBS. Price makes the following arguments for CMBS:

There are currently plenty of attractive CMBS, evident by their low debt-to-service coverage ratios and low loan-to-value ratios.

Contraction risk on a CMBS can be substantially lower than on a residential MBS due to prepayment lock out periods and yield maintenance charges.

Camby, however, disagrees with his father-in-law. He suggests that Peterson should invest in residential MBS, citing the following reasons:

Residential MBS have more certain cash flows than a CMBS because you can rely on their government-backed guarantee.

Residential MBS have more reliable collateral than CMBS, due to the fact that CMBS are structured with defeasance clauses which act to lower the credit quality of the underlying loan pool.

What affect will the shifting-interest mechanism connected to the ABS backed by home-improvement loans have on the senior tranches?

Credit Risk? Prepayment Risk?

Increase Reduce

Reduce Increase

Reduce Reduce

Explanation

Shifting-interest mechanisms reduce the proportional share of the outstanding loan balance in junior tranches as prepayments occur. This has the effect of reducing credit risk for the senior tranches but increasing their prepayment risk. (Study Session 13, LOS 42.d)

The ABS Price and Camby discussed at lunch is most likely backed by:

Small Business Administration (SBA) loans. auto loans.

home-equity loans.

Explanation

The low prepayment risk eliminates home-equity loans, which have a high prepayment risk. The fact that the loans have a fixed interest rate suggests they are not SBA loans, most of which have a variable rate. That leaves auto loans, and the characteristics of the ABS presented in the vignette can all apply to auto-loan-backed securities. (Study Session 13, LOS 42.e)

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It is cheaper to purchase exposure to an asset through a swap than to purchase the asset directly.

Only the senior section must be funded.

A bank can use a synthetic CDO to take debt off the balance sheet without the consent of borrowers.

Explanation

For a synthetic CDO, only the junior section must be funded. The other statements are accurate. (Study Session 13, LOS 42.f)

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Camby is incorrect in stating residential MBShave more certaincashflows thanaCMBSbecause youcanrely on their government-backed guarantee.Although it is true that government agency issued MBSdo come withapseudo-governmental guarantee, many residential MBSare non-agency issued, meaning they are issuedby private entities anddo not come witha government guarantee.

Camby's statement regarding aCMBSdefeasance clause is incorrect.If the borrower makes early payments on the mortgage loan, the mortgage loancanbe defeased, which means the loanproceeds are receivedby the loan servicerand invested in U.S.Treasury securities, essentially creating cashcollateral against the loan.Treasuries provide higher-quality collateral than the underlying real estate, so loans structuredwithdefeasance increase the credit quality ofaCMBS loanpool. (Study Session 15, LOS 48.l)

Identify three risks associatedwithinvesting inmortgage-backed securities (MBS). Risks associatedwithinvesting in MBSare:

interest rate risk, default risk, and prepayment risk. interest rate risk, contractionrisk, and servicing fee risk. extensionrisk, credit risk, anddowngrade risk.

Explanation

Amortgage is aloan that is collateralizedwitha specificpiece ofrealproperty, eitherresidentialorcommercial.The borrowermust make a series ofmortgage payments over the life of the loan, and the lenderhas the right to "foreclose" orlayclaimagainst the real estate in the event ofaloandefault.An MBSrepresents aclaimagainst apoolofmortgages.The cashflows from the poolare distributedamongst the holders ofall the MBSas per the terms of the issue.

Risks associatedwithinvestment in MBS:

Interest rate risk−changes in the value of the MBSas interest rates change (usuallyinverse).

Default risk−risk that some orallof the borrowers default and the collateralis not enough tocover the entire mortgage. Prepayment risk−risk that the borrowers prepayas interest rates decline.

Whichof the following bestdescribes a strippedmortgage-backed security (MBS)? A stripped MBSis a security:

whose distribution of principal and interest has been altered from a pro rata distribution to an unequal distribution.

whose distributionofprincipalandinterest has beenalteredfromanunequaldistribution toa proratadistribution.

that provides nointerest payments.

Explanation

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onaproratabasis.This means that eachpassthroughcertificate holderreceives the same amount ofinterest and the same amount of principal.Strippedmortgage-backed securities differin that principalandinterest are not allocatedonaproratabasis.

Anannualized measure of the prepayments experiencedby apool of mortgages is its:

PSA prepayment benchmark.

conditional prepayment rate. single monthly mortality rate.

Explanation

The conditional prepayment rate (CPR) is anannualized measure ofa mortgage pool's prepayments.The single monthly mortality rate is the percentage by whichprepayments have reduced the month-endprincipal balance.The PSAprepayment benchmark is a monthly series ofCPRs to whicha mortgage pool's CPR may be compared.

Which of the following is the primary difference betweenresidential Mortgage-BackedSecurities (MBS)andCommercial Mortgage-BackedSecurities (CMBS)credit risk?

Residential credit risk does not use financial ratio analysis for the determination of borrower credit worthiness.

Residential credit risk is difficult to quantify because of the nature of the residential borrower.

Inresidential MBS securities, the lenderhas the ability to seek repayment from the borrowerbeyond the value of the collateral.

Explanation

All CMBS mortgages are non-recourse loans;however, the residential mortgage lendercan go back to the borrower personally inanattempt to repay adelinquent mortgage loan.

The primary motivationfor investing in the support tranche ofaplannedamortizationclass CMO, compared to investing in another tranche, is that the support tranche offers:

more protection against extension risk. ahigher interest rate.

more protectionagainst contractionrisk.

Explanation

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Question #25 of 131

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PAC tranches.Because of these higherrisks, the support tranches offerahigher interest rate than the PAC tranches.

Whichof the following most accuratelydescribesamortgage passthroughsecurity?

An option on a pool of mortgages.

Asecurity that paysoff the fullamount of the mortgage if the borrowerdefaults. Aparticipationcertificate inapoolofmortgages.

Explanation

Amortgage passthroughsecurityrepresentsaclaimagainst apoolofmortgages.Anynumberofmortgagesmaybe used toform the pool, andanymortgage includedin the poolisreferred toasasecuritizedmortgage.

Howis the principalretiredwhenan earlyamortizationprovisionis triggered? It isretiredby:

reinvesting credit card borrowers' principal payments in receivables. maturing credit cardreceivable-backedsecuritiesimmediately.

paying credit cardborrowers' principalpaymentsdirectly toinvestorswithout using them to purchase more receivables.

Explanation

When earlyamortizationoccurs, the credit card tranchesare retiredsequentially.Thisisaccomplishedbypaying prepayments to investorsinsteadofusing them topurchase more receivables.

Whichof the following factorsdoes NOTaffect prepayments?

Characteristics of the underlying mortgage pool. Defeasance.

Housing turnover.

Explanation

Defeasance isa type ofcallprotectionusedincommercialloans.

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Question ID: 463925

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Question #2

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Question ID: 463974

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average time toreceipt of:

expected prepayments. scheduledprincipal payments.

bothscheduledprincipal paymentsand expectedprepayments.

Explanation

The average life ofan MBSrepresents the average time toreceipt ofbothscheduledprincipal paymentsand expected prepayments.

Whichof the following is the bestdescriptionof excessservicing spreadaccountsasaninternalcredit enhancement? Excessservicing spreadaccountsinvolve the allocationof:

excess cash into a separate reserve account after paying out coupon, servicing fee and other expenses.

all expensesintoaseparate reserve account. the servicing fee intoaseparate reserve account.

Explanation

All excesscashispaidinto the excessservicing spreadaccount inorder tobe used topayforpossible future losses.

Prepayment tranching refers to:

subdividing a corporate bond so some components pay earlier coupon payments than others.

subdividing anasset ormortgage backedsecurity sosome componentsare exposed tomore prepayment risk thanothers.

subdividing acorporate bondsosome componentspay couponandotherspay principal.

Explanation

Prepayment tranching refers towhenanasset ormortgage backedsecurity issubdividedsosome componentsare exposed tomore prepayment risk thanothers.

The cashflowsfrommortgage-backedandsome asset-backedsecuritiesare:

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Question #31 of 131

Question ID: 460704

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interest rate pathdependent.

interest rate pathindependent.

Explanation

The cashflowsfrommortgage-backedandsome asset-backedsecuritiesare interest-rate pathdependent.

Acollateralizeddebt obligation (CDO)isanasset that isleastlikely tobe backedby whichof the following typesofdebt obligations:

bank loans to corporations.

non-investment grade corporate bonds. investment grade corporate bonds.

Explanation

ACDO isanasset-backedsecurity (ABS) that iscollateralizedby apool ofdebt obligationscomprising belowinvestment grade corporate bonds, corporate loansadvancedby commercial banks, andbondissuesin emerging markets.Investment grade bondsare not typically anunderlying asset inCDOs.

Twostructuresofcollateralizedmortgage obligations (CMO)are being considered.In the first structure, $300 millionofpass-throughswill be usedascollateralfor twosequential-pay tranches: $225millionofbondsof tranche U and $75millionofbondsof tranche V.The principalfor tranche U must be completelypaidoffbefore anypaymentsare made to tranche V.In the secondstructure, the $300 million ofpass-throughswillbe usedascollateralfor $225millionof X bondsinaplannedamortization tranche and $75millionof Y bondsina support tranche. Whichof the following isleastaccurate? The:

U bonds have less contraction risk than the V bonds. U bondshave less extensionrisk than the V bonds. X bondshave lesscontractionrisk than the Y bonds.

Explanation

The U bondshave less extensionrisk, but theyprovide protectionfor the V bondsagainst contraction.

Acollateralizeddebt obligation (CDO)inwhich the collateral isapool ofresidential mortgage-backedsecuritiesismost accuratelydescribedasa:

structured finance CDO.

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Question #32 of 131

Question ID: 463962

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Question #33 of 131

Question ID: 463928

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Question ID: 460702

syntheticCDO.

Explanation

Inastructuredfinance CDO the collateral isapool ofmortgage-backedsecurities, asset-backedsecurities, orotherCDOs.In asyntheticCDO the collateral isapool ofcredit default swaps.InaCLO the collateral isapool of leveragedbank loans.

Suppose that the collateralforanasset-backedsecurities (ABS)structure hasa grossweightedaverage couponof10.5%.The servicing fee is50 basispoints.The tranchesissuedhave aweightedaverage couponrate of 8.5%. What is the excessservicing spread?

2.50%. 1.50%. 1.00%.

Explanation

The excessservicing spreadisdeterminedasfollows:

Grossweightedaveragecoupon =10.50%

−Servicing fee = 0.50%

Spreadavailabletopaytranches=10.00%

−Netweightedaveragecoupon = 8.50%

Excessservicing spread. =1.50% = 150 bps.

Whichof the following is NOTafeature ofanasset-backedsecurity backedby non-amortizing assets?

A call provision can be triggered when collateral reaches a certain level. During a lockout period, principal paymentsare not distributed to the bondholders. The compositionof the underlying loansdoesnot change.

Explanation

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Question #35 of 131

Question ID: 415451

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Question ID: 463890

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Question ID: 463874

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Whichof the following statementsconcerning the support tranche inaplannedamortizationclass (PAC)CMO backedby agency RMBSisleastaccurate?

The purpose of a support tranche is to provide prepayment protection for one or more PAC tranches.

Ifprepaymentsare too low tomaintain the scheduled PACpayments, the shortfall is providedby the support tranche.

The support tranchesare exposed tohigh levelsofcredit risk.

Explanation

The support tranchesare exposed tohigh levelsofprepayment risk, not credit risk.

Whichof the following isa generalproblemassociatedwith externalcredit enhancements? Externalcredit enhancements:

are subject to the credit risk of the third-party guarantor. are onlyavailable onashort-termbasis.

are verylong-termagreementsandare therefore relatively expensive.

Explanation

If the guarantorisdowngraded, the issue itselfcouldbe subject todowngrade evenif the structure isperforming as expected.

Prepaymentscause the timing andamount ofcashflowsfrommortgage loansandmortgage-backedsecurities (MBS) tobe uncertain.Thus:

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

the analyst must make specificassumptionsabout the rate at whichprepaymentsof the pooledmortgagesoccurswhenvaluing the passthroughsecurities.

regulatorsmandate the conventionfirmsmust use when estimating prepayment rates.

Explanation

The analyst must make specificassumptionsabout the rate at whichprepaymentsof the pooledmortgagesoccurwhen valuing the passthroughsecurities.

Whichof the following typesofassetsare leastlikely tobe securitizedasasset-backedsecurities (ABS)?

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Question ID: 463936

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Question ID: 463865

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Question ID: 463886

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Auto loans. Insurance policies.

Explanation

Insurance policiesare not assetssecuritizedinABSstructures. Home equity linesofcredit andauto loansare often securitized.

Howis the price ofaninterest-only mortgage stripaffectedby declining mortgage ratesin the market below the contract rate? The price of the interest-only strip:

decreases.

may increase ordecrease. increases.

Explanation

Whenmortgage ratesdecline, prepaymentsare expected toincrease.Thisresultsinadeteriorationof the expectedcash flowsfromaninterest-only strip.

Whichof the following ismostlikelyaweaknessofreducedformmodels?

Hazard rate estimation procedures predict future defaults using historic information.

The model assumes that acompany's equity tradesinfrictionlessmarkets. The model'scredit riskchangeswith the businesscycle.

Explanation

Unless the model isproperly back testedandformulated, the use ofhistorical datamay not be appropriate forpredicting the future. Only asingle issue of zerocoupondebt isassumed to trade under the reducedformmodels. Underreducedform models, the credit riskisallowed tochange withbusinesscycle.Thisishowever, anadvantage.There isnorequirement that the company's equity is traded.

Paymentsin excessof the requiredmonthly payment amount are called:

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Question ID: 463873

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Question ID: 460700

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Question ID: 463935

ᅞ A) ᅚ B) ᅞ C) Explanation

Paymentsin excessof the requiredmonthly payment amount are calledprepayments.

Carco MotorCompany isanautomobile manufacturer that isin the processofcreating asset-backedsecurities (ABS)by utilizing apool of loansfromcars the company hadfinancedforitscustomersandselling them toaseparate legal entity.The issuerof the ABSisalsoreferred toas:

a special purpose vehicle. the servicer.

the seller.

Explanation

Aspecial purpose vehicle (SPV)is establishedfor eachsecuritizationof loans.The loansare sold to the SPV, whichin turnis the entity whichissues the ABS.

Asequential-pay CMO has two tranches. Principal ispaid toTranche Suntil it ispaidoff, afterwhichprincipal ispaid to Tranche R.Compared toTranche R, Tranche Shas:

more contraction risk and less extension risk. more contractionriskandmore extensionrisk. lesscontractionriskandmore extensionrisk.

Explanation

Inasequential-pay CMO the short tranche, whichreceivesprincipal paymentsandprepaymentsfirst, hasmore contraction risk, while the tranche that receivesprincipal paymentsandprepayments last hasmore extensionrisk.

Interest only (IO)stripcashflow:

starts out small and gets bigger over time. startsout big and getssmallerover time. are the same throughout the life of the security.

Explanation

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Question ID: 463964

Whichof the following statementsregarding the basicstructure ofanasset-backedsecurity (ABS)isleastaccurate?

The flow of funds from the underlying loan, through the servicer and issuer and finally to the investor, is called the waterfall.

The sellerand the servicerof the ABSare always the same entity.

Corporate bondsand emerging market bondscanbe collateralized tocreate anABS.

Explanation

The twoseparate functionsofsellerandservicerofanABScanbe performedby either twodifferent entitiesor the same entity.

Jim Metabo, SeniorAnalyst with Pearl Partners, is evaluating anasset-backedsecurity (ABS)forinclusioninclient portfolios. The masterprospectus establishes the shifting interest mechanismfor thisABSinaccordance withTable 1.

Table1

SeniorPrepaymentPercentage

YearsafterIssuance SeniorPrepaymentPercent

1-5 100

6 70

7 60

8 40

9 20

after year 9 0

The structure for the ABSis:

Senior tranche $190 million Subordinated tranche 1 $20 million Subordinated tranche 2 $10 million

The value of the collateral for the structure is $220 millionandsubordinated tranche 2is the first loss tranche.ThisABSis wrappedand10% of the securitizationis guranteedby a thirdparty monoline insurer.

Dataabout the weightedaverage couponratesfor the structure isasfollows:

Gross WAC 7.00%

Servicing andother

fees 0.25%

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Question ID: 463965

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Question ID: 463967

Inaccordance with the seniorrepayment percentage presentedinTable 1, ifprepaymentsinmonth110 are $5million the senior tranche ispaid:

$0 million. $5million.

$1million.

Explanation

Ifprepaymentsinmonth110(whichisbeyond the 9 year) total $5million, the amount paid to the senior tranche inaccordance withTable 1 ("seniorprepayment percentage")is 0.00% $0 million.

(LOS 49.b)

Inaccordance with the seniorprepayment percentage presentedinTable 1, ifprepaymentsona $50 millionoffering inmonth30 are $2

million, the amount paid to the senior tranche is:

$1 million. $2million.

$50 million.

Explanation

Ifprepaymentsinmonth30 total $2million, the amount paid to the senior tranche inaccordance with the Table 1seniorprepayment percentage is100% of the $2million.

(LOS 49.b)

If lossesdue todefault over the life of the structure total $7.5million, the amount of the lossfor each tranche isclosest to:

Senior Subordinated1 Subordinated2

$0.0 $2.5 $5.0

$0.0 $0.0 $7.5

$7.5 $0.0 $0.0

Explanation

The total lossisfirst applied to the subordinate tranche 2.Since $7.5millionis less thansubordinated tranche 2's losscapacity of $10 million, there isno lossforsubordinated tranche 1or the senior tranche.

(LOS 49.b)

If lossesdue todefault over the life of the structure total $25.0 million, the amount of the lossfor each tranche isclosest to:

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Question ID: 463968

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Question ID: 463969

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Senior Subordinated1 Subordinated2

$5.0 $5.0 $10.0

$0.0 $15.0 $10.0

$2.5 $2.5 $15.0

Explanation

The lossisfirst applied tosubordinate tranche 2. Witha $25million loss, subordinated tranche 2iscompletely liquidated to pay lossesof $10 million, and the next $15millionin lossesare applied tosubordinated tranche 1.The senior trache doesnot sufferany losses.

(LOS 49.b)

Internal credit enhancementsfor thisABSinclude

a reserve fund and a senior-subordinate structure. overcollateralizationandasenior-subordinate structure. areserve fundandamonoline insurer guarantee.

Explanation

Credit enhancementscanbe either external orinternal. External credit enhancementscanbe guaranteesfrommonoline insurers, lettersofcredit by banksor guarantee ofassetsby the seller.Internal credit enhancementsinclude reserve funds, senior-subordinate structures, andovercollateralization.

ThisABSincludesareserve fundby excessspreadaccounts- the difference between the grossweightedaverage coupon (gross WAC)and the net WACplus the servicing andotherfees.The difference ispositive: 7.00% − 0.25% − 6.25% = 0.50%, so there isa50 basispointsspreadforanreserve account topay forpotential losses.

The senior-subordinate structure (givenin the vignette) enhances the creditworthinessof the seniorclass. Overcollaterializationdoesnot exist as the amount securitizedmatches the value of the collateral.

Although thisABSiswrapped, a guarantee fromamonoline insurerisconsideredan external credit enhancement.

(LOS 49.d)

Assuming that the ABSasset iscredit cardreceivableswitha lockout of2 years.If15monthsafter the securitization, an additional $20 millionin excessof the scheduledprincipal andinterest paymentswere paid.The senior tranche ismostlikely toreceive:

Question #51 of 131

Question ID: 463889

ᅞ A) ᅞ B) ᅚ C)

Question #52 of 131

Question ID: 463924

ᅚ A)

ᅞ B)

ᅞ C)

Question #53 of 131

Question ID: 463970

ᅚ A)

ᅞ B)

ᅞ C) Explanation

Credit cardreceivablesare non-amortizing assetsandassuchwill not pay downprincipal during the lockout periodof the first 24 months.The $20 millionis likely used topay foradditional credit cardreceivables.

(LOS 49.e)

Whichof the following mostaccuratelydescribesprepayments?

A payment that pays the mortgage in full prior to maturity.

Prepayment occursifbothinterest andprincipalare paidbefore the endof the mortgage term. Apayment made in excessof the monthlymortgage payment.

Explanation

It ispossible foramortgage borrower topayanamount in excessof the requiredpayment or even topayoff the loan entirely. Payments in excessof the requiredmonthlyamount are calledprepayments.

Whichof the following isleastaccurate regarding plannedamortizationclass (PAC)versussupport tranches?

The PAC tranches have the greatest prepayment risk in the collateralized mortgage obligation (CMO) structure.

There isaninverse relationshipbetween the prepayment riskof the PAC tranchesand the prepayment riskassociatedwith the support tranches.

The prepayment riskprotectionprovidedby the support tranchescauses the average life to extendandcontract.

Explanation

The support trancheshave the greatest prepayment riskin the CMO structure, not the PAC tranches.

Whichof the following statementsregarding credit cardreceivable-backedsecuritiesisleastaccurate?

Credit card receivable-backed securities pay principal and interest each payment just like a mortgage-backed security.

The cashflow to the pool ofcredit cardreceivablesconsistsoffinance charges, fees, andprincipal repayment.

Credit cardreceivable-backedsecuritiesuse amaster trust structure.

Question #5

4

of 131

Question ID: 463990

ᅚ A)

ᅞ B) ᅞ C)

Question #55 of 131

Question ID: 463947

ᅚ A)

ᅞ B)

ᅞ C)

Question #5

6

of 131

Question ID: 460696

ᅚ A) ᅞ B) ᅞ C)

Credit cardreceivable-backedsecurities do not pay principal andinterest eachpayment just like amortgage-backedsecurity. Interest ispaidperiodically andprincipal isplacedundera lockout period.

Whichof the following statementsregarding CMOsisleastaccurate? The:

early maturing tranches offer relatively greater protection against contraction risk.

early maturing tranchesofferrelatively greaterprotectionagainst extensionrisk. longer-term tranchesofferrelatively greaterprotectionagainst contractionrisk.

Explanation

The early maturing tranchesofferrelatively greaterprotectionagainst extensionrisk, not contractionrisk.

Whichof the following regarding key credit enhancement featuresofdefeasance asprepayment protectionisleastaccurate?

The duration of the defeasance funds reduces the credit risk of the commercial mortgage-backed securities (CMBS).

Nodistributionsare made when the defeasance takesplace, so there isnoissue concerning howprepayment penaltieswill be disbursed.

The cashflowfrom the defeasance fundsissubstitutedforpaymentsmade by the borrower.

Explanation

Durationisrelated tointerest rate risk;it isnot related tocredit risk.

Amortgage that includessome repayment ofprincipal in eachpayment, andhasanoutstanding principal balance at maturity, ismostaccuratelydescribedasa:

partially amortizing mortgage. hybridmortgage.

rollovermortgage.

Explanation

Question #5

7

of 131

Question ID: 463994

ᅚ A) ᅞ B) ᅞ C)

Question #5

8

of 131

Question ID: 463861

ᅚ A)

ᅞ B)

ᅞ C)

Question #5

9

of 131

Question ID: 463992

ᅚ A) ᅞ B) ᅞ C)

Whichof the following statementsregarding collateralizeddebt obligations (CDOs)isleastaccurate?

Interest rate swaps are rarely used due to scrutiny from rating agencies. The senior tranche isusually paidafloating rate.

Mezzanine tranchesreceive afixedrate.

Explanation

The collateral usually hasamix offloating andfixedrate debt sointerest rate swapsare used tomanage the riskfromcash flowmismatches.Interest rate swapsare oftenusedby asset managers tocontrol the interest rate riskimposedby this mismatch, Rating agenciesusually mandate the use ofswaps.InCDOs there isusually asenior tranche that receivesa floating rate, mezzanine tranches that receive afixedrate, andasubordinate or equity tranche that providesprepayment and credit protection to the other tranches.

Whichof the following statementsregarding credit ratingsisleastaccurate?

An advantage of traditional credit ratings is that they tend to vary with the business cycle which accurately reflects current risk.

Adisadvantage of traditional credit ratingsis that they are stable over time which reduces the correlationwithadebt offering'sdefault probability.

Anadvantage of traditional credit ratingsis that they provide asimple way of summarizing complex credit analysis.

Explanation

Traditional credit ratings tend tobe stable over the businesscycle.Thisisadisadvantage asadebt offering'sdefault probability will vary with the cycle.

Whichof the following isreferred toasasequential-payCMO? Asequential-payCMO isstructuredso that eachclassofbond:

is retired sequentially.

receivesprepaymentsonasequentialpro-ratabasis. hasdifferent credit risk.

Explanation

Question #

60

of 131

Question ID: 463934

ᅚ A) ᅞ B)

ᅞ C)

Question #

6

1 of 131

Question ID: 463876

ᅚ A) ᅞ B) ᅞ C)

Question #

6

2 of 131

Question ID: 463938

ᅞ A) ᅚ B)

ᅞ C)

Question #

6

3 of 131

Question ID: 463930

ᅞ A) ᅞ B)

Whichof the following explainswhy the companion trancheshave the greatestprepayment riskinaCMO structure? The companion tranches:

have to support any principal payments in excess of the scheduled principal payments. consist ofunderlying mortgagesforwhichprepayment isallowed, asopposed to the PAC

tranches.

are more interest rate sensitive and therefore prepayment riskishigher.

Explanation

There isaninverse relationshipbetween the prepayment riskof PAC tranchesand the prepayment riskassociatedwith the support tranches.Inotherwords, the certaintyof PACbondcashflowcomesat the expense ofincreasedrisk to the support tranches.

Inapassthroughstructure, the principalcashflowfrom the credit cardaccountsare:

paid to security holders on a pro rata basis. amoritizedwithout penalty.

neverpaiddue tointerest rate charges.

Explanation

Inapassthroughstructure, the principalcashflowfrom the credit cardaccountsare paid tosecurityholdersonaproratabasis.

All of the following statementsregarding nonagency securitiesare correct EXCEPT:

loans used to back nonagency CMOs are referred to as nonconforming loans. the collateral behindnonagency collateralizedmortgage obligationsispassthrough securities.

the collateral behindnonagency CMOsisapool of loans.

Explanation

The collateral behindnonagency CMOsisapool of loans, not passthroughsecurities.

Whichof the following is NOTaformofinternalcredit enhancement?

Reserve funds.

ᅚ C)

Question #

64

of 131

Question ID: 463951

ᅞ A) ᅚ B) ᅞ C)

Question #

6

5 of 131

Question ID: 463998

ᅞ A)

ᅞ B)

ᅚ C)

Question #

66

of 131

Question ID: 460694

ᅞ A)

ᅞ B) ᅚ C)

Sequential-paystructure.

Explanation

Asequential-paystructure isnot acredit enhancement. Externalcredit enhancementsare financial guaranteesfrom thirdparties that generallysupport the performance of the bond.Internalcredit enhancementsdonot relyona third-party guarantee.Theycommonly include setting aside reserve fundsandstructures that containseniorandsubordinateddebt.

Whichof the following isleastlikelyan example ofinternal credit enhancement?

Over-collateralization. Bondinsurance.

Excessservicing spreadaccounts.

Explanation

Bondinsurance isan example of external, not internal, credit enhancement.

Whichof the following statementsregarding collateralizedmortgage obligations (CMOs)isleastaccurate:

The Z-tranche or accrual tranche does not receive current interest until the other tranches have been paid off.

CMOsare securitiesissuedagainst passthroughsecuritiesforwhich the cashflows have beenreallocated todifferent bondclassescalled tranches.

CMOsperfectly protect investorsagainst contractionriskbut donot protect against extensionrisk.

Explanation

CMOsdonot perfectly protect investorsagainst contractionrisk.They offersome protectionagainst bothcontractionand extensionrisks, but not perfect protectionagainst either.

Total cashflows toinvestorsinanABSissue are:

equal to the total interest and principal payments from the underlying asset pool if only one class of ABS has been issued from the trust.

equal to the total interest andprincipal paymentsfrom the underlying asset pool. less than the total interest andprincipal paymentsfrom the underlying asset pool.

Question #

67

of 131

Question ID: 460698

ᅞ A) ᅞ B) ᅚ C)

Question #

68

of 131

Question ID: 463912

ᅞ A) ᅚ B)

ᅞ C)

Question #

69

of 131

Question ID: 463923

ᅞ A) ᅚ B) ᅞ C)

Cashflowsfrom the underlying asset pool are used topay fees to the serviceraswell aspayments to the ABSinvestors.Thus payments toinvestorsare less than the total cashflowsfrom the pool ofassets.

Amortgage-backedsecurity hasapass-throughrate of 4.3%.The average interest rate onitsunderlying pool ofmortgagesis 4.5%.The difference between these ratesismostlikelydue to:

slower-than-expected prepayments. faster-than-expectedprepayments. issuance andservicing costs.

Explanation

Pass-through (i.e., coupon)ratesonan MBSare less than the average interest rate onitsunderlying pool ofmortgages because some of the cashflowsfrom the mortgagesare used topay issuance costsandfees to the servicerof the mortgages.

Whichof the following is the best explanationofaconditionalprepayment rate? The conditionalprepayment rate is the:

realized prepayment rate of a pool.

prepayment rate assumedforapoolbasedon the characteristicsof the pooland the economic environment.

percentage of the totalliability that aborrowerprepaysconditionalon the fact that he prepays.

Explanation

The conditionalprepayment rate conventionfordescribing the patternofprepaymentsand the cashflowofapassthroughassumes that some fractionof the remaining principalin the poolispre-paid eachmonthfor the remaining termof the mortgage.The rate isinfluenced

by the economic environment and the characteristicsof the mortgage pool.

The statedmaturity ofamortgage passthroughsecurity is:

will always be longer than its true life. unlikely to equal its true life.

will alwaysbe shorter thanits true life.

Explanation

Question #

70

of 131

Question ID: 463933

ᅞ A) ᅞ B) ᅚ C)

Question #

7

1 of 131

Question ID: 472713

ᅞ A) ᅚ B) ᅞ C)

Question #

7

2 of 131

Question ID: 463885

ᅚ A) ᅞ B) ᅞ C)

Question #

7

3 of 131

Question ID: 463948

Whichof the following is the bestdescriptionofcashreserve fundsasaninternalcredit enhancement? Cashreserve fundsare investmentsin:

U.S. Treasury bonds created from issuance proceeds.

moneymarket instrumentscreatedfromsecuritizing mortgages.

moneymarket instrumentscreatedfromissuance proceeds.

Explanation

Cashreserve fundsare cashdeposits that come fromissuance proceeds.This excesscashprovidesfor the establishment ofareserve account topayforfuture losses.Cashreserve fundsare usuallyusedalong with externalcredit enhancements.

Whichof the following isreferred toasprincipal-amortizationperiodforacredit cardreceivable-backedsecurity? The principal

-amortizationperiodis the periodduring which the:

interest is reinvested.

principalisnolongerreinvested, but paid toinvestors.

principalisreinvested.

Explanation

Since credit cardbalancesare revolving, principalisnot amortized.Assuch, interest oncredit cardABSsispaidperiodicallyand the principalisplacedundera "lockout period," during which time noprincipalispaid to the ABSholders. Principalpaymentsmade during the lockout periodare used topurchase additionalunderlying assetsorreceivables. Once the lockout period ends, principalpaymentsare passedon to the securityholders.Thispost-lockout periodisknownas the "principalamortizationperiod."

Whichof the following is the bestdefinitionof extensionrisk? The adverse consequencesof:

increasing interest rates on passthrough securities. lowerprepayment rates.

declining interest ratesonpassthroughsecurities.

Explanation

ᅞ A)

ᅚ B) ᅞ C)

Question #

74

of 131

Question ID: 463917

ᅞ A) ᅚ B) ᅞ C)

Question #

7

5 of 131

Question ID: 463866

ᅞ A)

ᅞ B) ᅚ C)

Question #

76

of 131

Question ID: 463991

Commercial mortgage-backedsecurities (CMBS)provide call protection through loan-level andindividual mortgage call protection. Whichof the following are leastlikelyformsofcall protection?

Borrowers are charged the amount of interest lost by the lender had the loan not been prepaid.

Ifborrowersprepay their loan, proceedsare distributed toinvestors. Penalty feesassessedagainst the borrowerforprepayment.

Explanation

Loan-level call protectionincludes: defeasance, prepayment penalty charges, prepayment lockout period, and yield maintenance charges. Prepayment proceedsshould not be distributed to investors. When borrowers prepay, the mortgage loan can be "defeased" - the loan proceeds are received by the loan servicer and invested in U.S. Treasuries to create cash collateral against the loan.

Whichof the following is a reason why the average life of a mortgage-backed security is a more relevant measure than the security's maturity? The average life:

takes interest rate risk into account.

takes into account the assumed prepayment rate. takes the economic environment into account.

Explanation

The stated maturity of a mortgage passthrough security is unlikely to equal its true life because of prepayments. Average life is used

because it represents the average time to receipt of both scheduled principal payments and expected prepayments.

Whichof the following two securities are most likelyused to calculate the term structure of credit spreads?

A corporate issuer's coupon paying bond and the same issuer's zero coupon bond.

A corporate issuer's senior debt and the same issuer's subordinateddebt. A corporate issuer's zero coupon bond and a default free zero coupon bond.

Explanation

ᅚ A)

U bonds have less prepayment risk than the V bonds, which have less prepayment risk