LOS e CFA Level 1 - Fixed Income: Structured Securities Session 15 - Reading 58 Asset-Backed Sector of the Bond Market

CFA Level 1 - Fixed Income: Structured Securities Session 15 - Reading 58 Asset-Backed Sector of the Bond Market - LOS e (Notes, Practice Questions, Sample Questions) 1. Which of the following statements regarding securities backed by closed-end home equity loans is CORRECT? A) Prepayments are not allowed. B) The prepayment benchmark is issuer specific. C) The securities in those deals are typically floating-rate tranches. Explanation — (B) Unlike the PSA benchmark, the prepaymentbenchmark speed in the prospectus is issuer specific 2. In a passthrough structure, the principal cash flow from the credit card accounts are: A) paid to security holders on a pro rata basis. B) amoritized without penalty.C) never paid due to interest rate charges. Explanation — (A) In a passthrough structure, the principal cash flowfrom the credit card accounts are paid to security holders on a prorata basis

3.1 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, RogerCamby, 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 whichasset-backed securities (ABS) to purchase. Over the last two weeks,Price Enterprises signed up a half-dozen new clients and receivedseveral million in new funds from existing clients, and the companyneeds 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 newcollateralized mortgage obligation (CMO) issued by Trident Mortgage.Both securities offer similar total return potential and seem reasonablyvalued. Both Camby and Price believe the other analyst’s preferredsecurities are too risky. Unable to come to an agreement about which ABS to purchase, Cambyand Price return to an old topic of discussion, the merits of collateralizeddebt obligations, (CDOs). Both analysts agree on the benefits of CDOs,which allow investors to profit off the spread between return oncollateral and the cost of funding. But they disagree on the beststrategy for constructing a CDO. Price prefers a simple cash CDO andcriticizes Camby for his preference for more complicated syntheticsecurities. Camby argues that synthetic CDOs offer several advantagesover cash CDOs:

It is cheaper to purchase exposure to an asset through a swap than topurchase 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 sheetwithout the consent of borrowers.Bindle Bonds, a consultancy that sets up payment structures for entitiesthat wish to issue asset-backed securities, has a referral relationshipwith Price Enterprises. Just before lunch, Bindle sales director MartyMalkin calls Price to offer him a piece of a new ABS comprised ofthousands of home-improvement loans. Price likes the interest ratesand the senior/subordinated structure that contains several juniortranches and senior tranches. But during his analysis of the default andprepayment projections, Price becomes concerned that Bindle isunderestimating the risks. In response to Price’s concerns, Malkinexplains that the ABS has a shifting-interest mechanism designed tolimit risk for the senior tranches. After Price agrees to invest in the new Bindle ABS, he and Camby go tolunch. As they wait for their food, they discuss an investment acolleague pitched to Camby that morning. The ABS issuer used aconditional prepayment rate to estimate prepayment risks. According tothe issuer’s model, prepayment risks are modest, in part becauserefinancing is not a major concern with the underlying securities. Theunderlying securities are fixed-rate loans, and their default risk is fairlyhigh. One benefit of the securities is the fact that principal payments areimmediately passed on to investors. Immediately after Price and Camby return from lunch, Kay Peterson, alongtime client of Price Enterprises, comes into the office with questions

about investing in the mortgage securities market. Price and Cambyagree that this is an excellent time for Peterson to enter the MBSmarket, but disagree which mortgage securities would be best. Pricebelieves Peterson’s best alternative would be a commercial MBS. Pricemakes the following arguments for CMBS: There are currently plenty of attractive CMBS, evident by their lowdebt-to-service coverage ratios and low loan-to-value ratios.Contraction risk on a CMBS can be substantially lower than on aresidential MBS due to prepayment lock out periods and yieldmaintenance charges.Camby, however, disagrees with his father-in-law. He suggests thatPeterson should invest in residential MBS, citing the following reasons: Residential MBS have more certain cash flows than a CMBS becauseyou can rely on their government-backed guarantee.Residential MBS have more reliable collateral than CMBS, due to thefact that CMBS are structured with defeasance clauses which act tolower the credit quality of the underlying loan pool.What affect will the shifting-interest mechanism connected to the ABSbacked by home-improvement loans have on the senior tranches? Credit Risk? Prepayment Risk? A) Increase ReduceB) Reduce Reduce C) Reduce Increase Explanation — (C) Shifting-interest mechanisms reduce theproportional share of the outstanding loan balance in junior tranches

as prepayments occur. This has the effect of reducing credit risk forthe senior tranches but increasing their prepayment risk. 3.2 The ABS Price and Camby discussed at lunch is most likely backed by: A) Small Business Administration (SBA) loans. B) auto loans. C) home-equity loans. Explanation — (B) The low prepayment risk eliminates home-equityloans, which have a high prepayment risk. The fact that the loanshave a fixed interest rate suggests they are not SBA loans, most ofwhich have a variable rate. That leaves auto loans, and thecharacteristics of the ABS presented in the vignette can all apply toauto-loan-backed securities. 3.3 Which of Camby’s statements about the advantage of synthetic CDOs is least accurate? A) Only the senior section must be funded. B) A bank can use a synthetic CDO to take debt off the balance sheetwithout the consent of borrowers.C) It is cheaper to purchase exposure to an asset through a swap thanto purchase the asset directly. Explanation — (A) For a synthetic CDO, only the junior section mustbe funded. The other statements are accurate.

3.4 Camby’s preference for Glendo’s bonds suggests he is most likely concerned about: A) prepayment risk. B) credit risk.C) interest-rate risk. Explanation — (A) We have little information about the Glendo’s andTrident bonds. All we know is that the Glendo’s ABS is backed byconsumer credit accounts, while the Trident securities are backed bymortgage loans. Most consumer-credit accounts are nonrevolving,meaning that during the lockout period, any prepayments will beinvested in new loans. As such, the Glendo’s ABS probably has lessprepayment risk than the Trident ABS. We don’t know enough aboutthe loans to conclude anything about their credit or interest-rate risk.But the difference in prepayment risk is apparent. Camby’spreference for Glendo’s suggest he wants to avoid prepayment risk. 3.5 With regard to statements made by Price concerning the reasons why Peterson should invest in commercial MBS: A) only one statement is correct. B) both statements are correct.C) both statements are incorrect. Explanation — (A) Only one of Price’s statements is correct regardingcommercial MBS. He is correct that contraction risk on a CMBS canbe lowered by adding prepayment lock out periods and yieldmaintenance charges, as well as other loan-level call protections

such as defeasance and prepayment penalty points. Price is incorrectto state that a low debt-to-service coverage ratio makes a CMBSattractive. A high debt-to-service coverage ratio and lowloan-to-value ratio are better for lenders. 3.6 With regard to statements made by Camby concerning the reasons why Peterson should invest in residential MBS: A) both statements are correct. B) both statements are incorrect. C) only one statement is correct. Explanation — (B) Camby is incorrect in stating residential MBS havemore certain cash flows than a CMBS because you can rely on theirgovernment-backed guarantee. Although it is true that governmentagency issued MBS do come with a pseudo-governmental guarantee,many residential MBS are non-agency issued, meaning they areissued by private entities and do not come with a governmentguarantee.Camby’s statement regarding a CMBS defeasance clause is incorrect.If the borrower makes early payments on the mortgage loan, themortgage loan can be defeased, which means the loan proceeds arereceived by the loan servicer and invested in U.S. Treasury securities,essentially creating cash collateral against the loan. Treasuriesprovide higher-quality collateral than the underlying real estate, soloans structured with defeasance increase the credit quality of aCMBS loan pool.

4. The measure of prepayments associated with securities backed by auto loans is called: A) auto-backed prepayments.B) collateralized prepayment speed. C) absolute prepayment speed. Explanation — (C) The measure of prepayments associated withsecurities backed by auto loans is called absolute prepayment speed 5. Relative to mortgage-backed securities and home equity loan-backed assets, prepayments for manufactured housing-backed securities are: A) more significant because the underlying loans are more sensitive torefinancing. B) less significant because the underlying loans are not as sensitiveto refinancing. C) equally as significant. Explanation — (B) Relative to mortgage-backed securities and homeequity loan-backed assets, prepayments for manufacturedhousing-backed securities are less significant because the underlyingloans are not as sensitive to refinancing 6. How is the principal retired when an early amortization provision is triggered? It is retired by: A) maturing credit card receivable-backed securities immediately.

B) paying credit card borrowers' principal payments directly toinvestors without using them to purchase more receivables. C) reinvesting credit card borrowers' principal payments in receivables. Explanation — (B) When early amortization occurs, the credit cardtranches are retired sequentially. This is accomplished by payingprepayments to investors instead of using them to purchase morereceivables 7. A closed-end home equity loan (HEL) is a secondary mortgage that is structured like: A) a variable rate, amortizing loan. B) a standard, fixed-rate, fully amortizing loan. C) a standard balloon payment loan. Explanation — (B) Closed-end HELs are structured like standard,fixed rate, fully amortizing loans 8. Prepayments are more stable for manufactured housing-backed securities (HBS) because: A) borrowers are not sensitive to refinancing since they have fewalternative financing sources. B) manufactured housing securities have very high interest rates.C) manufactured housing loans are too large to be marketed separately. Explanation — (A) Manufactured home borrowers are not sensitiveto refinancing as they have few alternative financing sources

9. Prepayments for manufactured housing-backed securities are less significant because the underlying loans are not as sensitive torefinancing. This is correct for all of the following reasons EXCEPT: A) Loan balances are usually small, reducing the savings resulting fromrefinancing. B) Often borrowers are using Federal Housing Administration (FHA)and Veterans Administration (VA) loans, which prohibit refinancing. C) Depreciation of mobile homes in the early years can cause the loanoutstanding to be greater than the value of the asset. Explanation — (B) Borrowers are not necessarily borrowing throughthe FHA or VA, and even if they were, they would not be prohibitedfrom refinancing 10. A home equity loan (HEL) is a loan backed by residential property. Which of the following generally does NOT describe a HEL? A) It is frequently a first lien on property owned by a borrower withan excellent credit history. B) The loan often does not meet agency requirements for a qualifiedloan.C) It is frequently a first lien on property owned by a borrower with amarginal credit history Explanation — (A) HELs are frequently a first lien on property ownedby a borrower with a marginal credit history, not an excellent credithistory