CFA Level 2 - Fixed Income Session 15-Reading 58 Asset-Backed Sector of the Bond Market-LOS e (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 speci c. C) The securities in those deals are typically oating-rate tranches Explanation — B) Unlike the PSA benchmark, the prepayment benchmark speed in the prospectus is issuer speci c 2. In a passthrough structure, the principal cash ow 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 ow from the credit card accounts are paid to securityholders on a pro rata basis 3.1. Financial consultant George Price advises high-net-worth individuals on income investments. His rm, Price Enterprises,specializes in asset-backed securities (ABS). Price’s son-in-law,Roger Camby, also works for the rm. Price and Camby do notget along well, and they often engage in heated arguments inthe oﬃce.
On a certain morning, Price and Camby are arguing aboutwhich asset-backed securities (ABS) to purchase. Over the lasttwo weeks, Price Enterprises signed up a half-dozen newclients and received several million in new funds from existingclients, and the company needs some new ideas for theportfolios.Camby is excited about a new ABS issued by a large retailer,Glendo’s. The ABS re ects a bundle of nonamortizingconsumer credit accounts. As usual, Price prefers a diﬀerentoption, in this case a new collateralized mortgage obligation(CMO) issued by Trident Mortgage. Both securities oﬀersimilar total return potential and seem reasonably valued. BothCamby and Price believe the other analyst’s preferredsecurities are too risky.Unable to come to an agreement about which ABS to purchase,Camby and Price return to an old topic of discussion, themerits of collateralized debt obligations, (CDOs). Both analystsagree on the bene ts of CDOs, which allow investors to pro toﬀ the spread between return on collateral and the cost offunding. But they disagree on the best strategy forconstructing a CDO. Price prefers a simple cash CDO andcriticizes Camby for his preference for more complicatedsynthetic securities. Camby argues that synthetic CDOs oﬀerseveral advantages over cash CDOs:It is cheaper to purchase exposure to an asset through a swapthan 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 balancesheet without the consent of borrowers.Bindle Bonds, a consultancy that sets up payment structuresfor entities that wish to issue asset-backed securities, has areferral relationship with Price Enterprises. Just before lunch,Bindle sales director Marty Malkin calls Price to oﬀer him apiece of a new ABS comprised of thousands ofhome-improvement loans. Price likes the interest rates and thesenior/subordinated structure that contains several junior
tranches and senior tranches. But during his analysis of thedefault and prepayment projections, Price becomes concernedthat Bindle is underestimating the risks. In response to Price’sconcerns, Malkin explains that the ABS has a shifting-interestmechanism designed to limit risk for the senior tranches.After Price agrees to invest in the new Bindle ABS, he andCamby go to lunch. As they wait for their food, they discuss aninvestment a colleague pitched to Camby that morning. TheABS issuer used a conditional prepayment rate to estimateprepayment risks. According to the issuer’s model,prepayment risks are modest, in part because re nancing isnot a major concern with the underlying securities. Theunderlying securities are xed-rate loans, and their defaultrisk is fairly high. One bene t of the securities is the fact thatprincipal payments are immediately passed on to investors.Immediately after Price and Camby return from lunch, KayPeterson, a longtime client of Price Enterprises, comes into theoﬃce with questions about investing in the mortgagesecurities market. Price and Camby agree that this is anexcellent time for Peterson to enter the MBS market, butdisagree which mortgage securities would be best. Pricebelieves Peterson’s best alternative would be a commercialMBS. Price makes the following arguments for CMBS:There are currently plenty of attractive CMBS, evident by theirlow debt-to-service coverage ratios and low loan-to-valueratios.Contraction risk on a CMBS can be substantially lower than ona residential MBS due to prepayment lock out periods andyield maintenance charges.Camby, however, disagrees with his father-in-law. He suggeststhat Peterson should invest in residential MBS, citing thefollowing reasons:Residential MBS have more certain cash ows than a CMBSbecause you can rely on their government-backed guarantee.Residential MBS have more reliable collateral than CMBS, dueto the fact that CMBS are structured with defeasance clauses
which act to lower the credit quality of the underlying loanpool.What aﬀect will the shifting-interest mechanism connected tothe ABS backed by home-improvement loans have on thesenior tranches?Credit Risk? Prepayment Risk? A) Increase ReduceB) Reduce Reduce C) Reduce Increase Explanation — C) Shifting-interest mechanisms reduce the proportional share of the outstanding loan balance in juniortranches as prepayments occur. This has the eﬀect of reducingcredit risk for the senior tranches but increasing theirprepayment 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-equity loans, which have a high prepayment risk. Thefact that the loans have a xed interest rate suggests they arenot SBA loans, most of which have a variable rate. That leavesauto loans, and the characteristics of the ABS presented in thevignette can all apply to auto-loan-backed securities 3.3. Which of Camby’s statements about the advantage of synthetic CDOs is least accurate?
Explanation — A) Only the senior section must be funded. B) A bank can use a synthetic CDO to take debt oﬀ the balancesheet without the consent of borrowers.C) It is cheaper to purchase exposure to an asset through aswap than to purchase the asset directly A) For a synthetic CDO, only the junior section must befunded. 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 and Trident bonds. All we know is that the Glendo’sABS is backed by consumer credit accounts, while the Tridentsecurities are backed by mortgage loans. Mostconsumer-credit accounts are nonrevolving, meaning thatduring the lockout period, any prepayments will be invested innew loans. As such, the Glendo’s ABS probably has lessprepayment risk than the Trident ABS. We don’t know enoughabout the loans to conclude anything about their credit orinterest-rate risk. But the diﬀerence in prepayment risk isapparent. Camby’s preference for Glendo’s suggest he wants toavoid 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 regarding commercial MBS. He is correct that contraction riskon a CMBS can be lowered by adding prepayment lock outperiods and yield maintenance charges, as well as otherloan-level call protections such as defeasance and prepaymentpenalty points. Price is incorrect to state that a lowdebt-to-service coverage ratio makes a CMBS attractive. Ahigh debt-to-service coverage ratio and low loan-to-valueratio 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 have more certain cash ows than a CMBS because youcan rely on their government-backed guarantee. Although it istrue that government agency issued MBS do come with apseudo-governmental guarantee, many residential MBS arenon-agency issued, meaning they are issued by private entitiesand do not come with a government guarantee.Camby’s statement regarding a CMBS defeasance clause isincorrect. If the borrower makes early payments on themortgage loan, the mortgage loan can be defeased, whichmeans the loan proceeds are received by the loan servicer andinvested in U.S. Treasury securities, essentially creating cashcollateral against the loan. Treasuries provide higher-qualitycollateral than the underlying real estate, so loans structuredwith defeasance increase the credit quality of a CMBS loanpool
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 with securities backed by auto loans is called absoluteprepayment speed 5. Relative to mortgage-backed securities and home equity loan-backed assets, prepayments for manufacturedhousing-backed securities are: A) more signi cant because the underlying loans are moresensitive to re nancing. B) less signi cant because the underlying loans are not assensitive to re nancing. C) equally as signi cant Explanation — B) Relative to mortgage-backed securities and home equity loan-backed assets, prepayments formanufactured housing-backed securities are less signi cantbecause the underlying loans are not as sensitive tore nancing 6. How is the principal retired when an early amortization provision is triggered? It is retired by: A) maturing credit card receivable-backed securitiesimmediately. B) paying credit card borrowers' principal paymentsdirectly to investors without using them to purchase morereceivables.
C) reinvesting credit card borrowers' principal payments inreceivables Explanation — B) When early amortization occurs, the credit card tranches are retired sequentially. This is accomplished bypaying prepayments to investors instead of using them topurchase more receivables 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, xed-rate, fully amortizing loan. C) a standard balloon payment loan Explanation — B) Closed-end HELs are structured like standard, xed rate, fully amortizing loans 8. Prepayments are more stable for manufactured housing-backed securities (HBS) because: A) borrowers are not sensitive to re nancing since theyhave few alternative nancing sources. B) manufactured housing securities have very high interestrates.C) manufactured housing loans are too large to be marketedseparately Explanation — A) Manufactured home borrowers are not sensitive to re nancing as they have few alternative nancingsources 9. Prepayments for manufactured housing-backed securities are less signi cant because the underlying loans are not as
sensitive to re nancing. This is correct for all of the followingreasons EXCEPT: A) Loan balances are usually small, reducing the savingsresulting from re nancing. B) Often borrowers are using Federal HousingAdministration (FHA) and Veterans Administration (VA)loans, which prohibit re nancing. C) Depreciation of mobile homes in the early years can causethe loan outstanding to be greater than the value of the asset Explanation — B) Borrowers are not necessarily borrowing through the FHA or VA, and even if they were, they would notbe prohibited from re nancing 10. A home equity loan (HEL) is a loan backed by residential property. Which of the following generally does NOT describea HEL? A) It is frequently a rst lien on property owned by aborrower with an excellent credit history. B) The loan often does not meet agency requirements for aquali ed loan.C) It is frequently a rst lien on property owned by a borrowerwith a marginal credit history Explanation — A) HELs are frequently a rst lien on property owned by a borrower with a marginal credit history, not anexcellent credit history