CFA Level 2 - Fixed Income Session 15 - Reading 58 Asset-Backed Sector of the Bond Market-LOS e

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 specific. C) The securities in those deals are typically floating-rate tranches Explanation — B) Unlike the PSA benchmark, the prepayment benchmark 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 flow from the credit card accounts are paid to security holders on a pro rata 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, 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. Immediately after Price and Camby return from lunch, Kay Peterson, a longtime client of Price Enterprises, comes into the office with questions about investing in the mortgage securities market. Price and Camby agree that this is an excellent time for Peterson to enter the MBS market, but disagree which mortgage securities would be best. Price believes Peterson’s best 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? A) Increase Reduce B) Reduce Reduce C) Reduce Increase Explanation — C) 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 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. 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 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 balance sheet without the consent of borrowers. C) It is cheaper to purchase exposure to an asset through a swap than to purchase the asset directly A) For a synthetic CDO, only the junior section must be 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 and Trident bonds. All we know is that the Glendo’s ABS is backed by consumer credit accounts, while the Trident securities are backed by mortgage loans. Most consumer-credit accounts are nonrevolving, meaning that during the lockout period, any prepayments will be invested in new loans. As such, the Glendo’s ABS probably has less prepayment risk than the Trident ABS. We don’t know enough about the loans to conclude anything about their credit or interest-rate risk. But the difference in prepayment risk is apparent. Camby’s preference 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 regarding commercial MBS. He is correct that contraction risk on a CMBS can be lowered by adding prepayment lock out periods and yield maintenance charges, as well as other loan-level call protections such as defeasance and prepayment penalty points. Price is incorrect to state that a low debt-to-service coverage ratio makes a CMBS attractive. A high debt-to-service coverage ratio and low loan-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 have more certain cash flows than a CMBS because you can rely on their government-backed guarantee. Although it is true that government agency issued MBS do come with a pseudo-governmental guarantee, many residential MBS are non-agency issued, meaning they are issued by private entities and do not come with a government guarantee. Camby’s statement regarding a CMBS defeasance clause is incorrect. If the borrower makes early payments on the mortgage loan, the mortgage loan can be defeased, which means the loan proceeds are received by the loan servicer and invested in U.S. Treasury securities, essentially creating cash collateral against the loan. Treasuries provide higher-quality collateral than the underlying real estate, so loans structured with defeasance increase the credit quality of a CMBS 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 with securities 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 to refinancing. B) less significant because the underlying loans are not as sensitive to refinancing. C) equally as significant Explanation — B) Relative to mortgage-backed securities and home equity loan-backed assets, prepayments for manufactured housing-backed securities are less significant because the underlying loans 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 to investors without using them to purchase more receivables. C) reinvesting credit card borrowers' principal payments in receivables Explanation — B) When early amortization occurs, the credit card tranches are retired sequentially. This is accomplished by paying prepayments to investors instead of using them to purchase 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, 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 few alternative 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 sensitive to 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 to refinancing. This is correct for all of the following reasons EXCEPT: A) Loan balances are usually small, reducing the savings resulting from refinancing. 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 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 not be prohibited from 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 with an excellent credit history. B) The loan often does not meet agency requirements for a qualified loan. C) It is frequently a first lien on property owned by a borrower with a marginal credit history Explanation — A) HELs are frequently a first lien on property owned by a borrower with a marginal credit history, not an excellent credit history