Deck 9: Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

Question 1

A(n)_________________________ occurs when two banks agree to exchange a portion or all of the loan repayments of their customers.

Answer 1

credit swap

Question 2

Often when loans are securitized,they are passed on to a(n)________________ which pools the loans and sells securities.

Answer 2

special-purpose entity

Question 3

The customer that is requesting a standby letter of credit is known as the __________.

Answer 3

account party

Question 4

A(n)_________________________ guarantees the swap parties a specific rate of return on their credit assets.Bank A may agree to pay the total return on the loan to Bank B plus any appreciation in the market value of the loan.In return Bank A will often get LIBOR plus a fixed spread plus any depreciation in the value of the loan.

Question 5

A relatively new type of credit derivative is a CDO which stands for _______________.

Question 6

A(n)__________________________ is related to a credit option and is usually aimed at lenders who are able to handle comparatively limited declines in value but want insurance against serious losses.

Question 7

A(n)_________________________ is a contingent claim of the firm that issues it.The issuing firm,in return for a fee,guarantees the repayment of a loan received by its customer or the fulfillment of a contract made by its customer to a third party.

Question 8

In a(n)_________________________ an outsider purchases part of a loan from the selling financial institution.Generally the purchaser has no influence over the terms of the loan contract.

Question 9

The _________________________ of a standby letter of credit is a bank or other investor who is concerned about the safety of funds committed to the account party.

Question 10

A(n)_________________________ allows homeowners to borrow against the residual value of their residence.

Question 11

When a bank sets aside a group of income-earning assets and then sells securities based upon those assets,it is ________________________ those assets.

Question 12

_________________________ allow the banks to generate fee income after they have sold a loan.The bank continues to collect interest and principal from the borrowers and passes these collections to the loan buyers.

Question 13

A(n)_________________________ combines a normal debt instrument with a credit option.It allows the issuer of the debt instrument to lower its loan repayments if some significant factor changes.

Question 14

A(n)_______________ is an over-the-counter agreement offering protection against loss when default occurs on a loan or other debt instrument.

Question 15

A(n)__________________ guards against the losses in the value of a credit asset.It would pay off if the asset declines significantly in value or if it completely turns bad.

Question 16

There has been an exponential growth in the ___________________ market in recent years.These instruments rest on pools of credit derivatives that mainly insure against defaults on corporate bonds.The creators of these instruments do not have to buy and pool actual bonds but can create these instruments and generate revenues from selling and trading in them.

Question 17

Insurance companies are the principal __________ of credit derivatives.

Question 18

A(n)_________________________ is a form of loan sale where the ownership of a loan is transferred to the buyer of the loan,who then has a direct claim against the borrower.

Question 19

A(n)__________________ is the party,often a bank or a financial institution,which guarantees the payment of the loan in a standby letter of credit.

Question 20

A(n)_________________________ is a type of loan sale which is a short-dated piece of a longer maturity loan,entitling the purchaser to a fraction of the expected loan income.

Question 21

The buyer of a participation loan must watch both the borrower and the seller bank closely.

Question 22

FNMA (Fannie Mae)and FHLMC (Freddie Mac)are examples of ____________.They appear to have the unofficial backing of the federal government in the event of default.

Question 23

Securitized assets,as a source of bank funds,are subject to reserve requirements set by the Federal Reserve Board.

Question 24

In securitization,a cash reserve which is created to give an impression to the buyers that the investment carries low risk is an example of ____________.

Question 25

Securitization has the added advantage of generating fee income for banks.

Question 26

When the FHLMC creates CMOs,they often use different _________________ to issue the securities,which are characterized by the differences in coupon rate,maturity and risk profile.

Question 27

A(n)__________________ rates the securities to be sold from a pool of securitized loans so that investors have a better idea of what the new securities are likely to be worth.

Question 28

Securitization tends to lengthen the maturity of a bank's assets.

Question 29

A loan sold by a bank to another investor with recourse means the bank has given the investor a call option on the loan.

Question 30

Under an assignment ownership,a loan is transferred to the buyer,though the buyer still holds only an indirect claim against the borrower.

Question 31

Lenders can set aside a group of loans on their balance sheet,issue bonds,and pledge the loans as collateral against the bonds in a type of securitization known as ___________.These usually stay on the bank's balance sheet as liabilities.

Question 32

Servicing rights on loans sold consist of the collection of interest and principal payments from borrowers and monitoring borrower compliance with loan terms.

Question 33

Securitizations of commercial loans usually carry the same regulatory capital requirements for a bank as the original loans themselves.

Question 34

Most loans that banks sell off their balance sheets have minimum denominations of at least a million dollars.

Question 35

Securitization raises the level of competition for the best-quality loans among banks.

Question 36

An account party will seek a standby credit guarantee if the bank's fee for issuing the guarantee is less than the value assigned to the guarantee by its beneficiary.

Question 37

Securitization is designed to turn illiquid loans into liquid assets in the form of securities sold in the open market.

Question 38

Securitized assets cannot be removed from a bank's balance sheet until they mature.

Question 39

In a participation loan,the purchaser is an outsider to the loan contract between the financial institution selling the loan and the borrower.

Question 40

Most loans that banks sell off their balance sheets carry interest rates that usually are connected to long-term interest rates (such as the 30-year Treasury bond rate).

Question 41

In a CMO,the buyers of different tiers (or tranches)of securities face the same degree of prepayment risk.

Question 42

Insurance companies are one of the principal sellers of credit derivatives.

Question 43

Securitization had its origin in the selling of securities backed by ____________.

A)credit card receivables
B)residential mortgage loans
C)computer leases
D)automobile loans
E)truck leases

Question 44

The difference in interest rates between securitized loans themselves and the securities issued against the loans is referred to as:

A)the funding gap.
B)residual income.
C)service returns.
D)security income.
E)None of the options is correct.

Question 45

Banks are the principal sellers of credit derivatives.

Question 46

Short-dated pieces of a longer-term loan,usually maturing in a few days or weeks,are called:

A)loan participations.
B)servicing rights.
C)loan strips.
D)shared credits.
E)None of the options is correct.

Question 47

Which of the following is a key advantage(s)of issuing standby letters of credit?

A)Letters of credit generate fee income for the bank.
B)Letters of credit typically reduce the borrower's cost of borrowing.
C)Letters of credit can usually be issued for a relatively low cost.
D)The probability is low that the issuer of the letter of credit will be called upon to pay.
E)All the options are correct.

Question 48

Banks that issue standby letters of credit may face which of the following types of risk?

A)Prepayment risk
B)Interest-rate risk
C)Liquidity risk
D)Options B and C only
E)All the options are correct.

Question 49

The credit derivatives market has grown many-fold during the recent years.

Question 50

Banks are one of the principal buyers of credit derivatives.

Question 51

A standby letter of credit substantially reduces the issuing bank's interest rate risk and liquidity risk.

Question 52

By agreeing to service any assets that are packaged together in the securitization process a bank can:

A)ensure the assets that are packaged and securitized remain in the package and are not sold off.
B)choose the best loans to go through the securitization process.
C)earn added fee income.
D)liquidate any assets it chooses.
E)None of the options is correct.

Question 53

Loan-backed securities,which closely resemble traditional bonds,carry various forms of credit enhancements,which may include all of the following,except:

A)credit letter guaranteeing repayment of the securities.
B)set aside of a cash reserve.
C)division into different risk classes.
D)early payment clauses.
E)None of the options is correct.

Question 54

The advantage of a credit swap is that it allows each bank in the swap to broaden its market area and spread out its credit risk on its loans.

Question 55

Loan sales are generally viewed as a risk-reducing mechanism for the selling financial institution.

Question 56

Securitized assets carry a unique form of risk called:

A)default risk.
B)inflation risk.
C)interest-rate risk.
D)prepayment risk.
E)None of the options is correct.

Question 57

In some instances,banks sell loans and agree to give the loan purchaser recourse to the seller for all or a portion of those loans that become delinquent.In this case,the purchaser,in effect,gets a:

A)call option.
B)put option.
C)forward contract.
D)futures contract.
E)None of the options is correct.

Question 58

Securitization of loans can easily be applied to business loans since these loans tend to have similar cash flow schedules and comparable risk structures.

Question 59

The party for whom a standby credit letter is issued by a bank is known as the:

A)account party.
B)beneficiary.
C)representative.
D)credit guarantor.
E)None of the options is correct.

Question 60

When a bank issues a standby credit guarantee on behalf of one of its customers,the party receiving the guarantee is known as the:

A)account party.
B)beneficiary.
C)obligator.
D)servicing agent.
E)None of the options is correct.

Question 61

A financial institution plans to issue a group of bonds backed by a pool of automobile loans.However,they fear that the default rate on the automobile loans will rise well above 4 percent of the portfolio-the projected default rate.The financial institution wants to lower the interest payments if the loan default rate rises too high.Which type of credit derivative contract would you most recommend for this situation?

A)Credit-linked note
B)Credit option
C)Credit risk option
D)Total-return swap
E)Credit swap

Question 62

The principal sellers of risk protection via credit derivatives include all of the following except:

A)insurance companies.
B)securities dealers.
C)fund management firms.
D)banks.
E)None of the options is correct.

Question 63

Loans that are to be securitized are passed on to ____________.This helps ensure that if the lender goes bankrupt,it does not affect the credit status of the pooled loans.

A)the originator
B)a special-purpose entity
C)the trustee
D)a servicer
E)the credit enhancer

Question 64

A bank plans to offer new subordinated notes in the open market next month but knows that its credit rating is being reviewed by a credit rating agency.The bank wants to avoid paying sharply higher credit costs.Which type of credit derivative contract would you most recommend for this situation?

A)Credit-linked note
B)Credit option
C)Credit risk option
D)Total-return swap
E)Credit swap

Question 65

When two banks simply agree to exchange a portion of their customers' loan repayments,they are using:

A)a credit option.
B)a standby letter of credit.
C)a credit linked note.
D)a credit swap.
E)None of the options is correct.

Question 66

If a credit letter is issued to backstop payments on loan-backed securities,the credit letter is a form of:

A)collateralized asset.
B)residual income.
C)direct loan obligation.
D)credit enhancement.
E)None of the options is correct.

Question 67

A bank or any other lender whose loans are pooled is called:

A)the originator.
B)the special-purpose entity.
C)the trustee.
D)the servicer.
E)the credit enhancer.

Question 68

A hybrid instrument which allows the issuer to lower its coupon payments if some significant factor changes is called:

A)a credit option.
B)a standby letter of credit.
C)a credit-linked note.
D)a credit swap.
E)None of the options is correct.

Question 69

A bank that wants to protect itself from higher borrowing costs due to a decrease in its credit rating might purchase:

A)a credit risk option.
B)a standby letter of credit.
C)a credit linked note.
D)a credit swap.
E)None of the options is correct

Question 70

A securitized asset where the asset used to back the securities is a loan based on the residual value of a homeowner's residence is called:

A)a mortgage-backed security.
B)a credit-card-backed security.
C)an automobile-backed security.
D)a loan-backed bond.
E)a home-equity-loan-backed-security.

Question 71

A bank is about to make a $50 million project loan to develop a new oil field and is worried that the petroleum engineer's estimates of the yield on the field are incorrect.The bank wants to protect itself in case the developer cannot repay the loan.Which type of credit derivative contract would you most recommend for this situation?

A)Credit-linked note
B)Credit option
C)Credit risk option
D)Total-return swap
E)Credit swap

Question 72

A bank has a limited geographic area of operations.It would like to diversify its loan income with loans in other market areas but does not want to actually make loans in those areas because of its limited experience in those areas.Which type of credit derivative contract would you most recommend for this situation?

A)Credit-linked note
B)Credit option
C)Credit risk option
D)Total return swap
E)Credit swap

Question 73

According to the text,in 2005 the securitization of loans reached:

A)million dollar market.
B)billion dollar market.
C)trillion dollar market.
D)market unknown in value.
E)small but growing market.

Question 74

A bank has a long-term relationship with a particular business customer.However,recently the bank has become concerned because of a potential deterioration in the customer's income.In addition,regulators have expressed concerns about the bank's capital position.The business customer has asked for a renewal of its $25 million dollar loan with the bank.Which of the following can be used to help this situation?

A)Standby letter of credit
B)Loan sale
C)Loan securitization
D)Credit risk option
E)Credit-linked notes

Question 75

Which of the following is a risk of using credit derivatives?

A)Credit derivatives do not protect against credit risk exposure.
B)The partner in a swap or an option contract may fail to perform.
C)Regulators may decide to lower the amount of capital needed for banks using these derivatives.
D)Regulators may decide that these derivatives make the bank more stable and efficient.
E)All the options are risks of using credit derivatives

Question 76

A bank has placed 5,000 consumer loans in a package to be securitized.These loans have an annual yield of 15.25 percent.The bank estimates that the securities on these loans are priced to yield 10.95 percent.The bank's default (charge-off)rate on the pooled loans is expected to be 1.45 percent.Underwriting and advisory services will cost 0.25 percent,and a credit guarantee,if more loans default than expected,will cost 0.35 percent.What is the residual income from this loan securitization?

A)3.70 percent
B)4.30 percent
C)2.25 percent
D)5.15 percent
E)None of the options is correct

Question 77

Securitization is used by the banks to:

A)fund a portion of a loan portfolio.
B)allocate capital more efficiently.
C)diversify funds sources.
D)lower the cost of fund raising.
E)All the options are correct.

Question 78

Loan sales by banks are generally of two types: (a)participation loans;and (b)_________.The term that correctly fills in the blank above is:

A)assignments
B)recourse loans
C)direct loans
D)subscription loans
E)None of the options is correct

Question 79

For an issuer,a standby credit letter is a(n):

A)securitized strip.
B)loan strip.
C)contingent obligation.
D)indirect loan.
E)None of the options is correct.

Question 80

A bank is concerned about excess volatility in its cash flows from some recent business loans it has made.Many of these loans have a fixed rate of interest and the bank's economics department has forecast a sharp increase in interest rates.The bank wants more stable cash flows.Which type of credit derivative contract would you most recommend for this situation?

A)Credit-linked note
B)Credit option
C)Credit risk option
D)Total-return swap
E)Credit swap