Question 1

Why are the regular GNMA pass-throughs not very attractive to insurance companies and pension funds seeking long-term duration assets to match their long-term duration liabilities?
A)Because of their short expected duration.
B)Because these bonds have the shortest average life with a maximum of prepayment protection.
C)Because they are zero coupon bonds and hence carry maximum amount of risk.
D)Because of their failures to offer prepayment protection.
E)Bondholders receive the promised coupon and principal payments but are not entitled to accrued interest payments.

Accepted Answer

Because of their failures to offer prepayment protection.

Question 2

Which of the following is an example of a negative duration asset that is valuable as a portfolio-hedging device for an FI manager when included with regular bonds whose price-yield curves show the normal inverse relationship.
A)PO strip.
B)IO strip.
C)Class B bonds
D)Class Z bonds
E)Class A bonds

Accepted Answer

An IO (Interest Only) strip is a negative duration asset that can act as a portfolio-hedging device for an FI manager when included with regular bonds whose price-yield curves show the normal inverse relationship. This is because the value of an IO strip increases when interest rates increase, thus offsetting potential losses in value of regular bonds. The other options listed (PO strips, Class B bonds, Class Z bonds, and Class A bonds) are not negative duration assets and do not act as effective hedging devices for an FI manager.

Question 3

Servicing a pass-through security refers to
A)an FI processing of all payments.
B)an FI provision of clearing services to set up the pass-through.
C)broker/dealer services provided by the FI to the ultimate holders of the pass-through.
D)guarantee by the FI of all principal and interest payments.
E)an FI provision of liquidity services to the ultimate holders of the pass-through.

Accepted Answer

Servicing a pass-through security refers to an FI processing of all payments, including principal and interest, on behalf of the investors in the security. This involves collecting payments from the borrower and distributing them to the investors.

Question 4

This is an accrual class of a CMO that makes a payment to bondholders only when preceding CMO classes have been retired.
A)Class A bonds.
B)Class B bonds.
C)Class C bonds.
D)Class Z bonds.
E)None of the options.

Accepted Answer

Class Z bonds are the last class to receive payments in a CMO structure. They are sometimes referred to as "Accrual bonds" because they don't receive cash flow until all the other classes of bonds have been retired.

Question 5

Why do garbage class bonds often have a negative duration?
A)The value of the returns in this bond class increases when interest rates increase.
B)It gives the rights to collateralization.
C)Bond values fall with interest rate increases.
D)It gives rights to reinvestment income on the cash flows in the CMO trust.
E)Significant risk premium required by the uninsured depositors.

Accepted Answer

Garbage class bonds, often referred to as high-yield or junk bonds, have a negative duration because their value tends to increase when interest rates rise. This is contrary to the typical bond behavior where values decrease as interest rates increase. The reason behind this anomaly is that higher interest rates often signal a stronger economy, which can improve the financial health of the issuers of high-yield bonds, thus reducing their default risk and increasing the value of these bonds.

Question 6

Why are the class C bonds of a CMO highly attractive to insurance companies and pension funds?
A)Because of their ability to offer perfect prepayment protection.
B)Because of the shortest average life with a minimum of prepayment protection.
C)Because of their long expected duration.
D)Because they are basically zero coupon bonds and hence carry a minimum amount of risk.
E)Because of their ability to offer perfect prepayment protection and because they are basically zero coupon bonds and hence carry a minimum amount of risk.

Accepted Answer

Class C bonds of a CMO have a long expected duration, meaning they offer stable cash flows over a longer period of time. This makes them highly attractive to insurance companies and pension funds who have long-term liabilities to fund. Class C bonds usually have a higher yield than other classes of bonds, making them a preferred investment option for these institutions. Class C bonds do not offer perfect prepayment protection and carry a certain amount of risk, which is why they usually offer a higher yield.

Question 7

Identify the residual class of a CMO that gives the owner the right to any remaining collateral in the trust after all other bond classes have been retired plus any reinvestment income earned by the trust.
A)Class A bonds.
B)Class B bonds.
C)Class C bonds.
D)Class Z bonds.
E)Class R bonds.

Accepted Answer

Class R bonds, or residual bonds, in a Collateralized Mortgage Obligation (CMO) structure, are those that give the owner the right to any remaining collateral in the trust after all other bond classes have been retired, plus any reinvestment income earned by the trust.

Question 8

Which of the following is NOT true of an R class CMO issue?
A)It is treated as "garbage class."
B)It is a high-risk investment class.
C)It gives the investor the rights to the over-collateralization and reinvestment income on the cash flows in the CMO trust.
D)Returns increase when interest rates increase.
E)It has a positive duration.

Accepted Answer

An R class CMO issue typically has a negative duration, meaning its value increases when interest rates rise, contrary to the statement in option E.

Question 9

Which of the following good news and bad news effect is NOT true when mortgage interest rates decline, resulting in faster repayments?
A)Lower market yields reduce the discount rates on any mortgage cash flows and increase the present value of any given stream of cash flows (good news effect).
B)Low yields lead to faster prepayment of the mortgage pool's principal (good news effect).
C)With early prepayments comes fewer interest payments in absolute terms (bad news effect).
D)Faster cash flows due to prepayments can only be reinvested at lower interest rates (bad news effect).
E)Faster cash flows due to prepayments can be reinvested at higher interest rates (good news effect).

Accepted Answer

When mortgage interest rates decline, resulting in faster repayments, it generally means that any reinvestments would have to be made at the current lower rates, not higher. Therefore, the statement that faster cash flows due to prepayments can be reinvested at higher interest rates is not true.

Question 10

Which of these CMO bond issues has characteristics of both a zero-coupon bond and a regular bond?
A)Class A bonds.
B)Class B bonds.
C)Class C bonds.
D)Class Z bonds.
E)None of the options.

Accepted Answer

Class Z bonds have characteristics of both a zero-coupon bond and a regular bond. They offer no coupon payment, like a zero-coupon bond, but are issued and traded at a discount and have a par value at maturity, like a regular bond.

Question 11

Mortgage-backed bonds (MBB) differ from pass-throughs and CMOs in which of the following ways?
A)The MBB bondholders have a junior claim to assets of the FI.
B)There is no direct link between the cash flow on the mortgages backing the bond and the interest and principal payments on the MBB.
C)The assets backing a MBB issue are normally removed from the balance sheet of the FI.
D)Tranches of a MBB are treated equally with respect to prepayments on mortgages backing the bond issue.
E)None of the options.

Accepted Answer

Pass-throughs and CMOs have a direct link between the cash flow on the mortgages backing the bond and the interest and principal payments on the bonds, whereas MBBs do not. MBB bondholders also typically have a senior claim to the assets of the issuing financial institution, and the assets backing a MBB issue are not normally removed from the FI's balance sheet. Tranches of a MBB may have different prepayment risks depending on their structure.

Question 12

Which of the following best explains the term burn-out factor?
A)The percent of mortgage contract that is transferred from the seller to the buyer of a house.
B)The required interest spread of a pass-through security over a treasury when prepayment risk is taken into account.
C)The aggregate percent of the mortgage pool that has been prepaid prior to the month under consideration.
D)A mortgage-backed bond issued in multiple classes or tranches.
E)Bonds collateralized by a pool of assets.

Accepted Answer

The burn-out factor is a measure of prepayment risk in mortgage-backed securities, representing the percentage of the mortgage pool that has been prepaid prior to the month under consideration. This is important to investors as it can impact the expected return on the security.

Question 13

What is defined as the sum of the products of the time when principal payments are received and the amount of principal received all divided by total principal outstanding?
A)Weighted-average life.
B)Burn-out factor.
C)Degree of collateralization.
D)Option-adjusted spread.
E)Time to maturity.

Accepted Answer

The given formula is the definition of weighted-average life, which measures the average time it takes for principal repayments to be received.

Question 14

Which of the following is true concerning an assumable mortgage?
A)The aggregate percent of the mortgage pool that has been prepaid prior to the month under consideration.
B)The mortgage contract is transferred from the seller to the buyer of a house.
C)The required interest spread of a pass-through security over a treasury when prepayment risk is taken into account.
D)A mortgage-backed bond issued in multiple classes or tranches.
E)Bonds collateralized by a pool of assets.

Accepted Answer

An assumable mortgage is a mortgage contract that can be transferred from the seller to the buyer of a house. The buyer takes over the seller's mortgage loan and assumes responsibility for making payments on the loan. This type of mortgage can be beneficial to both the buyer and the seller as it can offer flexibility in financing arrangements. The other options listed describe different concepts related to mortgages and mortgage-backed securities, but not specifically to assumable mortgages.

Question 15

The characteristics of a Collateralized Mortgage Obligation (CMO) securities issue include all of the following EXCEPT
A)the tranches will have different coupon rates.
B)the CMO securities are insured separately from the GNMA pass-through securities.
C)the principal payments are made totally to the earliest remaining tranche.
D)GNMA pass-through securities are used as collateral in a trust to support the CMOs.
E)the CMO securities are split into different tranches or groupings.

Accepted Answer

CMO securities are not typically insured separately from GNMA pass-through securities as both are backed by the same collateral pool of mortgages. Therefore, B is the correct answer as it is the only option that does not apply to the characteristics of a CMO securities issue.

Question 16

These bonds of a CMO have some prepayment protection and expected durations of five to seven years depending on the level of interest rates and are primarily purchased by pension funds and life insurance companies.
A)Class A bonds.
B)Class R bonds.
C)Class C bonds.
D)Class Z bonds.
E)Class B bonds.

Accepted Answer

Class B bonds of a Collateralized Mortgage Obligation (CMO) offer some level of prepayment protection and have expected durations that make them appealing to investors like pension funds and life insurance companies, who are typically looking for medium-term investments that align with their liabilities and investment strategies.

Question 17

A claim to the present value of the interest payments made by the mortgage holders in a GNMA pool is
A)a CARS.
B)an IO strip.
C)a CARD.
D)a PO strip.
E)a prepayment claim.

Accepted Answer

An Interest-Only (IO) strip is a claim to the interest payments made by mortgage holders in a GNMA pool. It is a type of derivative security that separates the interest portion of the mortgage payments from the principal portion. A CARS (Collateralized Automatic Repayment Security) is a type of security that pays investors from the principal payments made by mortgage holders, while a CARD (Collateralized Amortizing Revolving Debt) is a type of security that combines the features of both principal and interest payments. A PO strip (Principal-Only Strip) is a type of derivative security that separates the principal portion of the mortgage payments from the interest portion. Prepayment claims are not related to interest payments.

Question 18

In regard to a CMO, which of the following bonds have the shortest average life with a minimum of prepayment protection?
A)Class A bonds.
B)Class B bonds.
C)Class C bonds.
D)Class Z bonds.
E)Class R bonds.

Accepted Answer

Class A bonds in a Collateralized Mortgage Obligation (CMO) typically have the shortest average life and are the first to receive payments from the pool of mortgages, thus having minimal prepayment protection compared to other classes.

Question 19

Investors in mortgage-backed pass-through securities are exposed to a variety of risks.Compared to other fixed-income securities, the most unique of these risks is
A)prepayment risk
B)default risk
C)credit risk
D)interest rate risk
E)liquidity risk

Accepted Answer

Mortgage-backed pass-through securities are backed by a pool of mortgages, and therefore prepayment risk is the most unique risk associated with them. This risk occurs when borrowers pay off their mortgages early, which can negatively impact the returns of investors in these securities.

Question 20

Which of the following is NOT a factor that may cause the prepayment risk on a pool of mortgages to differ from the PSA's assumed pattern?
A)The age of the mortgage pool.
B)Geographic location.
C)Seasons in the year in which the mortgage was originated.
D)Full or partial amortization of the payments.
E)Assumability of mortgages in the pool.

Accepted Answer

While factors such as the age of the mortgage pool, geographic location, full or partial amortization of the payments, and assumability of mortgages in the pool can all influence prepayment risk, the seasons in which the mortgages were originated is not typically a significant factor. Therefore, choice C is the correct answer.

Quiz 27: Securitization

Why are the regular GNMA pass-throughs not very attractive to insurance companies and pension funds seeking long-term duration assets to match their long-term duration liabilities?

Which of the following is an example of a negative duration asset that is valuable as a portfolio-hedging device for an FI manager when included with regular bonds whose price-yield curves show the normal inverse relationship.

Servicing a pass-through security refers to

This is an accrual class of a CMO that makes a payment to bondholders only when preceding CMO classes have been retired.

Why do garbage class bonds often have a negative duration?

Why are the class C bonds of a CMO highly attractive to insurance companies and pension funds?

Identify the residual class of a CMO that gives the owner the right to any remaining collateral in the trust after all other bond classes have been retired plus any reinvestment income earned by the trust.

Which of the following is NOT true of an R class CMO issue?

Which of the following good news and bad news effect is NOT true when mortgage interest rates decline, resulting in faster repayments?

Which of these CMO bond issues has characteristics of both a zero-coupon bond and a regular bond?

Mortgage-backed bonds (MBB) differ from pass-throughs and CMOs in which of the following ways?

Which of the following best explains the term burn-out factor?

What is defined as the sum of the products of the time when principal payments are received and the amount of principal received all divided by total principal outstanding?

Which of the following is true concerning an assumable mortgage?

The characteristics of a Collateralized Mortgage Obligation (CMO) securities issue include all of the following EXCEPT

These bonds of a CMO have some prepayment protection and expected durations of five to seven years depending on the level of interest rates and are primarily purchased by pension funds and life insurance companies.

A claim to the present value of the interest payments made by the mortgage holders in a GNMA pool is

In regard to a CMO, which of the following bonds have the shortest average life with a minimum of prepayment protection?

Investors in mortgage-backed pass-through securities are exposed to a variety of risks.Compared to other fixed-income securities, the most unique of these risks is

Which of the following is NOT a factor that may cause the prepayment risk on a pool of mortgages to differ from the PSA's assumed pattern?