Mortgage-Backed Security (MBS) Instrument and Market Features

Disclaimer: Following are the questions provided by CFA Institute to its registered
candidates for practice purpose.

The following information relates to questions 1-2

Please refer to the information below to answer questions 1 and 2 regarding the bonds
securitized by the AR&C leases.

AR&C Limited Securitization of Private Jet Leases

AR&C Limited leases private jets to corporations in North America for a fixed term of
five years. AR&C retains ownership of the jets. The corporations make equal interest
payments each month. If a customer defaults, AR&C can repossess the jet. AR&C has
been in business for approximately fifteen years and has a B3 credit rating, meaning that
its debt is non-investment grade. AR&C has CAD500 million in leases on its balance sheet
that it wants to securitize into ABS.

Bond Class
A (senior) Tranche A Notes
Face value: CAD250 million
Interest rate: MRR + 1.00%
Maturity: One year
B (subordinated) Tranche B Notes
Face value: CAD100 million
Interest rate: MRR + 2.00%
Maturity: Two years
C (subordinated) Tranche C Notes
Face value: CAD100 million
Interest rate: MRR + 3.00%
Maturity: Three years
D (subordinated) Tranche D Notes
Face value: CAD50 million
Interest rate: MRR + 4.00%
Maturity: Four years
Total CAD500 million
 Mortgage-Backed Security (MBS) Instrument and Market Features

1. Compare the credit rating of the Class A bonds issued by the SPE and the
uncollateralized bonds issued directly by AR&C. The Class A bonds are most likely
rated:
A. lower than AR&C bonds.
B. the same as AR&C bonds.
C. higher than AR&C bonds.

2. Select which of the following statements related to the collateralized bonds issued
directly by the SPE is most accurate.
A. This senior/subordinated structure is an example of time tranching.
B. Losses are realized by the subordinated bond classes before any losses are
realized by Class A bonds.
C. In a waterfall structure such as this one, losses are shared proportionally across
all subordinated bond classes.

The following information relates to questions 3-4

A borrower wishes to procure a mortgage loan to purchase a property. Information
regarding the property, the desired loan, and the buyer’s finances is shown below:
§ Property price: CAD750,000
§ Desired loan amount: CAD525,000
§ Annual interest rate: 5.00%
§ Loan term: 30 years/360 months
§ Monthly payment: CAD2,818.31
§ Borrower’s annual pre-tax gross income: CAD210,000

3. The loan-to-value (LTV) ratio is closest to:

A. 54%.
B. 66%.
C. 70%.

4. The debt-to-income (DTI) ratio is closest to:

A. 1.30%.
B. 16.10%.
C. 250.00%.

5. For a CMO that includes Planned Amortization Class (PAC) tranches, if the
prepayment rate is within the anticipated range, which of the following tranches most
likely protects investors from prepayment risk?
A. PAC tranche
B. Senior tranche
C. Support tranche

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 Mortgage-Backed Security (MBS) Instrument and Market Features

6. Which of the following approaches redistributes prepayment risk?

A. Tranching
B. Excess spread
C. Overcollateralization

Use the following information for questions 7 and 8:

Shown below are five mortgages that comprise the entire pool in a mortgage-backed
security.

7. The WAM for this security is closest to:

A. 208 months.
B. 224 months.
C. 236 months.

8. Which of the following adverse consequences is most likely associated with extension
risk?
A. Investors must reinvest the proceeds at lower interest rates.
B. Higher interest rates reduce the value of the cash flows investors receive.
C. The prepayment option reduces the potential price appreciation for the bond.

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 Mortgage-Backed Security (MBS) Instrument and Market Features

Use the following information for questions 9, 10, and 11:

Shown below are three properties whose mortgages are securitized to create a
sequential-pay CMBS and information related to the four tranches comprising the CMBS.

9. The associated loan to value ratio is closest to:

A. 0.75.
B. 0.77.
C. 0.80.

10. The weighted average coupon payment is closest to:

A. 3.47%.
B. 3.50%.
C. 3.61%.

11. The weighted average proceeds from the mortgages is closest to:
A. 3.47%.
B. 3.50%.
C. 3.61%.

12. Which of the following would most likely increase balloon risk for a commercial
mortgage loan that is maturing?
A. High DSCR
B. Low LTV ratio

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 Mortgage-Backed Security (MBS) Instrument and Market Features

C. Lack of property buyers in market

13. Which of the following provides call protection for CMBS investors at the structural
level?
A. Defeasance
B. Prepayment lockout
C. Sequential-pay tranches

14. An investor who owns a mortgage pass-through security is exposed to contraction

risk, which is the risk that when interest rates:
A. decline, the security will effectively have a longer maturity than was anticipated
at the time of purchase.
B. decline, the security will effectively have a shorter maturity than was anticipated
at the time of purchase.
C. rise, the security will effectively have a shorter maturity than was anticipated at
the time of purchase.

15. Investors in commercial mortgage-backed securities (CMBS) face balloon risk, which
is most likely a type of:
A. call risk.
B. contraction risk.
C. extension risk.

16. In a mortgage pass-through security, the pass-through rate:

A. is adjusted as market rates rise or fall.
B. adjusts the rate on the underlying pool of mortgages by a servicing fee.
C. is equal to the mortgage rate on the underlying pool of mortgages.

17. An investor who owns a mortgage pass-through security is exposed to extension risk,
which is the risk that when interest rates:
A. fall, the security will effectively have a shorter maturity than was anticipated at
the time of purchase.
B. rise, the security will effectively have a shorter maturity than was anticipated at
the time of purchase.
C. rise, the security will effectively have a longer maturity than was anticipated at
the time of purchase.

18. Which of the following is least likely a feature typical of an agency residential
mortgage-backed security (RMBS)?
A. A guarantee by a government-sponsored enterprise
B. The satisfaction of specific established underwriting standards
C. The use of credit enhancements to reduce credit risk

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 Mortgage-Backed Security (MBS) Instrument and Market Features

Solutions
1. The correct answer is C. The Class A bonds issued by the SPE are backed by
collateral, the leases sold by AR&C to the SPE, and they are the most senior of the
bonds issued by the SPE. A secured bond is secured by collateral and is considered
less risky than a bond without collateral backing. The Class A bonds issued by the
SPE would most likely be rated higher than any unsecured corporate bonds issued
directly by AR&C.

2. The correct answer is B. Losses are realized by the subordinated bond classes before
any losses are realized by the senior Class A bonds. A is incorrect because this
senior/subordinated structure is an example of credit tranching, not time tranching.
C is incorrect because in a waterfall structure such as this one, the most junior
tranche, Class D, will absorb all losses up to its full CAD50 million par value first.
Then, if credit losses exceed that threshold, Bond Class C will absorb all losses up to
its full CAD100 million par value. The losses are not shared proportionally across all
subordinated bond classes; instead, they are absorbed by the most junior classes
first and subsequently by the more senior ones up to the value of the loss.

3. The correct answer is C. The loan-to-value ratio (LTV) is the ratio of the amount of
the loan/mortgage to the property’s value.
LTV = Amount of the Amount of loan divided by Property's value
LTV = 525,000/750,000
LTV = 70%.

4. The correct answer is B. The DTI is calculated using the monthly debt payment and
the borrower’s monthly pre-tax gross income, as follows:
DTI = Monthly debt payment divided by monthly pre-tax gross income
DTI = 2,818.31 divided by (210,000/12) = 16.10%

5. The correct answer is C. If the prepayment rate is within the specified range, all
prepayment risk is absorbed by the support tranche. This provides greater
predictability of the size and timing of cash flows paid to investors in the PAC
tranches.
A is incorrect because in a CMO that includes a PAC tranche, the PAC tranche is
protected from prepayment risk because all prepayment risk is absorbed by the
support tranche.
B is incorrect because in a CMO that includes a PAC tranche, the senior (PAC) tranche
is protected from prepayment risk because all prepayment risk is absorbed by the
support tranche.

6. The correct answer is A. The tranching structure in CMOs cannot eliminate

prepayment risk, but it can redistribute prepayment risk across the different

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 Mortgage-Backed Security (MBS) Instrument and Market Features

tranches, insulating some tranches more than others. CMO tranche structures reduce
the uncertainties of the size and timing of payments investors receive. B and C are
incorrect because excess spread and overcollateralization are both common forms of
credit enhancement, but they do not redistribute prepayment risk.

7. The correct answer is C. The weighted average maturity is calculated by weighting

the number of months to maturity for each mortgage in the pool by the percentage
of the outstanding mortgage balance relative to the outstanding amount of all the
mortgages in the pool, as shown in the following equation:

8. The correct answer is B. Extension risk is the risk that the borrower might pay back
the money borrowed more slowly than anticipated, extending the time of repayment
and the maturity of the bond. For investors, this has one adverse consequence: Higher
interest rates reduce the value of the cash flows investors receive. The payments
the investors receive will be discounted at a higher interest rate, and the extension
stretches out the payments the investors receive.

A is incorrect because contraction risk (the risk that the borrower might pay back
the money borrowed more quickly than anticipated, reducing the amount of future
payments the investor receives), not extension risk, has the adverse consequence
that investors must reinvest the proceeds at lower interest rates.

C is incorrect because contraction risk (the risk that the borrower might pay back
the money borrowed more quickly than anticipated, reducing the amount of future
payments the investor receives), not extension risk, has the adverse consequence
that the prepayment option reduces the potential price appreciation for the bond.

9. The correct answer is A. The associated loan to value ratio is calculated as the total
value of all loans (mortgages) divided by the total value of the properties associated
with the mortgages, as follows:

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 Mortgage-Backed Security (MBS) Instrument and Market Features

10. The correct answer is A. The weighted average coupon payment is calculated as the
value of each tranche’s coupon rate weighted by the principal value of that tranche
as a percentage of the total value of all tranches:

11. The correct answer is C. The weighted average proceeds from the mortgages (WAMP
shown below) is calculated as the coupon rate of each mortgage weighted by that
mortgage’s value/amount as a percentage of the total value of all the mortgages:

12. The correct answer is C. A lack of property buyers in the market will make it
challenging for a borrower to sell a property to generate sufficient funds to pay off
the outstanding principal balance. A is incorrect because a high DSCR would reduce
the balloon risk. B is incorrect because a low LTV ratio would also reduce the balloon
risk of a maturing loan.

13. The correct answer is C. Structural call protection is achieved through sequential-
pay tranches in the CMBS as a lower-rated tranche cannot be paid down until the
higher-rated tranche is completely retired. A is incorrect because defeasance
provides call protection at the individual loan level. Defeasance allows prepayment,
but the borrower must purchase a portfolio of government securities that fully
replicates the cash flows of the remaining scheduled principal and interest payments,
including the balloon loan balance, on the loan. B is incorrect because prepayment
lockout provides call protection at the individual loan level. Prepayment lockout is a
contractual agreement that prohibits any prepayments during a specified period.

14. B is correct. Contraction risk is the risk faced by investors when interest rates fall
in that the security will effectively have a shorter maturity than was anticipated at
the time of purchase because homeowners can refinance at new, lower interest rates.

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 Mortgage-Backed Security (MBS) Instrument and Market Features

15. C is correct. Balloon risk is the risk that the borrower will not be able to arrange for
refinancing or sell the property to make the balloon payment typically associated with
commercial loans backing CMBS. As a result, the CMBS may extend in maturity,
implying that balloon risk is a type of extension risk.

16. B is correct. In a mortgage pass-through security, the pass-through rate is less than
the mortgage rate on the underlying pool of mortgages by an amount equal to the
servicing (and other administrative) fees.

17. C is correct. Extension risk is the risk faced that when interest rates rise, fewer
prepayments will occur because homeowners will be reluctant to give up the benefits
of a contractual interest rate that is now lower than the market rate. As a result,
the security becomes longer in maturity than anticipated at the time of purchase.

18. C is correct because RMBS issued by GSEs do not carry the full faith and credit of
the government, but rather the GSEs’ guarantee of the timely payment of interest
and principal for the securities. The GSE’s charge a fee for this guarantee.

Due to changing regulatory guidance and increased scrutiny, non-agency-RMBS all but
disappeared after the global financial crisis. They were issued by banks, financial
institutions, and other private businesses and were not beneficiaries of government
guarantees. These private pass-throughs or private label MBS gained credit
enhancement through pool insurance, letters of credit, guarantees, or subordination.

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