Mortgage-Backed Securities

Question 1

Mortgage Backed Securities (MBS)

Answer 1

-banks will underwrite then sell mortgages to an intermediary
-intermediary will then pool large numbers of loans into a porfolio
-intermediary will then sell securities backed by the portfolio

Question 2

MBS structures

Answer 2

-pass through MBS
-collateralized mortgage obligation (CMO)

Question 3

pass through MBS

Answer 3

principal and interest paid on the mortgages are immediately passed through to the investors

Question 4

collateralized mortgage obligation (CMO)

Answer 4

securities which are collateralized by MBS. this allows for various distinct traches, depending on investor needs

Question 5

2 types of CMO

Answer 5

1. credit tranching
2. time tranching

Question 6

credit tranching

Answer 6

there will be one, or multiple, subordinated tranches. these are the tranches which take the first loss.

senior tranches are protected by the subordinated. subordinated pay a higher rate of return

Question 7

time tranching

Answer 7

the first tranche receives all principal repayment from the pool, before the other tranches. this allows investors to match the duration to their time horizon

Question 8

important organizations in MBS

Answer 8

Government national mortgage association (GNMA, ginnie mae)

federal national mortgage association (FNMA, fannie mae)

federal home loan mortgage corporation (FHLMC, freddie mac)

Question 9

government national mortgage association GNMA

Answer 9

guarantees timely payments on MBS. GNMA is a government agency, so this guarantee dramatically reduces the risk of loss

very low risk

Question 10

federal national mortgage association FNMA

Answer 10

purchases mortgages from larger commercial banks, then guarantees these mortgages and sells them as MBS

Question 11

federal home loan mortgage corporation FHLMC

Answer 11

purchase mortgages from smaller banks or credit unions, securitizes said mortgages, guarantees repayment, then sells these MBS

Question 12

if an MBS is issued by any of the above it is an

Answer 12

agency MBS

(guaranteed)

Question 13

if an MBS is issued by any other issuer it is a

Answer 13

non-agency MBS

Question 14

benefits of MBS for lenders

Answer 14

improved liquidity in banking sector

Question 15

improved liquidity in banking sector

Answer 15

when a bank sells mortgages, it receives cash and is then able to underwrite more mortgages
-capital requirement
-when the bank sells a mortgage to an intermediary, it generates a profit, and no longer needs to keep capital on hand to service that mortgage

Question 16

capital requirement

Answer 16

banks must keep a certain threshold of capital on hand, for every loan it has extended

Question 17

benefits of MBS for investors

Answer 17

tranching
diversification

Question 18

tranching

Answer 18

the tranching allows investors to purchase cash flows which meet their specific time horizon and risk tolerance
-funds or family offices
-pension funds or investment grade debt fund

Question 19

funds or family offices

Answer 19

purchase junior tranches for yield

Question 20

pension funds or investment grade debt fund

Answer 20

purchase senior tranches for low risk yield

Question 21

diversification

Answer 21

there is a lesser chance of loss when investing in a pool backed by 1,000 different mortgages than investing in one mortgage
-there are some flaws in this logic which was demonstrated by 2008
-how diversified are defaults of various borrowers?

Question 22

factors which impact cash flow

Answer 22

amortization schedule
weighted average coupon
weighted average maturity
default rate
prepayment

Question 23

amortization schedule

Answer 23

when will borrowers be required to repay principle?

-fully amortizing
-partially amortizing
-interest only

Question 24

fully amortizing

Answer 24

there will be no principal left outstanding at maturity. principal is evenly split up among the monthly mortgage payments

Question 25

partially amortizing

Answer 25

monthly payments include some principal payments, but there is a lump sum due at maturity. this lump is called a bullet

Question 26

interest only

Answer 26

monthly payments only represent interest, the entire mortgage amount is due at maturity

Question 27

weighted average coupon

Answer 27

the weighted average of the interest rates of all the mortgages in the pool

Question 28

weighted average maturity

Answer 28

the weighted average of the final maturities of all the mortgages in the pool

Question 29

default rate

Answer 29

if a borrower defaults on a non-agency MBS, this reduces the cash flow to the investors

Question 30

prepayment

Answer 30

if an investor prepays the entire mortgage balance, it will speed up cash flows. this most often occurs during a refinance

Question 31

factors which impact prepayment

Answer 31

most common during fallen interest rate environment

general economic conditions
age of borrowers
interest rates

Question 32

general economic conditions

Answer 32

during poor economic conditions, people may default on their home– this is a prepayment (and potentially a loss)

Question 33

age of borrowers

Answer 33

people have a higher probability of selling their home when they retire, to roll equity into their retirement home

Question 34

interest rates

Answer 34

during periods of declining interest rates, borrowers refinance to a lower rate in order to lower monthly payments

Question 35

what accounts for the majority of prepayment?

Answer 35

interest rates

Question 36

MBS are a

Answer 36

fixed income security

Question 37

MBS valuation

Answer 37

MBS are a fixed income security and as a result have the same interest rate sensitivity as a bond

Question 38

prices decline when

Answer 38

interest rates increase

Question 39

prices increase when

Answer 39

interest rates decline but at a slower rate than bonds