Financial Markets Liquidity and Regulation: C1M5 Flashcards
(128 cards)
1
Q
What is a derivative?
A
A financial instrument whose value depends on the value of some underlying asset(s) and has a finite lifetime.
2
Q
What is a mortgage-backed security (MBS)?
A
A type of derivative security that is backed by a bundle of home loans.
3
Q
Define mortgage origination.
A
The creation of the mortgage loan itself, involving a bank entering a mortgage contract and lending money.
4
Q
What is securitization?
A
The creation of new securities that are collateralized by assets such as mortgages.
5
Q
What is credit risk?
A
The risk that the lender does not receive the money that is owed to them in full and on time.
6
Q
What are the typical terms for most traditional mortgages?
A
15 to 30 years with monthly payments due at the beginning of each month.
7
Q
What does fully amortizing mean in terms of mortgages?
A
Regular payment amount stays the same, but different proportions of principal vs. interest are paid over the life of the loan.
8
Q
What happens if a borrower cannot make timely payments on a mortgage?
A
The lender can take control over the property through a legal process called foreclosure.
9
Q
What are subprime mortgages?
A
Mortgages offered to borrowers with low credit ratings, often involving adjustable rates to compensate for additional risk.
10
Q
What is a jumbo loan?
A
A mortgage used to finance properties that exceed conventional mortgage limits set by the Federal Housing Finance Agency (FHFA).
11
Q
What is the maximum value for a conventional mortgage as of 2024?
A
$766,550 in most counties.
12
Q
What are the 5 Cs of credit analysis?
A
- Capacity
- Capital
- Character
- Collateral
- Conditions
13
Q
What does ‘capacity’ refer to in credit analysis?
A
The ability of the borrower to repay a loan, considering revenues and expenses.
14
Q
How is ‘capital’ defined in the context of credit analysis?
A
The net worth of an individual or company, calculated as total assets minus total liabilities.
15
Q
What does ‘character’ indicate in credit analysis?
A
The borrower’s history of repayment and responsibility in managing debt.
16
Q
Define collateral.
A
Assets that a borrower can put up as security for a loan.
17
Q
What do ‘conditions’ refer to in the context of loans?
A
Contractual terms of the loan, including principal amount, repayment period, interest rate, and the purpose of the loan.
18
Q
What is the risk associated with underwater mortgages?
A
The borrower owes more than the home is worth, leading to potential default.
19
Q
True or False: All mortgages have the same risk profile.
A
False.
20
Q
Fill in the blank: A bank that provides a mortgage is said to _______.
A
[originate a mortgage]
21
Q
What is the debt-to-income ratio (DTI)?
A
A metric comparing all outstanding debt to a person’s earnings; lower DTI indicates higher likelihood of timely payments.
22
Q
What significant event occurred during the housing bubble from 2004-2007?
A
Over $3 trillion worth of jumbo loans were originated with overly lenient terms.
23
Q
What does a borrower typically need for a down payment in the U.S.?
A
20% of the home price.
24
Q
What might lenders consider when assessing a borrower’s capacity?
A
Employment status, income, and existing debt obligations.
25
What is the collateral for a mortgage loan?
The house itself
## Footnote
The mortgage loan is secured by the property being purchased.
26
What percentage of the house price did Jacob afford as a down payment?
20%
## Footnote
Jacob's down payment was $100,000 on a $500,000 house.
27
How much is Jacob's mortgage loan amount?
$400,000
28
What is liquidity risk?
The risk of not being able to sell an asset at all or having to sell an asset at a steep discount.
29
What is concentration risk in banking?
Too much risk is concentrated in a single borrower.
30
What is the role of an investment bank in mortgage securitization?
To move mortgages into a special purpose entity (SPE) rather than holding them.
31
True or False: Investment banks store the mortgages they buy.
False
## Footnote
Investment banks sell the mortgages into an SPE.
32
What is a mortgage-backed security (MBS)?
A security backed or collateralized by many individual mortgages.
33
What does LTV stand for and what does it indicate?
Loan to Value; it indicates the ratio of the loan amount to the value of the property.
34
What is the DTI ratio and what does it signify?
Debt to Income; it signifies the percentage of a borrower's income that goes towards debt payments.
35
What does a high FICO score indicate?
A creditworthy borrower who is likely to repay their debts.
36
What are the five Cs of credit?
Capacity, Capital, Character, Collateral, Conditions.
37
What is the difference between senior and subordinated bond classes in securitization?
Senior classes are less risky and have priority in cash flows; subordinated classes absorb losses first.
38
What is prepayment risk?
The risk that a loan's principal is paid back earlier than agreed.
39
Fill in the blank: The process of creating different bond classes in securitization is called _______.
credit tranching.
40
What does time tranching address?
The uncertainty of cash flows due to prepayment risk.
41
What is the purpose of a special purpose entity (SPE) in securitization?
To issue bonds backed by specific collateral and to protect against issuer bankruptcy.
42
How does an SPE affect the rating of the bonds?
The SPE can receive a different rating from that of the issuing company.
43
What happens to mortgage payments from borrowers in the securitization process?
They are pooled and distributed to MBS investors.
44
What is the significance of having diversified underlying assets in an MBS?
It reduces concentration risk associated with individual borrowers.
45
What is the relationship between yield and risk in bond classes?
Higher risk classes typically have higher yields.
46
What happens when defaults exceed the capacity of the subordinated tranches?
The senior tranches incur losses.
47
Why might a bank face reinvestment risk after receiving early loan repayments?
They may have to reinvest the returned principal at lower interest rates.
48
What type of loans would be preferable from a collateral perspective?
Loans with a lower average LTV ratio.
49
What might be a preferable condition for loans in terms of interest rates?
Higher interest rates are preferable for better returns.
50
What are the 5 Cs of credit analysis?
The 5 Cs of credit analysis are Character, Capacity, Collateral, Conditions, and Capital.
51
What credit characteristics indicate a subprime mortgagor?
1. Two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months.
2. Judgment, foreclosure, repossession, or charge-off in the prior 24 months.
3. Bankruptcy in the last 5 years.
4. High default probability indicated by a credit bureau risk score (FICO) of 660 or below.
5. Debt service-to-income ratio of 50 percent or greater.
52
How does a high LTV ratio affect mortgage default probability?
A high LTV ratio, especially as it approaches 100, suggests a higher probability of default.
53
What is the significance of first-lien loans compared to second-lien loans?
First-lien loans have priority over second-lien loans, meaning the first-lien lender is repaid first in case of default.
54
What is a cash-out refinance?
A cash-out refinance allows a borrower to withdraw principal they have repaid on an existing mortgage, often for other uses.
55
What are NINJA loans?
NINJA loans are loans where the borrower provides no income, no job, and no assets information to the lender.
56
What is asymmetric information in the context of mortgages?
Asymmetric information occurs when one party, typically the borrower, has more information about their financial situation than the lender.
57
What is moral hazard?
Moral hazard describes a situation where one party takes excessive risks because they do not bear the full consequences of those risks.
58
What are 'liar loans'?
'Liar loans' refer to no-doc or low-doc loans where borrowers can exaggerate their income and assets without providing proof.
59
How does the non-recourse nature of mortgages affect borrower behavior?
The non-recourse nature allows borrowers to walk away from their loans without losing other assets, potentially leading to higher default rates.
60
What happens if a borrower defaults on a non-recourse mortgage?
The borrower can walk away without further financial obligation.
61
What is a moral hazard in the context of mortgages?
A situation where borrowers may choose to default if real estate prices decline significantly.
62
What does the reading 'Understanding the Securitization of Subprime Mortgage Credit' discuss?
It discusses informational frictions and moral hazards in the mortgage and MBS markets that contributed to the credit crisis.
63
What is a conflict of interest?
A situation where a party has multiple interests that are in conflict, affecting their decision-making.
64
Why should you avoid relying on Nushi's information about her watch's value?
Nushi has a conflict of interest in providing accurate information about the watch's value.
65
Why are rating agencies considered to have conflicts of interest?
They are paid by the issuers of the debt they are rating, which may bias their assessments.
66
What does the aphorism 'All models are wrong but some are useful' imply?
No model is perfect, but judicious use of models can provide useful insights.
67
What does Probability of Default (PD) measure?
The likelihood that a borrower will default on their debt obligations within a specific time frame.
68
What is Loss Given Default (LGD)?
The estimated amount a financial institution loses when a borrower defaults, expressed as a percentage of total exposure.
69
What is Exposure at Default (EAD)?
The total value of a loan that a bank is exposed to when a borrower defaults.
70
What is the default recovery rate (RR)?
The percentage of each dollar invested that is expected to be recovered in case of a default.
71
What is model risk?
The risk of model failure due to inappropriate assumptions or inputs.
72
What did the Dodd-Frank Act address?
It aimed to regulate conflicts of interest in rating agencies and improve transparency in financial markets.
73
What is the main risk in the credit market?
Credit risk, or the probability of default.
74
What is liquidity risk?
The risk that an asset cannot be sold quickly enough in the market to prevent a loss.
75
What is the relationship between credit spread and probability of default?
The credit spread reflects the credit risk associated with the probability of default.
76
What is the significance of credit scores in the U.S.?
They capture the credit quality of individuals, influencing lending decisions.
77
What are the 5 Cs of credit analysis?
The 5 Cs of credit analysis are not explicitly listed in the text, but they are commonly known as Character, Capacity, Capital, Collateral, and Conditions.
78
What is the relationship between a mortgage and derivatives?
A mortgage exhibits nonlinearity, similar to other derivatives such as call and put options.
79
What contributed to the Great Financial Crisis?
Model risk contributed to the Great Financial Crisis.
80
What are moral hazards in the context of credit markets?
Moral hazards include information asymmetry and conflict of interest in the mortgage and bond markets.
81
What regulation was introduced in response to issues in the credit markets?
The Dodd-Frank Act was introduced in the U.S. in response to issues in the credit markets.
82
What does the credit market include?
The credit market includes securities that involve borrowing or debt, synonymous with the debt market.
83
How does the bond market compare to the equity market?
The bond market is vast compared to the global equity market, with significantly higher annual issuance.
84
What was the bond issuance ratio in 2020 compared to equity issuance?
Bond issuance in 2020 was 1.5 times larger than equity issuance.
85
Which countries had the largest values of bonds outstanding in 2020?
The five largest countries by bond value outstanding in 2020 were the United States, European Union, China, Japan, and the United Kingdom.
86
What is liquidity risk?
Liquidity risk is the risk that investors won’t find a market for the bond, preventing them from buying or selling when they want.
87
What is the significance of liquidity in bond markets?
Investors looking for low liquidity risk should consider large bond markets, as they are more likely to find liquid bonds.
88
What is a credit spread?
A credit spread is the difference in yield between a particular bond and the risk-free rate for the same maturity.
89
How is the probability of default calculated?
The probability of default (PD) can be calculated using the formula PD = CS / (1 - RR), where CS is the credit spread and RR is the recovery rate.
90
What is a credit default swap (CDS)?
A CDS is a financial derivative that allows an investor to 'swap' or transfer the credit risk of a bond to another party.
91
How do CDSs commodify credit risk?
CDSs allow for the easy buying and selling of credit risk, packaging and pricing it as a commodity.
92
What are the implications of higher probability of default on credit spread?
Higher probability of default implies a higher credit spread.
93
What defines investment grade bonds?
Investment grade refers to bonds rated BBB or better, while bonds rated below BBB are called 'junk' or 'high yield.'
94
What does a AAA bond rating indicate?
A AAA bond rating indicates almost no risk of default, meaning the probability of default (PD) is at or very near zero.
95
What is meant by 'investment grade' bonds?
'Investment grade' refers to bonds rated BBB or better.
96
What are bonds rated below BBB called?
Bonds rated below BBB are called 'junk' or 'high yield.'
97
How do credit ratings relate to probabilities of default?
Credit ratings are based on the PDs calculated by rating agencies; a low PD is associated with a high rating.
98
What happens to credit spreads as ratings worsen?
Credit spreads increase as ratings worsen, e.g., from BBB to BB+ or from B+ to B-.
99
How does time to maturity affect credit spreads?
Credit spreads increase as you move to longer-term bonds, compensating investors for additional default risk.
100
What is the correlation between credit spread and rating?
Credit spread and rating are negatively correlated; as the rating improves, the credit spread decreases.
101
What is a major issue with rating agencies?
Rating agencies often lag in updating ratings, leading to a reactive rather than proactive assessment of credit quality.
102
What is liquidity risk?
Liquidity risk refers to the risk that investors won’t find a market for the bond, preventing them from buying or selling when desired.
103
How is liquidity defined?
Liquidity is defined as the closeness of market value and selling price; the more liquid an asset, the closer these values are.
104
What is the bid-ask spread?
The bid-ask spread is the difference between current offer prices to sell and bid prices to buy for a security.
105
How does transaction volume relate to liquidity?
Lower transaction volumes imply less liquidity; higher volumes correlate with more liquid markets.
106
What is fungibility in the context of liquidity?
Fungibility refers to how easily an asset can be interchanged with another of the same type; stocks are fungible, while houses are not.
107
What is the relationship between credit spread and probability of default?
Credit spread and probability of default are positively correlated; higher spreads indicate higher probabilities of default.
108
What is the conclusion of the lesson?
The lesson covered credit market sizing, calculating credit spreads, the role of CDS, and the complexities of liquidity risk.
109
What does leverage lead to a discussion of?
Leverage leads to a discussion of its risks and the need for regulation.
110
What is one approach to calculating the Probability of Default (PD)?
Using the credit spread is one approach to calculating the PD.
## Footnote
This is why there is a probability of default and not the probability of default.
111
What is model risk?
Model risk is the risk of not using the most appropriate model for calculations.
112
What is the relationship between bond yield and probability of default?
As bond yield increases, the probability of default is expected to increase as well.
113
What are CDS and credit ratings indicators of?
They are indicators of credit risk in terms of probability of default.
114
What is correlation?
Correlation measures the strength and direction of a linear relationship between two variables.
115
What correlation method is used in this lesson?
Pearson correlation is used, which assumes the data have particular distributions.
116
What are the two ways to understand the relationship between stock and real estate markets discussed by Yuksel?
The wealth effect and the credit-price effect.
117
What is the wealth effect?
Changes in a consumer's wealth cause changes in consumption amounts and distribution.
118
What is the psychological component of perceived wealth?
Consumers may feel richer due to increases in the assessed value of their assets, even if their purchasing power remains unchanged.
119
How did housing wealth effects impact the economy in the early 2000s?
They played an important role in the boom and subsequent recession, significantly affecting the business cycle.
120
According to the wealth effect, is it a good time to buy or sell a house in a rising stock market?
It’s a good time to sell because increased demand leads to better prices; it’s a bad time to buy due to rising prices.
121
What does the credit-price effect suggest about rising real estate prices?
They should help the stock market by allowing companies to borrow more at cheaper rates.
122
What is leverage risk?
It refers to the additional risks associated with borrowing to invest, such as real estate price risk.
123
What are closed-end funds (CEFs) and exchange-traded funds (ETFs)?
Distinct investment types that can entail leverage and allow buying and selling shares on an exchange.
124
What is the relationship between borrowing and leverage?
Borrowing can amplify both potential gains and risks, particularly in housing markets.
125
What is moral hazard?
It occurs when market participants take excessive risks because they do not bear the consequences of their actions.
126
Why was extensive regulation needed after the Great Financial Crisis?
To address the large-scale moral hazard that the market could not manage on its own.
127
What is the argument against centralized regulation according to Taleb?
He argues that it releases people from responsibility and can lead to unethical behavior.
128
What is the conclusion of the lesson?
Leverage can be both helpful and dangerous, necessitating new regulations to combat moral hazard.
