READING 65 MORTGAGE-BACKED SECURITY (MBS) INSTRUMENT AND MARKET FEATURES

Question 1

Which of the following best describes prepayment risk in mortgage-backed securities (MBS)?

A. The risk that borrowers will default on their scheduled mortgage payments.
B. The risk that mortgage borrowers will repay principal faster or slower than expected.
C. The risk that MBS investors will receive lower coupon payments over time.

Answer 1

Correct Answer: B

Explanation:

Correct: Prepayment risk is the uncertainty regarding the timing of cash flows due to borrowers paying off mortgages earlier or later than expected.

A is incorrect: Default risk refers to the failure to make payments, not early or late repayment.

C is incorrect: MBS investors receive full contractual payments unless prepayment occurs; lower coupons are not the direct concern.

Question 2

Which of the following scenarios most likely results in contraction risk for MBS investors?

A. Rising interest rates and lower refinancing activity
B. Falling interest rates and increased refinancing activity
C. A slowdown in the housing market

Answer 2

Correct Answer: B

Explanation:

Correct: Falling rates encourage borrowers to refinance, leading to early repayments (contraction risk).

A is incorrect: Rising rates slow prepayments, which leads to extension, not contraction.

C is incorrect: A slower housing market might reduce both purchases and prepayments, typically leading to extension.

Question 2

Contraction risk primarily affects MBS investors in which of the following ways?

A. Investors receive principal repayments earlier and face reinvestment risk.
B. Investors are exposed to higher default rates during economic downturns.
C. Investors benefit from higher yields as prepayments increase.

Answer 2

Correct Answer: A

Explanation:

Correct: Early repayments during contraction risk mean investors must reinvest at lower rates.

B is incorrect: This describes credit risk, not contraction risk.

C is incorrect: Increased prepayments reduce yield potential, not increase it.

Question 3

Which statement best describes extension risk in an MBS?

A. It occurs when borrowers default due to economic distress.
B. It is the risk that interest payments will be reduced due to government regulation.
C. It arises when prepayments slow, extending the average life of the MBS.

Answer 3

Correct Answer: C

Explanation:

Correct: Extension risk happens when borrowers stop prepaying, delaying cash flows.

A is incorrect: That describes default or credit risk.

B is incorrect: There’s no direct link between regulation and reduced interest in this context.

Question 4

Why do MBS prices typically rise less than other fixed-income securities when interest rates decline?

A. Because MBS have higher default risk.
B. Because prepayment expectations limit future cash flows.
C. Because MBS coupons are not fixed.

Answer 4

Correct Answer: B

Explanation:

Correct: Investors expect borrowers to refinance, shortening the life of the MBS and capping price gains.

A is incorrect: Default risk isn’t the reason for limited price movement.

C is incorrect: MBS typically have fixed payments based on the underlying mortgages.

Question 5

Which of the following best explains negative convexity in MBSs?

A. The price of an MBS falls more slowly than other bonds when yields rise.
B. The price of an MBS rises more slowly when yields fall due to prepayment risk.
C. The duration of an MBS increases when interest rates decline.

Answer 5

Correct Answer: B

Explanation:

Correct: Negative convexity means prices rise less when yields fall due to increased prepayments.

A is incorrect: Prices fall more quickly, not slowly, with rate increases due to extension risk.

C is incorrect: Duration actually contracts with declining rates due to faster prepayments.

Question 6

MBSs behave similarly to which of the following fixed-income instruments?

A. Putable bonds
B. Callable bonds
C. Floating-rate notes

Answer 6

Correct Answer: B

Explanation:

Correct: Like callable bonds, MBSs can be “called” by the borrower via prepayment.

A is incorrect: Putable bonds give the investor the option, not the borrower.

C is incorrect: MBS cash flows are not tied to floating interest rates.

Question 7

When interest rates rise, MBS investors face:

A. Higher prepayment risk due to borrower refinancing
B. Contraction risk due to early principal repayment
C. Extension risk as borrowers slow or stop refinancing

Answer 7

Correct Answer: C

Explanation:

Correct: Rising rates make refinancing unattractive, slowing prepayments and extending cash flows.

A is incorrect: Higher rates reduce prepayment risk.

B is incorrect: Contraction occurs when borrowers pay early — unlikely in a high-rate environment.

Question 8

Which of the following best describes how time tranching helps manage MBS prepayment risk?

A. It redistributes prepayment risk across tranches with different maturities.
B. It eliminates all forms of interest rate risk from the MBS structure.
C. It allows all investors to receive equal principal payments throughout the MBS life.

Answer 8

Correct Answer: A

Explanation:

Correct: Time tranching spreads risk between short- and long-term tranches.

B is incorrect: It doesn’t eliminate interest rate risk.

C is incorrect: Payments are prioritized by tranche — not equal.

Question 9

What is the primary risk faced by investors in early-maturing tranches of a time-tranched MBS?

A. Contraction risk
B. Extension risk
C. Credit risk

Answer 9

Correct Answer: B

Explanation:

Correct: If prepayments slow, early tranches may take longer to receive principal.

A is incorrect: Early tranches benefit from prepayments and are less exposed to contraction.

C is incorrect: Credit risk is separate from prepayment structure.

Question 10

Which tranche in a time-tranched MBS structure is most protected from contraction risk?

A. The first tranche to receive principal
B. The last tranche to receive principal
C. All tranches are equally exposed

Answer 10

Correct Answer: B

Explanation:

Correct: Later tranches receive principal only after earlier ones are paid, so they continue receiving interest even if prepayments come early.

A is incorrect: Early tranches get paid off quickly and lose reinvestment opportunities.

C is incorrect: Risks are not shared equally — they’re redistributed.

Question 11

Which of the following is a key assumption in the valuation of MBS?

A. An assumption of constant credit risk
B. A forecast of borrower employment trends
C. An estimated prepayment rate

Answer 11

Correct Answer: C

Explanation:

Correct: MBS valuation depends on expected prepayment speed, which affects cash flows.

A is incorrect: Credit risk is important but not the central valuation input here.

B is incorrect: While employment may influence payments, it’s not a direct valuation input.

Question 12

What causes the average life of an MBS to shorten unexpectedly?

A. Rising mortgage rates
B. Increased borrower defaults
C. Increased borrower prepayments

Answer 12

Correct Answer: C

Explanation:

Correct: More prepayments = shorter life.

A is incorrect: Rising rates reduce prepayments.

B is incorrect: Defaults disrupt payments but don’t reduce life predictably.

Question 13

In the context of MBSs, prepayments are:

A. Optional interest payments made by the lender
B. Scheduled payments agreed upon at loan issuance
C. Early principal payments in excess of required amortization

Answer 13

Correct Answer: C

Explanation:

Correct: Prepayments are extra principal payments made before scheduled maturity.

A is incorrect: Borrowers make payments, not lenders.

B is incorrect: Scheduled payments are not considered prepayments.

Question 14

Which of the following best describes the collateral in a residential mortgage loan?

A. The borrower’s income stream
B. Residential real estate used as security for the loan
C. The borrower’s credit score

Answer 14

Correct Answer: B

Explanation:
Collateral in a residential mortgage loan is the residential property itself, such as a house or apartment.

A is incorrect: Income supports repayment ability but is not collateral.

C is incorrect: Credit score measures creditworthiness but is not collateral.

Question 14

Which feature of an MBS makes its price less responsive to interest rate declines compared to a bullet bond?

A. Lower credit rating
B. Embedded prepayment option
C. Higher coupon rate

Answer 14

Correct Answer: B

Explanation:

Correct: The prepayment option allows borrowers to refinance when rates fall, capping price appreciation.

A is incorrect: Credit rating impacts default risk, not price sensitivity to interest rates.

C is incorrect: Coupon size doesn’t reduce interest rate sensitivity as much as prepayment behavior does.

Question 15

What legal right does a lender typically have if a borrower defaults on a residential mortgage loan?

A. To seize the borrower’s personal assets immediately
B. To take possession of the collateral property and sell it through foreclosure
C. To modify the loan terms unilaterally

Answer 15

Correct Answer: B

Explanation:
The lender has a first lien on the property, enabling foreclosure to recover losses if the borrower defaults.

A is incorrect: Personal asset claims depend on recourse status and are not automatic.

C is incorrect: Loan modifications require agreement, not unilateral action.

Question 16

Which statement best distinguishes Residential Mortgage-Backed Securities (RMBS) from Commercial Mortgage-Backed Securities (CMBS)?

A. RMBS are backed by loans on properties used to generate income.
B. RMBS are backed by loans on residential real estate where borrowers live.
C. RMBS always have recourse loans, unlike CMBS.

Answer 16

Correct Answer: B

Explanation:
RMBS are backed by residential mortgages, i.e., homes where borrowers live.

A is incorrect: That describes CMBS.

C is incorrect: Recourse status varies and is not a defining difference.

Question 17

What is the primary purpose of a prepayment penalty in residential mortgage loans?

A. To increase borrower default risk
B. To compensate lenders for losses when borrowers repay principal early
C. To encourage borrowers to refinance when interest rates fall

Answer 17

Correct Answer: B

Explanation:
Prepayment penalties protect lenders from losses when borrowers refinance and repay early.

A is incorrect: Penalties reduce, not increase, lender risk.

C is incorrect: Penalties discourage, not encourage, refinancing.

Question 18

Which of the following best describes a nonrecourse loan?

A. The lender can only claim the specified property as collateral if the borrower defaults.
B. The lender can claim the borrower’s other assets beyond the collateral in case of default.
C. The borrower has no legal obligation to repay the loan.

Answer 18

Correct Answer: A

Explanation:
Nonrecourse loans limit lender claims to the collateral property only.

B is incorrect: This describes a recourse loan.

C is incorrect: Borrowers are always legally obligated to repay.

Question 19

If a borrower has a recourse loan and the foreclosure sale does not cover the outstanding balance, what can the lender do?

A. Accept the loss and take no further action
B. Pursue the borrower’s other assets to recover the remaining balance
C. Automatically forgive the remaining loan balance

Answer 19

Correct Answer: B

Explanation:
Recourse loans allow lenders to pursue additional borrower assets beyond the collateral.

A is incorrect: Lenders typically pursue deficiency balances.

C is incorrect: Forgiveness requires negotiation, not automatic.

Question 20

What is an underwater mortgage?

A. When the loan balance exceeds the value of the collateral property
B. When the borrower has made all payments on time
C. When the mortgage loan has a prepayment penalty

Answer 20

Correct Answer: A

Explanation:
An underwater mortgage occurs when the property’s market value is less than the loan balance (negative equity).

B is incorrect: Payment status is unrelated to being underwater.

C is incorrect: Prepayment penalties do not define underwater status.

Question 21

In which region are prepayment penalties more common for residential mortgages?

A. The United States
B. Europe
C. Both regions have equal prevalence

Answer 21

Correct Answer: B

Explanation:
Prepayment penalties are common in Europe but rare in the United States.

A is incorrect: U.S. loans rarely have penalties.

C is incorrect: There is a notable regional difference.

Question 21

Why are borrowers with nonrecourse loans more likely to strategically default on underwater mortgages?

A. Because they can refinance easily without penalties
B. Because the lender cannot pursue their other assets beyond the collateral
C. Because they want to maintain their credit score

Answer 21

Correct Answer: B

Explanation:
Nonrecourse loans limit lender claims to the collateral, so borrowers may prefer default if the house value is low.

A is incorrect: Strategic default is about walking away, not refinancing.

C is incorrect: Default harms credit scores.

Question 22

Which of the following statements about residential mortgage loans in the United States is generally true? A. Most loans are recourse loans regardless of state. B. The recourse status varies by state, but most loans are nonrecourse. C. Borrowers are always personally liable beyond the collateral.

Answer 22

Correct Answer: B Explanation: In the U.S., recourse laws vary by state, but most residential mortgages are nonrecourse loans. A is incorrect: Recourse status is not uniform. C is incorrect: Many loans limit liability to the collateral.

Question 23

Which of the following best describes the loan-to-value (LTV) ratio? A. The ratio of the borrower's monthly debt payments to their monthly income. B. The percentage of the property value financed by the lender. C. The total loan amount divided by the borrower’s total annual income.

Answer 23

Correct Answer: B Explanation: The LTV ratio is the amount of the loan divided by the value of the property. It reflects how much of the property’s value is being financed by debt. Option A describes the debt-to-income ratio. Option C confuses loan amount with income, which is not the correct definition of LTV.

Question 24

A loan with a low Loan-to-Value ratio is generally considered less risky because: A. The borrower has less equity and is more likely to default B. The borrower has more equity and has greater financial incentive to avoid default C. The borrower’s monthly income is high relative to debt payments

Answer 24

Correct Answer: B Explanation: Lower LTV means higher borrower equity, reducing default risk. Option A reverses the relationship. Option C describes DTI, not LTV.

Question 25

Which risk does a lender face if the property value is close to or less than the loan amount? A. The lender may receive early repayments reducing expected interest income B. The lender may not recover the full loan amount through foreclosure C. The borrower’s income may decline, increasing risk

Answer 25

Correct Answer: B Explanation: If collateral value is low relative to loan, lender faces loss risk in foreclosure. Option A relates to prepayment risk, not LTV. Option C concerns borrower income but not specifically collateral risk.

Question 26

Debt-to-Income (DTI) ratio is best defined as: A. The loan amount divided by the property value B. The borrower’s monthly debt payments divided by monthly gross income C. The borrower’s total liabilities divided by total assets

Answer 26

Correct Answer: B Explanation: DTI measures monthly debt payments relative to monthly income. Option A describes LTV. Option C is a solvency ratio unrelated to DTI.

Question 27

A borrower with a high DTI ratio is considered: A. Less likely to default because they have high income B. More risky because a larger portion of income is committed to debt payments C. More likely to have a low Loan-to-Value ratio

Answer 27

Correct Answer: B Explanation: High DTI means less disposable income, increasing default risk. Option A ignores debt burden. Option C confuses DTI with LTV.

Question 28

Which combination of borrower characteristics typically defines a prime loan? A. Good credit, low LTV, low DTI B. Poor credit, high LTV, high DTI C. Average credit, low LTV, high DTI

Answer 28

Correct Answer: A Explanation: Prime loans have borrowers with good credit and conservative debt and equity levels. Options B and C describe riskier profiles, closer to subprime.

Question 29

Which of the following best describes an agency RMBS in the United States? A. It is guaranteed by private entities and does not require underwriting standards. B. It is guaranteed by the government or a government-sponsored enterprise (GSE) and must meet minimum underwriting standards. C. It is issued by private banks and backed by subprime mortgages without any guarantees.

Answer 29

Correct Answer: B Explanation: Agency RMBSs are guaranteed either by the government or a GSE and require loans to meet minimum underwriting standards. Option A incorrectly states private guarantees and no standards. Option C describes non-agency RMBSs.

Question 30

What is a key difference between guarantees provided by the government and by government-sponsored enterprises (GSEs)? A. Guarantees from GSEs carry the full faith and credit of the U.S. government. B. Guarantees from GSEs only carry the credit of the GSE itself, not the full government backing. C. There is no difference; both are fully backed by the government.

Answer 30

Correct Answer: B Explanation: GSE guarantees are backed only by the GSE’s creditworthiness, not the full faith and credit of the government. Option A and C incorrectly claim full government backing.

Question 31

Non-agency RMBSs are primarily issued by: A. Government-sponsored enterprises with strict underwriting requirements. B. Private entities such as banks without government or GSE guarantees. C. The U.S. Treasury with full government guarantees.

Answer 31

Correct Answer: B Explanation: Non-agency RMBSs are issued by private entities and lack government or GSE guarantees. Option A describes agency RMBSs. Option C incorrectly implies direct government issuance.

Question 32

Which of the following credit enhancements is commonly used in non-agency RMBSs? A. Full government guarantee B. External insurance and tranching C. Federal Reserve backstop

Answer 32

Correct Answer: B Explanation: Non-agency RMBSs use credit enhancements such as external insurance, letters of credit, and tranching to reduce risk. Option A applies to agency RMBSs. Option C is not a credit enhancement feature of non-agency RMBSs.

Question 33

Non-agency RMBSs played a significant role in which of the following events? A. The 2007–2009 global financial crisis due to defaults in subprime mortgages B. The recovery of the housing market in the early 2000s C. The issuance of government-backed loans during the financial crisis

Answer 33

Correct Answer: A Explanation: Non-agency RMBSs backed by subprime mortgages suffered large losses and contributed to the global financial crisis. Option B is unrelated. Option C refers to government-backed programs, not non-agency RMBS.