Chapter 24: Managing Risk Off the Balance Sheet with Loan Sales and Securitization
True/False
1. Subprime related mortgage losses are expected to reach $400 billion.
Answer: True
Level: Easy
2. A mortgage pass-through security is a bond issue backed by a group of mortgages that pays
fixed semi-annual coupon payments where the principle is repaid only at maturity.
Answer: False
Level: Easy
3. In 2007 loan sales primarily consisted of sales of distressed loans.
Answer: False
Level: Easy
4. The buyer of a loan in a participation has a double risk exposure, one to the borrower and one to
the selling bank.
Answer: True
Level: Easy
5. A loan sold without recourse generates a contingent liability for the selling bank.
Answer: False
Level: Easy
6. More than 90% of loan sales are via assignments.
Answer: True
Level: Easy
7. Loans sold to correspondent banks are predominantly sales of distressed HLT loans.
Answer: False
Level: Easy
8. Vulture funds specialize in buying distressed loans.
Answer: True
Level: Easy
9. Most loan sales are now accomplished in about 10 days.
Answer: True
Level: Easy
10. The possibility that a bank will make excessively risky loans knowing that they can then sell
the loans to others is called the moral hazard problem.
Answer: True
Level: Medium
11. Advantages of Brady bonds over LDC loans include improved liquidity and higher coupon
rates.
Answer: False
Level: Medium
12. Under current reserve requirements, bank loan sales with recourse are considered a liability
and are subject to reserve requirements.
Answer: True
Level: Medium
13. The sale or transfer of assets at less than fair value that occurs at a time when the seller is
insolvent is termed fraudulent conveyance.
Answer: True
Level: Medium
14. When a vulture fund acquires a distressed loan the fund usually assists the distressed firm’s
managers in formulating a long term plan for restoring profitability.
Answer: False
Level: Easy
15. A financial intermediary that is concerned that falling interest rates would reduce the market
value of equity could purchase an PO security to help reduce their interest rate risk.
Answer: True
Level: Medium
16. Falling interest rates unambiguously increase the value of an IO security but may or may not
increase the value of a PO security.
Answer: False
Level: Medium
17. An investor in a GNMA mortgage backed security may be able to earn a return higher than the
rate on a comparable maturity Treasury without taking on much if any default risk.
Answer: True
Level: Medium
18. An advantage of securitization and loan sales over interest rate swaps as a risk management
tool is that securitization, by removing loans from the balance sheet, reduces the regulatory tax
imposed by existing regulations.
Answer: True
Level: Medium
19. Because of the government backing, investors in GNMA pass-throughs are guaranteed to earn
at least the T-bill rate on their investments.
Answer: False
Level: Easy
20. A CMO is a multi-class pass-through that helps investors choose the amount of prepayment
risk they will face.
Answer: True
Level: Easy
Multiple Choice
21. Advantages of loan sales and securitization typically include all but which one of the
following?
A) Reduction in credit risk
B) Reduction in interest rate risk
C) Increase in liquidity of the balance sheet
D) Reduction in regulatory tax burden
E) Increase in net interest income
Answer: E
Level: Medium
22. In selling loans, FIs act as an asset _____ and in creating CMOs FIs act as an asset _____.
A) Transformer, broker
B) Transformer, transformer
C) Broker; broker
D) Broker, transformer
Answer: D
Level: Difficult
23. A pass-through security is best characterized as
A) A multi-class mortgage backed bond
B) A security with a prorata claim to the underlying pool of assets
C) A bond backed by real estate
D) A part of a loan assignment
E) A part of a loan participation
Answer: B
Level: Easy
24. Which one of the following types of transactions leaves the assets on the balance sheet?
A) Loan sale without recourse
B) GNMA pass throughs backed by mortgages placed in trust
C) CMOs issued using mortgage pool as collateral
D) Mortgage backed bonds issued
E) None of the above
Answer: D
Level: Easy
25. For a loan sold with recourse
A) The loan seller has no further obligation at all to the loan buyer
B) The loan seller removes the assets from the balance sheet and does not report a contingent
liability in the footnotes
C) The loan buyer cannot collect from the loan seller in the event of borrower default
D) No reserve requirement is imposed
E) None of the above
Answer: E
Level: Medium
26. In a loan participation which of the following is/are true?
I. The loan buyer has no part in the original underlying credit agreement, even after purchase of the
loan.
II. If the selling bank fails, the loan buyer's claim against the selling bank may be treated as
unsecured.
III. In the event the selling bank fails, the original borrower's deposits may be used to reduce the
loan amount without any proceeds going to the loan buyer.
A) I only
B) II only
C) II and III only
D) I and II only
E) I, II and III
Answer: E
Level: Difficult
27. Characteristics of loan participations include:
I. The loan participant is not a primary creditor on the loan.
II. The original lender can change some loan terms without the participant’s permission.
III. Participations are without recourse.
A) I only
B) II only
C) II and III only
D) I and II only
E) I, II and III
Answer: D
Level: Medium
28. If a mortgage pass through experiences smaller prepayments than expected early on in the life
of the security the result will be that pass through holders will receive _______ than expected cash
flows early on and _______ than expected cash flows later on.
A) greater; less
B) greater; greater
C) less; greater
D) less; less
E) less; no different
Answer: C
Level: Medium
29. You own a mortgage backed security and you will receive fixed semiannual interest payments
and no principal payments as long as prepayments remain within a given range. If prepayments
move outside the range you will receive prepayments. You must be holding a
______________________.
A) Class C or lower sequential pay CMO
B) PAC CMO
C) PO security
D) Pass-through security
E) CDO
Answer: B
Level: Medium
30. The traditional interbank loan sale market has diminished because of
I. Reduced importance of correspondent banking
II. Decreases in barriers to nationwide banking
III. Increases in moral hazard concerns
A) I only
B) II only
C) III only
D) I and II only
E) I, II and III
Answer: E
Level: Medium
31. Important buyers of loans include all but which one of the following?
A) Foreign banks
B) Insurance companies
C) Closed-end bank loan mutual funds
D) Vulture funds
E) Credit unions
Answer: E
Level: Easy
32. A loan that finances a merger or acquisition that results in a high leverage ratio for the
borrower is called a
A) correspondent loan
B) CMO
C) HLT loan
D) low recourse loan
E) distressed loan
Answer: C
Level: Easy
33. Banks were willing to swap LDC loans for Brady bonds because:
A) Brady bonds carried higher interest rates than the loans
B) The bonds had variable interest rates
C) The bonds were marketable and the loans were not
D) The bonds were uncollateralized
E) None of the above
Answer: C
Level: Medium
34. Loan sales are likely to continue because
I. They can increase near term reported earnings
II. They reduce the amount of capital required
III. More corporate borrowers have access to the commercial paper market
A) I and II only
B) II and III only
C) I and III only
D) II only
E) I, II and III
Answer: A
Level: Medium
35. Fraudulent conveyance proceedings are
A) Charges that a loan was improperly sold according to the conditions of the original loan
agreement
B) Charges of improprieties in HLTs
C) Evidence of moral hazard on the part of the loan buyer
D) Illegal methods to boost borrower's earnings to increase probability of loan acceptance
E) The primary cause of the subprime mortgage crisis
Answer: A
Level: Easy
36. The act of buying a share in a loan syndication with limited contractual control and rights over
the borrower is called a
A) correspondent loan
B) loan assignment
C) HLT loan
D) loan participation
E) distressed loan
Answer: D
Level: Medium
37. A four class CMO has Class A, Class B, Class C and the residual Class Z securities
outstanding. Which class has the longest duration?
A) Class A
B) Class B
C) Class C
D) Class Z
E) All have the same duration
Answer: D
Level: Easy
Refer to the information below for questions 38-40:
Figure 24-1
A bank originates $150,000,000 worth of 30 year single family mortgages funded by demand
deposits and the required amount of capital. Reserve requirements are 10% and the bank pays 32
basis points in deposit insurance premiums. The bank is earning a 6.25% coupon on the
mortgages. The mortgages are priced at par and total monthly payments on the mortgages are
$923,576.
38. How much capital is required to back the mortgages if the minimum risk based capital
requirement is 8%?
A) $75.0 million
B) $37.5 million
C) $12.0 million
D) $3.0 million
E) $6.0 million
Answer: D
Refer To: 24-1
Response: $150,000,000 x 0.50 x 0.08 = 6,000,000; mortgages carry a 50% risk weight
Level: Medium
39. If the mortgages are securitized and deposits are reduced how much will the bank save in the
first year's reserve requirements and deposit insurance premiums in total?
A) $144,460,800
B) $160,512,000
C) $165,476,200
D) $178,332,500
E) $181,249,300
Answer: B
Refer To: 24-1
Response: 150-6 = 144 M deposits available to finance mortgages requires [(150,000,000 –
6,000,000) / (1 – 0.1)] = 160M deposits. Reserve requirements are 160M x 0.1 = 16M; Deposit
insurance premiums = (160,000,000 x 0.0032) = 512,000; total = 160,512,000
Level: Difficult
40. If the bank can originate and securitize this amount of mortgages with the same terms four
times over the next year (including the existing mortgages) and the bank earns a servicing fee each
month equal to 3.5% of the monthly payments, what will be the bank’s monthly fee income 12
months from now?
A) $110,456
B) $116,432
C) $122,673
D) $129,301
E) $133,444
Answer: D
Refer To: 24-1
Response: 4 x 923,576 x 0.035 = 129,301
Level: Difficult
41. A form of trust that can issue multiple class debt securities without having to pay taxes on the
interest paid is called a
A) CMO
B) REMIC
C) MBB
D) PIP
E) GNMA
Answer: B
Level: Easy
42. If mortgage interest rates fall and prepayments occur the holder of a GNMA pass-through
selling at a _____ will have a _____.
I. Discount; capital gain
II. Premium; capital loss
III. Discount; capital loss
IV. Premium; capital gain
A) I only
B) I and III only
C) I and II only
D) II and IV only
E) III and IV only
Answer: B
Level: Difficult
43. In a 3 class sequential pay CMO, if we consider Class B holders as having average
prepayment risk then Class A holders have _____________ prepayment risk and Class C holders
have _____________ prepayment risk.
A) Above average; below average
B) Below average; below average
C) Below average; above average
D) Above average; above average
Answer: A
Level: Medium
44. A 3 class sequential pay CMO has an initial principle balance of $50 million per class. In the
first month, interest payments of $5 million and principle payments of $2 million are received. In
the second month, Class A holders receive interest on _____ principle and Class B holders receive
interest on _____ principle.
A) $30 million; $30 million
B) $28 million; $28 million
C) $27 million; $27 million
D) $28 million; $30 million
E) $30 million; $28 million
Answer: D
Level: Difficult
45. Which one of the following forms of securitization is usually "double securitization?"
A) Mortgage backed bonds
B) CMO
C) Pass-through
D) Loan sale
Answer: B
Level: Medium
46. The typical duration of a Class B CMO is
A) 1.5-3 years
B) 3-5 years
C) 5-7 years
D) 7-10 years
E) 18-20 years
Answer: C
Level: Medium
47. The sum of the market values of all the classes of a CMO is greater than the total value of the
GNMA pass-throughs backing the CMO because:
A) The CMO has less credit risk than the pass-through.
B) CMO investors can choose their degree of prepayment protection.
C) The government guarantees CMOs' performance.
D) CMOs have more favorable tax status than pass-throughs.
E) CMOs investors have no prepayment risk.
Answer: B
Level: Medium
48. The FDIC is concerned about issuance of mortgage backed bonds (MBBs) because
A) The FDIC is concerned about investors' prepayment risk.
B) MBBs increase deposit insurance premiums.
C) The process takes loans off the balance sheet and replaces them with liabilities.
D) The process reduces the amount of assets available to back insured deposits.
E) None of the above
Answer: D
Level: Medium
49. The price yield relationship is steeper for ______________ than for a standard coupon bond.
A) an IO
B) a PO
C) a PAC
D) a callable bond
E) a MBB
Answer: B
Level: Medium
50. If interest rates fall below the coupon rate on the mortgages in a pool, which of the following
are likely?
I. The value of an IO may fall rather than rise
II. The value of a PO will rise, but by less than a similar straight coupon bond
III. The value of a PO will rise, but by more than a similar straight coupon bond
IV. The cash flows to a pass through holder will fall this month
A) II and IV only
B) I and III only
C) I, III and IV only
D) III and IV only
E) I, III and IV only
Answer: B
Level: Difficult
51. An IO holder benefits from ______ than expected prepayments, and a PO holder benefits
from lower than expected _____________.
A) Lower; prepayments
B) Higher; prepayments
C) Lower; interest rates
D) Higher; interest rates
E) None of the above
Answer: C
Level: Difficult
52. With a GNMA pass through the investor bears ________ of the prepayment risk, with a
noncallable mortgage backed bond the investor bears _________ of the prepayment risk and with a
CMO the investor bears ______________ of the prepayment risk.
A) Some, all, none
B) All, some, none
C) All, none, some
D) None, some, all
E) None, some, none
Answer: C
Level: Difficult
Short Answer
53. Loan sales and securitization provide five advantages to FIs. What are they?
Answer:
1. Ability to reduce interest rate risk exposure
2. Ability to reduce credit risk exposure
3. Improved liquidity of assets
4. Provide fee based income (insensitive to interest rates)
5. Reduce the effect of regulatory taxes
Level: Easy
Refer to the information below for questions 54 & 55:
Figure 24-2
On January 1 a bank had originated 500 thirty year fixed rate mortgages with a 6.25% coupon at
par. The average mortgage size is $255,000. The bank charges a 1% origination fee for each
mortgage but processing costs amount to 0.4%. After securitization the bank will retain 35 basis
points in fee income for servicing the mortgage payments. The cost of this processing is 12 basis
points.
54. What is the total amount of net fee revenue generated from the mortgages over the year?
Answer:
Net origination fee income = (500 x $250,000) x (1%-0.4%) = $765,000
Monthly payments on the mortgages sum to (500 x $255,000) / PVIFA (r = 6.25/12%, N = 360)
or monthly payment = $785,039.43
The bank nets 35-12 = 23 basis point on this total per month or 0.0023 x $785,039.43 x 12 months
= $21,667.09 per year.
Total annual net fee income = $765,000 + $21,667 = $786,667
Refer To: 24-2
Level: Difficult
55. The bank keeps a capital to asset ratio of 8%. If the bank does not securitize the mortgages,
they will be fully funded with demand deposits that have a reserve requirement of 10%. The
demand deposits also have a deposit insurance premium of 0.20 cents per $100 of deposits. If the
bank securitizes the mortgages, how much less capital will the bank require? If the savings from
not having the required reserves and the deposit insurance premiums could be invested at 5%, what
is the dollar opportunity cost of not securitizing?
Answer:
Capital requirement from the mortgages = (500 x $255,000) x 0.50 risk weight x 0.08 capital /
Asset = $5,100,000
Opportunity cost from required reserves and deposit insurance:
Total deposits required to fund mortgages = ($127,500,000 - $5,100,000) / (1 – 0.10) = $136
million ; Reserve requirements of 10% on this amount gives $136 million x 0.10 = reserves of
$13.60 million, which earn 0%.
Deposit insurance premiums = $136 million x 0.0020 = $272,000
Total costs = $13.6 million + $272,000 = $13.872 million
This total could be invested an earn 5% so that in one year the bank could have had $12,872
million x 1.06 = $14.5656 million.
The opportunity cost is thus the sum of the lost interest income and the deposit insurance premium
cost = ($14.5656 - $13.8) + $0.272 = $0.9656 million or $965,600.
Refer To: 24-2
Level: Difficult
56. How does a mortgage pass-through differ from a CMO?
Answer: A pass-through simply "passes through" payments made by households to the investors
on a prorata basis. A CMO is a multi-class pass-through where the issuer transforms or
repackages the monthly mortgage payments made by households to provide investors with
different risk and return characteristics. The CMO holder has less prepayment risk than a pass-
through holder.
Level: Easy
57. Why are most loan sales on an assignment basis rather than a participation basis?
Answer: Assignment provides the loan buyer with clear legal rights in the event of default by the
loan seller or borrower. In a participation the loan buyer is not a direct claimant of the borrower,
whereas a loan buyer has a direct claim on the original borrower in an assignment. In a
participation, the loan seller also retains broad powers to modify the credit agreement without the
consent of the loan buyers. This is not true in an assignment.
Level: Difficult
58. What are the major differences in the traditional and HLT segments of the loan sale market
with respect to the types of loans sold?
Answer: In the traditional short term segment, loan sales are generally sales of high quality loans
issued for 90 days or less with rates tied to the commercial paper market. Loans in the HLT
segment are longer maturity (3 to 6 years) and have floating rates tied to LIBOR. Some HLT loans
are quite large and because of the high leverage of the borrower, many HLT loans are distressed.
Level: Medium
59. Why has securitization progressed most rapidly for home mortgages?
Answer: Home mortgages have standard maturities, easily appraisable collateral, and default
insurance is provided by FHA, VA, FmHA or some private source to alleviate the need for
security investors to assess default risk. These features make it easier to create and sell large
amounts of marketable securities for mortgages than for other loan types.
Level: Medium
60. How does mortgage securitization reduce the regulatory tax burden of a depository institution?
Answer: 1. By reducing the amount of capital an FI is required to back the mortgages. 2. By
reducing reserve requirements on demand deposits used to fund the mortgage loans. 3. By
reducing the amount of FDIC insurance premiums required on deposits used to fund the
mortgages.
Level: Medium
61. A three class (Class A, B and C) sequential pay CMO starts with an $80 million principal
amount in each class. The mortgages in the pool have a 7% interest rate. The CMO classes receive
monthly payments. During the first month $1 million in interest is received from mortgage holders
and $1.5 million in principle. What principle amounts are outstanding for each class during the
second month? How will this affect the total payment each class receives? Explain.
Answer: During the second month Class A holders have total principle amount outstanding of $80
– $1.5 million = $78.5 million. They will receive interest on the reduced principle amount so the
total payment they receive will fall. Class B and C holders are protected from prepayments as long
as Class A has principle outstanding so Class B and C holders will receive interest only payments
on the original $80 million principle amount.
Level: Medium
62. Why are MBBs the least used form of mortgage securitization?
Answer: The process of creating pass throughs and CMOs removes mortgages from FI balance
sheets; the creation of MBBs does not. The purpose of issuing MBBs instead of debentures is to
provide collateral to the bondholder to improve the credit rating and get a lower debt cost.
However the issuer of the MBB bears all the prepayment risk (just like in a pass-through the
investor bears all the prepayment risk), so the bonds issued must be substantially
overcollateralized. They also do not eliminate the regulatory tax burden, nor improve
diversification. These drawbacks limit their attractiveness to issuers.
Level: Difficult
63. How does a PAC CMO differ from a sequential pay CMO?
Answer: A PAC investor received constant cash flows if prepayments remain within a given
range. PACs have principal repayment schedule absent from sequential pay CMOs that give the
investor more certain cash flows. A PAC is another way to limit prepayment risk. In a sequential
pay CMO investors who desire greater prepayment risk choose a class with greater prepayment
protection, but at some point their class will become unprotected. With a PAC the PAC investor
always remains in the better protected class.
Level: Difficult
64. What are the major factors that are likely to contribute to continued growth in the loan sale
market?
Answer:
*Ability to manage credit risk by selling problem loans and achieving better diversification.
* Loan sales can generate immediately recognized fees that boost current income levels.
*Loan sales improve the liquidity of the loan portfolio.
*Loan sales reduce capital and reserve requirements.
Level: Medium
65. Explain the payment pattern on a GNMA pass–through and a new Class B CMO when
interest rates fall. Which has more predictable payments, and why would an investor care?
Answer: Prepayments increase as interest rates fall. The GNMA investor will receive their pro–
rate share of all prepayments and the prepaid amounts will reduce the principle of their investment
and thus reduce all subsequent dollars of interest earned on the security. The holder of the new
Class B CMO will initially be protected from any prepayments until all of the principle of the Class
A CMO holders is paid off, so the Class B CMO holder will have no principle reduction and will
continue to collect the same dollars of interest.
Level: Medium
66. What loans other than mortgages are currently being securitized?
Answer:
* Automobile loans
* Credit card loans
* Small business loans backed by the SBA
* C&I loans
* Student loans
* Mobile home loans
* Junk bonds
* Time share loans
* ARMs
Level: Difficult
67. Explain how an IO and a PO could be used to change the effective duration of a given bond
portfolio.
Answer: An institution concerned about rising interest rates could purchase IOs because IOs can
increase in value as rates rise. The increase in value of the IO could offset the loss of value of the
bonds that would occur when rates rise. An institution expecting a drop in interest rates could
purchase POs. PO prices move in the same direction as bond prices but their prices are more
sensitive to interest rate changes than similar bonds so they can increase the overall rate sensitivity
of the bond portfolio.
Level: Difficult
68. How did securitization help create the subprime mortgage crisis? What changes should be
made to the process now?
Answer: Securitization did two things. It allowed mortgage originators to create more mortgage
credit than they would have otherwise. This made the size of the problem much greater when it
occurred. Second, a significant moral hazard problem emerged. Because originators did not
provide the ultimate financing, but quickly sold the mortgages, originators granted mortgages to
large numbers of less than creditworthy customers. Part of the reason for this was that the long
run up in home prices caused lenders to underestimate the riskiness of the mortgage and housing
markets. Securitization has net benefits to homeowners and our economy and it should not be
prohibited, but it makes sense to ensure that originators apply reasonable credit standards when
granting mortgages. Perhaps mortgage originators should be licensed and should have to maintain
some percentage investment in all mortgages sold.
