Understanding Mortgage Backed Securities, Asset Backed Securities, and Credit Analysis

Posted on Aug 14, 2024 in Economy

Mortgage Backed Securities (MBS) and Asset Backed Securities (ABS)

Amortization and Prepayment Calculations

Question 1: Amortization Schedule

Complete the amortization schedule for the first three (3) months only on a 30-year fully amortizing mortgage loan with a mortgage rate of 7.25% where the amount borrowed is $150,000. The monthly mortgage payment is $1,023.26.

Question 2: Single Monthly Mortality (SMM) and Conditional Prepayment Rate (CPR)

Consider the following information:

  • Mortgage balance in month 42 = $260,000,000
  • Scheduled principal payment in month 42 = $1,000,000
  • Prepayment in month 42 = $2,450,000

a) What is the Single Monthly Mortality (SMM) amount for month 42?
b) What is the Conditional Prepayment Rate (CPR) for month 42?

Question 3: Prepayment Speeds and PSA

Which of the following represents the fastest level of prepayments for a Mortgage Backed Security (MBS)?

  1. 50 PSA
  2. 100 PSA
  3. 200 PSA
  4. 300 PSA

Question 4: Planned Amortization Class (PAC) Bond and Average Life

Suppose that a Planned Amortization Class (PAC) bond is created using prepayment speeds of 90 PSA and 240 PSA and the average life is 5 years. Will the average life for this PAC tranche be shorter than, longer than, or equal to 5 years if the collateral pays at 140 PSA over its life?

Question 5: Purpose of a PAC Bond

What is the primary reason for creating a Planned Amortization Class (PAC) Bond?

Question 6: Role of a Support Tranche

What is the role of a support tranche in a CMO structure?

Asset Backed Security Structure and Analysis

Question 1: Overcollateralization and Loss Allocation

Suppose that the structure for an asset-backed security transaction is as follows:

  • Senior tranche: $220 million
  • Subordinate tranche 1: $50 million
  • Subordinate tranche 2: $30 million

And that the value of the collateral for the structure is $320 million. Subordinate tranche 2 is the first loss tranche.

a. How much is the overcollateralization in this structure?
b. What is the amount of the loss for each tranche if losses due to defaults over the life of the structure total $15 million?
c. What is the amount of the loss for each tranche if losses due to defaults over the life of the structure total $35 million?
d. What is the amount of the loss for each tranche if losses due to defaults over the life of the structure total $85 million?
e. What is the amount of the loss for each tranche if losses due to defaults over the life of the structure total $110 million?

Question 2: Loss Absorption Capacity of Senior Tranche

Given the following Asset Backed Security structure, what total amount of losses could be realized by the collateral before the Senior Tranche A experiences a loss?

Concept Questions on Asset Backed Securities

Question 3: Cash Reserve Fund vs. Excess Servicing Spread Account

What is the difference between a cash reserve fund and an excess servicing spread account for an Asset Backed Security?

Question 4: Credit Tranching

What is meant by credit tranching?

Question 5: Lockout Period for Non-Amortizing ABS

What is the purpose of a lockout period for a non-amortizing Asset Backed Security?

Question 6: Internal Credit Enhancements

What are three types of Internal Credit Enhancements for an Asset Backed Security?

Question 7: CLO vs. CBO

What is the difference between a CLO and a CBO?

Investment Management and Portfolio Strategies

Problems and Concepts

Question 1: Economic Surplus

What is the economic surplus of an institution?

Question 2: Funded Investor

What is a funded investor?

Question 3: Investment Objective of a Funded Investor

What is the investment objective of a funded investor?

Question 4: Active vs. Passive Bond Portfolio Strategy

What is the difference between an active and a passive bond portfolio strategy?

Question 5: Immunization

What is immunization (in reference to a future liability?)

Question 6: Investment Management Process

What are the 4 stages of the investment management process?

Question 7: Liability Type

A future liability where the timing is known but the amount is uncertain would be described as a Type _____ liability? (fill in the blank)

Question 8: Characteristics of an Effective Benchmark

What are the six characteristics of an effective benchmark?

Question 9: Performance Measurement vs. Performance Evaluation

What is the difference between performance measurement and performance evaluation?

Question 10: Break-Even Interest Rate and Investment Decisions

Suppose a portfolio manager observed the following two quotes: 1 year T-bill: 3.3% BEY, 6 month T-bill: 3.0% BEY. What is the break-even interest rate for the 6-month term starting in 6 months where the manager is indifferent between these two investment alternatives? What should the manager do if her view is different from the market expectations?

Question 11: Economic Surplus and Interest Rate Changes

Suppose that the present value of the liabilities of a financial institution is $6 billion and the economic surplus is $8 billion. The duration of the liabilities is equal to 5. The duration of the assets is 6.

a. What is the market value of the asset portfolio?
b. What is the dollar duration per 100 par value for the asset portfolio?
c. What is the dollar duration per 100 par value for the liabilities?
d. Suppose that interest rates increase by 50 basis points. What is the approximate new value for the economic surplus?
e. Suppose that interest rates decrease by 50 basis points. What is the approximate new value for the economic surplus?

Credit Analysis and Risk Assessment

Covenants, Agency Problems, and Credit Risk

Question 1: Negative Covenant vs. Affirmative Covenant

What is a negative covenant? What is an affirmative covenant?

Question 2: Agency Problem in Company Management

What is meant by the agency problem with regards to company management?

Question 3: Factors Considered by Rating Agencies

What are some of the major factors considered by rating agencies in assessing the quality of management?

Question 4: The 4 Cs of Credit Analysis

What are the 4 Cs of credit analysis?

Question 5: Components of Credit Risk

What are two components of credit risk?

Question 6: Current Ratio, Debt/Capitalization Ratio, and Credit Risk

Given the following 2 companies, Company A and Company B, compute the Current Ratio and the Total Debt/Capitalization ratio for both companies. Based on these two ratios, which company represents a lower credit risk?

Question 7: EBIT Interest Coverage Ratio and Risk Assessment

a) If a company’s Earnings Before Interest and Taxes (EBIT) is $175,000 and current debt outstanding is $800,000 with an annual interest rate of 5.25%, what is the EBIT Interest coverage ratio?
b) If the EBIT Interest coverage ratio in the following year is 2.3x, has the risk level for lending to this company increased or decreased?