Mortgage-Backed Securities (MBS) Concepts Quiz

Play an AI-generated podcast conversation about this lesson

What type of risk do MBS investors face when prepayments occur slower than expected?

Prepayment penalty risk
Contraction risk
Interest rate risk
Extension risk (correct)

What primarily drives the speed of mortgage prepayments?

Interest rate environment (correct)
Borrower's credit score
Loan-to-value ratio
Debt-to-income ratio

What happens to the prices of MBS when interest rates decrease?

Prices rise faster than other fixed-income securities
Prices remain unchanged
Prices rise slower due to embedded prepayment options (correct)
Prices fall due to reduced refinancing

What is the primary purpose of time tranching in MBS structures?

Redistribute contraction and extension risks (C) Signup and view all the answers

In the United States, mortgages with low loan-to-value (LTV) and debt-to-income (DTI) ratios are classified as:

Prime loans (B) Signup and view all the answers

What is a unique feature of non-agency RMBS compared to agency RMBS?

Inclusion of credit enhancements (B) Signup and view all the answers

A borrower defaults on a nonrecourse mortgage. What is the lender's claim?

The collateral property only (A) Signup and view all the answers

What effect does a decrease in interest rates have on the refinancing behavior of borrowers?

Borrowers are more likely to refinance their mortgages (B) Signup and view all the answers

What is the nature of nonrecourse loans in terms of collateral claims?

The lender's claims are limited to the specified collateral. (C) Signup and view all the answers

How does a collateralized mortgage obligation (CMO) structure manage prepayment risk?

By redistributing prepayment risk via tranches. (D) Signup and view all the answers

What does weighted average maturity (WAM) specifically take into account?

It averages the time to maturity according to principal balances. (B) Signup and view all the answers

In a sequential pay CMO, which tranche receives principal repayments first?

The tranche with the shortest maturity. (A) Signup and view all the answers

What defines prepayment risk in the context of mortgage-backed securities?

The unpredictability of prepayment speeds affecting cash flows. (D) Signup and view all the answers

What consequence do MBS investors face due to extension risk?

They experience delays in cash flows, discounted at higher rates. (A) Signup and view all the answers

What is a significant effect of declining interest rates on prepayment speeds?

Prepayment speeds tend to increase. (D) Signup and view all the answers

How does the structure of a CMO specifically benefit investors?

By matching different risk profiles through tranches. (A) Signup and view all the answers

What is a primary characteristic of a planned amortization class (PAC) tranche?

Provide stable cash flows by mitigating prepayment variability (B) Signup and view all the answers

Which of the following statements correctly distinguishes agency RMBS from non-agency RMBS?

Agency RMBS are backed by the government, non-agency RMBS are not (B) Signup and view all the answers

What is the role of credit enhancements in non-agency MBS?

To mitigate the risk of borrower defaults (C) Signup and view all the answers

What does the weighted-average life (WAL) of a mortgage-backed security (MBS) convey?

The average time until the principal is paid back (B) Signup and view all the answers

How does negative convexity typically impact the relationship between MBS prices and interest rates?

Prices fall more than expected as yields rise (B) Signup and view all the answers

Which prepayment model predicts that prepayment rates will increase with the age of a loan and then stabilize?

PSA prepayment model (B) Signup and view all the answers

What does prepayment risk directly affect in mortgage-backed securities?

Predictability of cash flows (B) Signup and view all the answers

What type of repayment structure do support tranches provide?

Consistent principal payment stream (C) Signup and view all the answers

What does the PSA model indicate about prepayment behavior over time?

Prepayments initially start slow, increase with seasoning, and stabilize after 30 months. (D) Signup and view all the answers

Which factor is the primary contributor to increasing contraction risk in MBSs?

Falling interest rates (A) Signup and view all the answers

What is the main advantage of investing in agency RMBS?

Guarantee of timely principal and interest payments by government-sponsored enterprises (GSEs) (C) Signup and view all the answers

Which type of mortgage-backed security does not protect against prepayment risk?

Pass-through securities (B) Signup and view all the answers

What is the primary function of a planned amortization class (PAC) tranche?

To provide stable cash flows by absorbing prepayment variability (C) Signup and view all the answers

How do agency RMBS differ from non-agency RMBS?

Agency RMBS are guaranteed by government entities while non-agency RMBS are not. (D) Signup and view all the answers

What is the main purpose of credit enhancement in non-agency MBS?

To reduce the risk associated with borrower defaults (D) Signup and view all the answers

What does the Conditional Prepayment Rate (CPR) represent?

The annualized percentage of the remaining loan balance that is expected to be prepaid (B) Signup and view all the answers

What is a key difference between a direct listing and an IPO?

It does not involve issuing new shares. (A) Signup and view all the answers

Which type of corporate issuer typically has the highest level of free float?

Public limited companies (B) Signup and view all the answers

Which advantage does a general partnership have over a sole proprietorship?

Access to more capital resources. (B) Signup and view all the answers

What distinguishes a C corporation from an S corporation?

The ability to raise capital through public markets. (C) Signup and view all the answers

In a publicly traded company, why does the principal-agent problem exist?

Managers' interests may not align with shareholders' goals. (A) Signup and view all the answers

What is the primary function of a corporate charter?

Define the company's objectives and governance structure. (C) Signup and view all the answers

What is one major benefit of a company going public through an IPO?

Increased capital from public investors. (D) Signup and view all the answers

Which of these is NOT a component of the principal-agent problem in corporations?

Direct involvement of shareholders in management. (B) Signup and view all the answers

What benefit does an IPO provide to shareholders?

Enhanced liquidity for shareholders (A) Signup and view all the answers

What is a significant reason for a corporate issuer to adopt a dual-class share structure?

Concentrate voting power with a specific group (B) Signup and view all the answers

Which characteristic is commonly associated with private equity ownership?

Focus on long-term investment (D) Signup and view all the answers

What is the primary purpose of corporate governance?

To ensure ethical and transparent decision-making (D) Signup and view all the answers

Which action is most likely to align managers' interests with those of shareholders?

Connecting executive pay to company performance (D) Signup and view all the answers

What is a prominent disadvantage of a corporation compared to a partnership?

Increased regulatory and compliance requirements (C) Signup and view all the answers

How can corporations mitigate conflicts of interest between shareholders and management effectively?

Linking executive bonuses to financial performance (D) Signup and view all the answers

In what way do dual-class share structures typically affect company control?

They allow founders more control over company decisions (A) Signup and view all the answers

Extension Risk

Extension risk is the potential loss an MBS investor faces if mortgage prepayments occur slower than anticipated, delaying cash flow returns.

Contraction Risk

Contraction risk is the risk that MBS investors face when mortgage prepayments are faster than anticipated, resulting in a reduced investment term.

What drives prepayment speed?

The interest rate environment is the primary driver of mortgage prepayment speed. Lower interest rates incentivize refinancing, increasing prepayment speeds.

How do MBS prices react to decreasing interest rates?

MBS prices rise slower than other fixed-income securities in a declining interest rate environment due to the embedded prepayment option. This option reduces the price appreciation potential.