FIN 480 FINAL EXAM QUESTIONS AND ANSWERS
2 conditions for banking system collapse - Answers - 1: banks must take on sufficient
risk in the loans they make
2: and they must have inadequate capital to absorb losses
What is structured finance? - Answers - The pooling of economic assets like loans,
bonds, and mortgages
Sometimes the issuance of a prioritized structure of claims
Tranches - Answers - Issuance of a prioritized structure of claims
Risk of tranches - Answers - The prioritization leads to many of the tranches having a
lower risk than the average of the underlying assets
Makes risky collateral "safe"
"Credit enhancement"
SPV - Answers - Special Purpose Vehicle
SIV - Answers - Structured Investment Vehicle
SPVs & SIVs - Answers - A legally separate entity that purchases and bundles assets
How do SPVs & SIVs work? - Answers - - Borrows short-term (asset-backed
commercial paper)
- Buys mortgages from a bank
- Removes them from the balance sheet of bank
- Bundles or securitizes the mortgages
- Divides the pool of mortgages into tranches
ABS - Answers - Asset backed securities
Asset backed securities (ABS) - Answers - A security whose income payments are
derived from a specific pool or underlying assets
-- small & illiquid
-- individual student loans, car loans, credit cards...
,-- mortgages ==> mortgage backed securities (MBS)
Each underlying asset is a small fraction of the total pool
-- diversified portfolio
-- ideally uncorrelated risk of default
MBS - Answers - mortgage backed securities
Mortgage-backed securities - Answers - An ABS backed by mortgages
- either commercial or residential
-- issued by government-sponsored enterprises (GSE) = Fannie Mae, Freddie Mac,
Ginnie Mae
-- or issued by private entities = banks or finance companies (non-depository
institutions)
-- allows mortgages to be sold by the originating company = removed from balance
sheet; "frees up" dollars for other mortgages
CMBS - Answers - Commercial Mortgage Backed Securities
RMBS - Answers - Residential Mortgage-Backed Securities
Who can issue MBS? - Answers - - Government-sponsored enterprises (GSE) = Fannie
Mae, Freddie Mac, Ginnie Mae
OR
- Private entities = banks or finance companies (non-depository institutions)
Structures of ABS - Answers - - Pool of debts that act similar to a bond
===> "pass through" - payments are aggregated and then divided across the ABS
holders; credit rating is average of individual credit risks
- Divided into tranches (more common)
--- each tranche has a different level of risk exposure
--- senior tranche gets paid first
--- the most "junior" or "subordinate" tranche gets paid last (suffers first losses)
Which tranche suffers first losses? - Answers - Junior or subordinate tranches
Credit rating of pass through ABS? - Answers - Average of individual credit ratings
Credit rating of tranche structured ABS? - Answers - Each tranche has a different credit
rating based on likelihood of payment (similar to a normal bond)
ABCP - Answers - Asset backed commercial paper
, Asset-backed commercial paper (ABCP) - Answers - Form of commercial paper that is
collateralized by other financial assets (ABS, MBS, CDO)
- short-term (maturity 1 - 270 days) [average 30 days]
- most AAA rated
SIV sells commercial paper and uses funds to buy assets
- earns a spread (difference between rate paid on CP and rate received from the
assets)
- "shadow banks" - short-term debt & long-term assets
Shadow banks - Answers - Short-term debt & long-term assets
A mortgaged backed security is most similar to a...
A: Stock
B: Bond
C: Demand Deposit
D: Insurance Contract - Answers - B: Bond
True for both pass through and tranche
What is a tranche worth? - Answers - In general, only pay the expected value of a
security (risk neutral)
Extend to which defaults are correlated across the underlying assets - Answers - A key
factor determining the ability to create tranches that are safer than the underlying
collateral
The lower the default correlation... - Answers - - The more improbable it is that all
assets default simultaneously
- The safer the senior-most tranche
Strong diversification (low correlations) - Answers - Reduce overall volatility
--> extremely good or bad outcomes more likely
Senior tranches tend to benefit from ______________ correlations - Answers - Low
- low probability of everything defaulting
Junior tranches tend to benefit from ______________ correlations - Answers - High
- if > 1 bond defaults, junior tranche suffers
- junior tranche is indifferent to 1 bond or more defaulting, lose either way
- junior only wins if NO defaults occur (extremely good outcome)
2 conditions for banking system collapse - Answers - 1: banks must take on sufficient
risk in the loans they make
2: and they must have inadequate capital to absorb losses
What is structured finance? - Answers - The pooling of economic assets like loans,
bonds, and mortgages
Sometimes the issuance of a prioritized structure of claims
Tranches - Answers - Issuance of a prioritized structure of claims
Risk of tranches - Answers - The prioritization leads to many of the tranches having a
lower risk than the average of the underlying assets
Makes risky collateral "safe"
"Credit enhancement"
SPV - Answers - Special Purpose Vehicle
SIV - Answers - Structured Investment Vehicle
SPVs & SIVs - Answers - A legally separate entity that purchases and bundles assets
How do SPVs & SIVs work? - Answers - - Borrows short-term (asset-backed
commercial paper)
- Buys mortgages from a bank
- Removes them from the balance sheet of bank
- Bundles or securitizes the mortgages
- Divides the pool of mortgages into tranches
ABS - Answers - Asset backed securities
Asset backed securities (ABS) - Answers - A security whose income payments are
derived from a specific pool or underlying assets
-- small & illiquid
-- individual student loans, car loans, credit cards...
,-- mortgages ==> mortgage backed securities (MBS)
Each underlying asset is a small fraction of the total pool
-- diversified portfolio
-- ideally uncorrelated risk of default
MBS - Answers - mortgage backed securities
Mortgage-backed securities - Answers - An ABS backed by mortgages
- either commercial or residential
-- issued by government-sponsored enterprises (GSE) = Fannie Mae, Freddie Mac,
Ginnie Mae
-- or issued by private entities = banks or finance companies (non-depository
institutions)
-- allows mortgages to be sold by the originating company = removed from balance
sheet; "frees up" dollars for other mortgages
CMBS - Answers - Commercial Mortgage Backed Securities
RMBS - Answers - Residential Mortgage-Backed Securities
Who can issue MBS? - Answers - - Government-sponsored enterprises (GSE) = Fannie
Mae, Freddie Mac, Ginnie Mae
OR
- Private entities = banks or finance companies (non-depository institutions)
Structures of ABS - Answers - - Pool of debts that act similar to a bond
===> "pass through" - payments are aggregated and then divided across the ABS
holders; credit rating is average of individual credit risks
- Divided into tranches (more common)
--- each tranche has a different level of risk exposure
--- senior tranche gets paid first
--- the most "junior" or "subordinate" tranche gets paid last (suffers first losses)
Which tranche suffers first losses? - Answers - Junior or subordinate tranches
Credit rating of pass through ABS? - Answers - Average of individual credit ratings
Credit rating of tranche structured ABS? - Answers - Each tranche has a different credit
rating based on likelihood of payment (similar to a normal bond)
ABCP - Answers - Asset backed commercial paper
, Asset-backed commercial paper (ABCP) - Answers - Form of commercial paper that is
collateralized by other financial assets (ABS, MBS, CDO)
- short-term (maturity 1 - 270 days) [average 30 days]
- most AAA rated
SIV sells commercial paper and uses funds to buy assets
- earns a spread (difference between rate paid on CP and rate received from the
assets)
- "shadow banks" - short-term debt & long-term assets
Shadow banks - Answers - Short-term debt & long-term assets
A mortgaged backed security is most similar to a...
A: Stock
B: Bond
C: Demand Deposit
D: Insurance Contract - Answers - B: Bond
True for both pass through and tranche
What is a tranche worth? - Answers - In general, only pay the expected value of a
security (risk neutral)
Extend to which defaults are correlated across the underlying assets - Answers - A key
factor determining the ability to create tranches that are safer than the underlying
collateral
The lower the default correlation... - Answers - - The more improbable it is that all
assets default simultaneously
- The safer the senior-most tranche
Strong diversification (low correlations) - Answers - Reduce overall volatility
--> extremely good or bad outcomes more likely
Senior tranches tend to benefit from ______________ correlations - Answers - Low
- low probability of everything defaulting
Junior tranches tend to benefit from ______________ correlations - Answers - High
- if > 1 bond defaults, junior tranche suffers
- junior tranche is indifferent to 1 bond or more defaulting, lose either way
- junior only wins if NO defaults occur (extremely good outcome)
