M19 - MBS

Extension in an agency residential mortgage-backed security is most likely to result from:

LMS

• A. exhaustion of a support tranche.

• B. a decrease in interest rates.

• C. slower-than-expected prepayments.

• Explanation

  An agency RMBS is said to extend when prepayments of the underlying mortgages are slower than expected. A decrease in interest rates would tend to accelerate prepayments, resulting in contraction. Agency RMBS are not typically structured with tranches. Exhaustion of a support tranche is a source of extension risk for a planned amortization class of a CMO.

A sequential-pay CMO has two tranches. Principal is paid to Tranche S until it is paid off, after which principal is paid to Tranche R. Compared to Tranche R, Tranche S has:

(LMS)

• D. less contraction risk and more extension risk.

• E. more contraction risk and less extension risk

• F. more contraction risk and more extension risk.

• Explanation

  In a sequential-pay CMO the short tranche, which receives principal payments and prepayments first, has more contraction risk, while the tranche that receives principal payments and prepayments last has more extension risk.

The risk that mortgage prepayments will occur more slowly than expected is best characterized as:

(LMS)

• D. default risk.

• E. extension risk.

• F. contraction risk.

• Explanation

  B is correct. Extension risk is the risk that prepayments will be slower than expected.
  Contraction risk is the risk that prepayments will be faster than expected.

Creating bond classes that possess different expected maturities is referred to as:

(LMS)

• D. subordination

• E. time tranching

• F. credit tranching

• Explanation

  The correct answer is B. An approach for reducing “prepayment risk” or “extension risk” among bond classes is to create bond classes that possess different expected maturities. This is referred to as time tranching. A and C are incorrect because subordination, also commonly referred to as a “waterfall” structure, involves directing losses to the subordinated bond classes before the senior bond classes, not creating bond classes that possess different expected maturities.

Issuing the collateralized bond classes with different expected maturities is most likely designed to mitigate:

(LMS)

• D. credit risk.

• E. default risk

• F. prepayment risk.

• Explanation

  The correct answer is C. Prepayment risk is the uncertainty that the cash flows will be different from the scheduled cash flows as set forth in the lease agreement because of the lessors’ ability to alter payments. The creation of bond classes with different expected maturities, referred to as time tranch- ing, allows prepayment risk to be redistributed among bond classes. A is incorrect because credit risk pertains to the risk of default in the assets backing the collateralized bonds, not to the timing of payments, and B is incorrect because default risk again pertains to the risk of default in the assets backing the collateralized bonds