Table of Contents
CFA Level 2 – Fixed Income, Session 15-Reading 58, Asset-Backed Sector of the Bond Market-LOS d
(Notes, Practice Questions, Sample Questions)
1. There are several types of external credit enhancements. All of the following are examples of external credit enhancements EXCEPT:
A) letters of credit.
B) setting aside reserve funds.
C) corporate guarantees
Explanation: B) Setting aside reserve funds is an example of internal, not external credit enhancement
2.1 The investment policy committee of Worthy, Drummond, Bakerslee & Corrier has decided to devote this month’s overview meeting to a review of the firm’s asset-backed securities (ABS) investments. Worthy Drummond runs several billion dollars of fixed income securities in a variety of portfolios, and the members of the investment policy committee are becoming concerned about the impact of economic weakness on credit quality.
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Jamison Bakerslee has recently led a project to review the guarantees on some of the firm’s ABS. He reports to the policy committee that one of the main guarantors of Worthy Drummond’s ABS portfolio, First Credit Systems, Inc., is the subject of rumors about a credit downgrade. Bakerslee points out, “If First Credit is downgraded, that means many of the issues we hold may be downgraded as well, since they have ratings that are already as high as First Credit’s current rating.” Lucinda Corrier agrees that a First Credit downgrade would be a potential problem, since “First Credit’s guarantee protects us against losses before the internal credit enhancements are used.”
Internal credit enhancements are of primary interest to Worthy Drummond because many of the securities the firm holds are in subordinated tranches. The policy committee is particularly concerned about its investments in a pool of boat loans that are not subject to any third-party guarantees. The pool consists of three tranches:
Senior tranche $460 million
Subordinated tranche A 90 million
Subordinated tranche B 50 million
The collateral for the pool of boat loans is $657 million.
Corrier, however, is more concerned about prepayment risk across the portfolio if economic weakness causes interest rates to decline. She reminds the investment policy committee, “Our auto loan-backed securities face the same prepayment risk that our collateralized mortgage obligations (CMOs) do.” Bakerslee points out that the firm’s investments in credit card receivable backed securities will still be in the lockout period for another two years, “so we don’t have to worry about prepayment of principal on those right now.”
What is the amount of overcollateralization on the pool of boat loans?
A) $57 million.
B) $140 million.
C) $0
Explanation: A) The pool of boat loans totals ($460 + 90 + 50 = ) $600 million dollars, and has collateral of $657 million.
Overcollateralization = $657 million – $600 million = $57 million
2.2 If the pool of boat loans suffers $154 million in losses, how much will holders of subordinated tranche A lose?
A) $23 million.
B) $47 million.
C) $90 million
Explanation: B) If the pool of boat loans suffers $154 million in losses, the losses will be first absorbed by the $57 million in overcollateralization. That leaves ($154 – 57 = ) $97 million in losses to be distributed among the tranches.
Subordinated tranche B will lose $50 million, leaving ($97 – 50 = ) $47 million in losses for holders of subordinated tranche A
2.3 Regarding the statements made by Bakerslee and Corrier about the risk of a downgrade of First Credit:
A) Bakerslee’s statement is correct; Corrier’s statement is correct.
B) Bakerslee’s statement is correct; Corrier’s statement is incorrect.
C) Bakerslee’s statement is incorrect; Corrier’s statement is correct
Explanation: A) The guarantee of a third party cannot provide a credit rating higher than the credit rating of the third party itself. Thus, if Worthy Drummond’s securities already have credit ratings as high as First Credit’s own rating and First Credit’s rating is downgraded; the credit ratings on the guaranteed securities will likely be downgraded. Bakerslee’s comment is correct.
Third party guarantees (an external credit enhancement) protect against losses before internal credit enhancements are used. Corrier’s statement is also correct
2.4 Jodie Taylor, an intern with Worthy Drummond, was asked to sit in the meeting and take notes. After the meeting, Taylor comes into Corrier’s office and tells Corrier that she wants to make sure she understands credit enhancements. She makes four statements:
Statement 1:
Corporate guarantees, bond insurance and cash reserve funds are all examples of external credit enhancements.
Statement 2:
The effectiveness of default protection offered by excess servicing spread funds can diminish if defaults are below initial projections.
Statement 3:
Third-party guarantees impose a limit on the guarantor’s liability for losses at a specified level.
Statement 4:
Cash reserve funds come from issuance proceeds.
Which of the following regarding Taylor’s statements is most accurate?
A) Statement 1 is correct and Statement 2 is incorrect.
B) Statement 4 is correct and Statement 3 is incorrect.
C) Statement 3 is correct and Statement 2 is incorrect
Explanation: C) Cash reserve funds are internal, not external, credit enhancements, therefore Statement 1 is incorrect. The effectiveness of default protection offered by excess servicing spread funds can diminish if defaults exceed certain projections. Defaults that are below projections would be a positive occurrence and would not cause protection provided by the servicing spread to decline – Statement 2 is incorrect. Statements 3 and 4 are both correct statements
2.5 Regarding the statements made by Bakerslee and Corrier about prepayment risk:
A) Bakerslee’s statement is incorrect; Corrier’s statement is incorrect.
B) Bakerslee’s statement is incorrect; Corrier’s statement is correct.
C) Bakerslee’s statement is correct; Corrier’s statement is incorrect
Explanation: C) No principal is paid to the ABS holders during the lockout period, so there can be no prepayment risk at that time. Bakerslee’s statement is correct.
The prepayments from a pool of auto loans are much more predictable and much less dependent on interest rate changes than prepayments on mortgage loans. Corrier’s statement is incorrect
2.6 Following the investment policy meeting, Peter Drummond sends an e-mail to the other partners regarding key points discussed in the meeting. In the section of his e-mail about payment structures, Drummond makes two points:
Point 1:
Under a bullet payment structure, investors receive the total principal amount in a single payment.
Point 2:
Prepayment risk applies to individual non-amortizing loans.
Which of the following regarding Drummond’s points is most accurate?
A) Points 1 and 2 are correct.
B) Point 1 is correct and Point 2 is incorrect.
C) Point 2 is correct and Point 1 is incorrect
