1. When a bank sets aside a group of income-earning assets and then sells securities based upon
those assets it is ________________________ those assets.
2. Often when loans are securitized they are passed on to a _________________________ who
pools the loans and sells securities.
3. A(n) _________________________ allows a homeowner to borrow against the residual value of
their residence.
4. _________________________ allow the bank to generate fee income after they have sold a loan.
The bank continues to collect interest and principal from the borrowers and passes these
collections to the loan buyers.
5. In a _________________________ an outsider purchases part of a loan from the selling financial
institution. Generally the purchaser has no influence over the terms of the loan contract.
6. A(n) _________________________ is a contingent claim of the bank that issues it. The issuing
bank, in return for a fee, guarantees the repayment of a loan received by its customer or the
fulfillment of a contract made by its customer to a third party.
7. A(n) _________________________ occurs when two banks agree to exchange a portion or all of
the loan repayments of their customers.
8. A(n) __________________ guards against the losses in the value of a credit asset. It would pay
off if the asset declines significantly in value or if it completely turns bad.
9. A(n) _________________________ combines a normal debt instrument with a credit option. It
allows the issuer of the debt instrument to lower its loan repayments if some significant factor
changes.
10. The _________________________ of a standby letter of credit is a bank or other investor who is
concerned about the safety of funds committed to the recipient of the standby letter of credit.
11. A(n) _________________________ guarantees the swap parties a specific rate of return on their
credit asset. Bank A may agree to pay the total return on the loan to Bank B plus any
appreciation in the market value of the loan. In return Bank A will often get LIBOR plus a fixed
spread plus any depreciation in the value of the loan.
12. The ________________________ is the party that is requesting a standby letter of credit.
13. The __________________ is the bank or financial institution which guarantees the payment of
the loan in a standby letter of credit.
14. A(n) _________________________ is a loan sale where ownership of the loan is transferred to
the buyer of the loan, who then has a direct claim against the borrower.
15. Another type of loan sale is a(n) _________________________ which is a short dated piece of a
longer maturity loan, entitling the purchaser to a fraction of the expected loan income.
16. A relatively new type of credit derivative is a CDO which stands for __________________.
17. Insurance companies are a prime __________ of credit derivatives.
18. A(n) is an over-the-counter agreement offering protection against
loss when default occurs on a loan or other debt instrument.
19. A(n) is related to the credit option and is usually aimed at lenders
able to handle comparatively limited declines in value but wants insurance against serious losses.
20. There has been an explosion in in recent years. These instruments rest
on pools of credit derivatives that mainly insure against defaults on corporate bonds. The creators
of these instruments do not have to buy and pool actual bonds but can create these instruments
and generate revenues from selling and trading in them.
21. A rates the securities to be sold from a pool of securitized loans
so that investors have a better idea of what the new securities are likely to be worth.
22. A(n) is an assurance that investors will be repaid in the event of
the default of the underlying loans in a securitization. These can be internal or external to the
securitization process and lower the risk of the securities.
23. When the FHLMC creates CMOs they often use different which each
24. Lenders can set aside a group of loans on their balance sheet, issue bonds and pledge the loans as
collateral against the bonds in . These usually stay on the
25. FNMA (Fannie Mae) and FHLMC (Freddie Mac) are examples of .
They appear to have the unofficial backing of the federal government in the event of default.
26. Securitization is designed to turn illiquid loans into liquid assets in the form of securities sold in
the open market.
27. Securitization has the added advantage of generating fee income for banks.
28. Securitized assets cannot be removed from a bank’s balance sheet until they mature.
29. Securitization raises the level of competition for the best-quality loans among banks.
30. Servicing rights on loans sold consist of the collection of interest and principal payments from
borrowers and monitoring borrower compliance with loan terms.
31. A loan sold by a bank to another investor with recourse means the bank has given the investor a
call option on the loan.
32. An account party will seek a bank’s standby credit guarantee if the bank’s fee for issuing the
guarantee is less than the value assigned the guarantee by its beneficiary.
33. Securitization tends to lengthen the maturity of a bank’s assets.
34. Securitized assets as a source of bank funds are subject to reserve requirements set by the Federal
Reserve Board.
35. Securitizations of commercial loans usually carry the same regulatory capital requirements for a
bank as the original loans themselves.
36. Most loans that banks sell off their balance sheets have minimum denominations of at least a
million dollars.
37. Most loans that banks sell off their balance sheets carry interest rates that usually are connected to
long-term interest rates (such as the 30-year Treasury bond rate).
38. In a participation loan the purchaser is an outsider to the loan contract between the financial
institution selling the loan and the borrower.
39. The buyer of a loan participation must watch both the borrower and the seller bank closely.
40. Under an assignment ownership of a loan is transferred to the buyer, though the buyer still holds
only an indirect claim against the borrower.
41. Loan sales are generally viewed as risk-reducing for the selling financial institution.
42. In a CMO, the different tiers (or tranches) of security purchasers face the same prepayment risk.
43. A standby letter of credit substantially reduces the issuing bank’s interest rate risk and liquidity
risk.
44. Securitization of loans can easily be applied to business loans since these loans tend to have
similar cash flow schedules and comparable risk structures.
45. The advantage of a credit swap is that it allows each bank in the swap to broaden its market area
and spread out its credit risk on its loans.
46. Bank use of credit derivatives is dominated by the largest banks.
47. The credit derivatives market has grown nine-fold during the recent years.
48. Banks are the principal sellers of credit derivatives.
49. Banks are one of the principal buyers of credit derivatives.
50. Insurance companies are one of the principal sellers of credit derivatives.
51. Securitized assets carry a unique form of risk called:
A) Default risk
B) Inflation risk
C) Interest-rate risk
D) Prepayment risk
E) None of the above
52. Short-dated pieces of a longer-term loan, usually maturing in a few days or weeks, are called:
A) Loan participations
B) Servicing rights
C) Loan strips
D) Shared credits
E) None of the above
53. The party for whom a standby credit letter is issued by a bank is known as the:
A) Account party
B) Beneficiary
C) Representative
D) Credit Guarantor
E) None of the above
54. When a bank issues a standby credit guarantee on behalf of one of its customers, the party
receiving the guarantee is known as the:
A) Account party
B) Beneficiary
C) Obligator
D) Servicing agent
E) None of the above
55. Securitization had its origin in the selling of securities backed by _____________
A) Credit card receivables
B) Residential mortgage loans
C) Computer leases
D) Automobile loans
E) Truck leases
56. Loan-backed securities, which closely resemble traditional bonds, carry various forms of credit
enhancements, which may include all of the following, EXCEPT:
A) Credit letter guaranteeing repayment of the securities.
B) Set aside of a cash reserve.
C) Division into different risk classes.
D) Early payment clauses.
E) None of the above.
57. In some instances, a bank will sell loans and agree to give the loan purchaser recourse to the
seller for all or a portion of those loans that become delinquent. In this case, the purchaser, in
effect, gets a:
A) Call option.
B) Put option.
C) Forward contract.
D) Futures contract
E) None of the above.
58. The key advantages of issuing standby letters of credit include which of the following:
A) Letters of credit generate fee income for the bank.
B) Letters of credit typically reduce the borrower’s cost of borrowing.
C) Letters of credit can usually be issued for a relatively low cost.
D) The probability is low that the issuer of the letter of credit will be called upon to pay.
E) All of the above.
59. Banks that issue standby letters of credit may face which of the following types of risk?
A) Prepayment risk.
B) Interest-rate risk.
C) Liquidity risk.
D) All of the above.
E) B and C only.
59. By agreeing to service any assets that are packaged together in the securitization process a bank
can:
A) Ensure the assets that are packaged and securitized remain in the package and are not sold
off.
B) Choose the best loans to go through the securitization process.
C) Earn added fee income.
D) Liquidate any assets it chooses.
E) None of the above.
60. The difference in interest rates between securitized loans themselves and the securities issued
against the loans is referred to as:
A) The funding gap
B) Residual income.
C) Service returns
D) Security income
E) None of the above
61. If a credit letter is issued to backstop payments on loan-backed securities, the credit letter is a
form of:
A) Collateralized asset
B) Residual income
C) Direct loan obligation
D) Credit enhancement
E) None of the above
62. Loan sales by banks are generally of two types: (a) participation loans; and (b)__________. The
term that correctly fills in the blank above is:
A) Assignments
B) Recourse loans
C) Direct loans
D) Subscription loans
E) None of the above.
63. A standby credit letter is a (or an):
A) Securitized strip
B) Loan strip
C) Contingent obligation
D) Indirect loan
E) None of the above.
64. A bank that wants to protect itself from higher credit costs due to a decrease in its credit rating
might purchase _________________________ .
A) A credit risk option
B) A standby letter of credit
C) A credit linked note
D) A credit swap
E) None of the above
65. When two banks simply agree to exchange a portion of their customers’ loan repayments, they are
using:
A) A credit option
B) A standby letter of credit
C) A credit linked note
D) A credit swap
E) None of the above
66. A debt instrument which allows the issuer to lower its coupon payments if some significant factor
changes is called:
A) A credit option
B) A standby letter of credit
C) A credit linked note
D) A credit swap
E) None of the above
67. Which of the following is a risk of using credit derivatives?
A) Credit derivatives do not protect against credit risk exposure
B) The partner in the swap or option contract may fail to perform
C) Regulators may decide to lower the amount of capital needed for banks using these
derivatives
D) Regulators may decide that these derivatives make the bank more stable and efficient
E) All of the above are risks of using credit derivatives
68. A securitized asset where the asset used to back the securities is a loan based on the residual value
of a homeowner’s residence is called:
A) A mortgage backed security
B) A credit card backed security
C) An automobile backed security
D) A loan backed bond
E) A home equity loan backed security
69. A financial institution plans to issue a group of bonds backed by a pool of automobile loans.
However, they fear that the default rate on the automobile loans will rise well above 4 percent of
the portfolio – the projected default rate. The financial institution wants to lower the interest
payments if the loan default rate rises too high. Which type of credit derivative contract would
you most recommend for this situation?
A) Credit linked note
B) Credit option
C) Credit risk option
D) Total return swap
E) Credit swap
70. A bank is about to make a $50 million project loan to develop a new oil field and is worried that
the petroleum engineer’s estimates of the yield on the field are incorrect. The bank wants to
protect itself in case the developer cannot repay the loan. Which type of credit derivative contract
would you most recommend for this situation?
A) Credit linked note
B) Credit option
C) Credit risk option
D) Total return swap
E) Credit swap
71. A bank plans to offer new subordinated notes in the open market next month but knows that its
credit rating is being reviewed by a credit rating agency. The bank wants to avoid paying sharply
higher credit costs. Which type of credit derivative contract would you most recommend for this
situation?
A) Credit linked note
B) Credit option
C) Credit risk option
D) Total return swap
E) Credit swap
72. A bank is concerned about excess volatility in its cash flows from some recent business loans it
has made. Many of these loans have a fixed rate of interest and the bank’s economics department
has forecast a sharp increase in interest rates. The bank wants more stable cash flows. Which
type of credit derivative contract would you most recommend for this situation?
A) Credit linked note
B) Credit option
C) Credit risk option
D) Total return swap
E) Credit swap
73. A bank has a limited geographic area. It would like to diversify its loan income with loans in
other market areas but does not want to actually make loans in those areas because of their
limited experience in those areas. Which type of credit derivative contract would you most
recommend for this situation?
A) Credit linked note
B) Credit option
C) Credit risk option
D) Total return swap
E) Credit swap
74. A bank has a long term relationship with a particular business customer. However, recently the
bank has become concerned because of a potential deterioration in the customer’s income. In
addition, regulators have expressed concerns about the bank’s capital position. The business
customer has asked for a renewal of its $25 million dollar loan with the bank. Which credit
derivative can help this situation?
A) Credit swap
B) Loan sale
C) Loan securitization
D) Credit risk option
E) Credit linked notes
75. A bank has placed 5000 consumer loans in a package to be securitized. These loans have an
annual yield of 15.25 percent. This bank estimates that the securities on these loans are priced to
yield 10.95 percent. The bank expects 1.45 percent of the loans will default. Underwriting and
advisory services will cost .25 percent and a credit guarantee if more loans default than expected
will cost .35 percent. What is the residual income from this loan securitization?
A) 3.70 percent
B) 4.30 percent
C) 2.25 percent
D) 5.15 percent
E) None of the above
76. Bank use of credit derivatives is dominated by
A) Community Banks
B) The largest (over $1 billion) banks
C) The retail banks
D) None of the banks
E) Banks do not use credit derivatives yet
77. According to the text, in 2005 the securitization of loans reached:
A) Million dollar market
B) Billion dollar market
C) Trillion dollar market
D) Market unknown in value
E) Small but growing market
78. The principal sellers of credit derivatives include all of the following except:
A) Insurance companies
B) Securities dealers
C) Fund management firms
D) Banks
E) None of the above
79. The bank or other lender whose loans are pooled is called:
A) The originator
B) The special purpose entity
C) The trustee
D) The servicer
E) The credit enhancer
80. Loans that are to be securitized pass to . This helps ensure that if the lender
goes bankrupt it does not affect the credit status of the pooled loans.
A) The originator
B) The special purpose entity
C) The trustee
D) The servicer
E) The credit enhancer
81. Someone appointed to ensure that the issuer fulfills all the requirements of the transfer of the
loans to the pool and provides all of the services promised to investors in the securities is called:
A) The originator
B) The special purpose entity
C) The trustee
D) The servicer
E) The credit enhancer
82. Someone who collects the payments on the securitized loans and passes those payments on to the
trustee is called:
A) The originator
B) The special purpose entity
C) The trustee
D) The servicer
E) The credit enhancer
83. Investors in securitized loans normally receive added assurance that they will be repaid in the
form of guarantees against default issued by:
A) The originator
B) The special purpose entity
C) The trustee
D) The servicer
E) The credit enhancer
84. When an issuer of securitized loans divides them into different risk classes or tranches, they are
providing an:
A) Internal credit enhancement
B) External credit enhancement
C) Internal liquidity enhancement
D) External liquidity enhancement
E) None of the above
85. When an issuer of securitized loans includes a standby letter of credit with the securitized loans,
they are providing an:
A) Internal credit enhancement
B) External credit enhancement
C) Internal liquidity enhancement
D) External liquidity enhancement
E) None of the above
86. When an issuer of securitized loans sets aside a cash reserve to cover loan defaults, they are
providing an:
A) Internal credit enhancement
B) External credit enhancement
C) Internal liquidity enhancement
D) External liquidity enhancement
E) None of the above
87. Which of the following is an advantage of securitizing loans?
A) Diversifying a lender’s credit risk exposure
B) Reducing the need to monitor each individual loan’s payment stream
C) Transforming illiquid assets into liquid securities
D) Serving as a new source of funds for lenders and attractive investments for investors
E) All of the above are advantages of securitizing loans
88. Why are securitized loans often issued through a special purpose entity?
A) Because the securitized loans often add risk to the bank and need to be held separately
B) Because the securitized loans are not profitable for the bank and need to be held separately
C) Because the special purpose entity might fail and this prevents the failure of the bank
D) Because the bank might fail and this protects the credit status of the securitized loans
E) All of the above
89. A group of pooled loans used is expected to yield a return of 23%. The coupon rate promised to
investors on securities issued against the pool of loans is 8%. The default rate on the pooled
loans is expected to be 4.5%. The fee to compensate a servicing institution for collecting
payments on the loans is 2%. Fees to set up credit and liquidity enhancements are 3%. The fee
for providing advising how to set up the pool of securitized loans is 1%. What is the residual
income on this pool of loans?
A) 18.5%
B) 9%
C) 4.5%
D) 2%
E) None of the above
90. The coupon rate promised investors on securities issued against a pool of loans is 6.5%. The
default rate on the pool of loans is expected to be 3.5%. The fee to compensate a servicing
institution for collecting payments on the loan is 2%. Fees to set up credit and liquidity
enhancements are 5%. The residual income on this pool of loans is 7%. What is the expected
yield on this pool of loans?
A) 24%
B) 12%
C) 10%
D) 6.5%
E) None of the above
91. In a collateralized mortgage obligation (CMO) a tranche:
A) Promises a different return (coupon) to investors
B) A liquidity enhancement
C) Carries a different risk exposure
D) A and C above
E) All of the above
92. What is one of the advantages of using loan-backed bonds?
A) Loans used as collateral for the bonds can be sold before the maturity of the bonds
B) Loan-backed bonds have longer maturities than deposits
C) Banks do not have to meet regulatory capital requirements on loans used as collateral
D) Banks can use less loans as collateral than the amount of bonds issued
E) All of the above are advantages of loan-backed bonds
93. What is one of the disadvantages of using loan backed bonds?
A) The cost of funding often rises
B) There is greater default risk on the bonds
C) Loans used as collateral for the bonds must be held until the bonds reach maturity
D) Loan backed bonds have shorter maturities than deposits
E) All of the above are disadvantages of loan-backed bonds
94. According to the textbook, what is the minimum size of the loan-backed securities offering that
are likely to be successful?
A) $1 million
B) $10 million
C) $25 million
D) $50 million
E) $1 trillion
95. Which of the following is a concern regulators have about securitization?
A) The risk of being an underwriter for asset-backed securities that cannot be sold
B) The risk of acting as a credit enhancer and underestimating the need for loan-loss reserves
C) The risk that unqualified trustees will fail to protect investors in asset-backed instruments
D) The risk that loan servicers will be unable to satisfactorily monitor loan performance
E) All of the above are concerns regulators have about securitization
96. What prompted a surge in loan sales in the 1980s?
A) A wave of corporate buyouts
B) An increase in lesser developed country loans
C) A loosening of government regulations
D) An increase in international lending
E) None of the above
97. Why have the use of standby credit letters grown in recent years?
A) The growth of bank loans sought by companies in recent years
B) The decreased demand for risk reduction devices
C) The high cost of standby credit letters in recent years
D) The rapid growth of direct financing by companies
E) All of the above
98. Which of the following is true regarding regulatory rules for standby credit letters issued by
banks?
A) They must list the standby credit letter as a liability on their balance sheet
B) They must count standbys as loans
C) They do not have to apply the same credit standards for approving standbys as direct loans
D) They can apply lower capital standards to standbys than loans
99. Which of the following is true regarding regulatory rules for standby credit letters issued by
banks?
A) They must list the standby credit letter as a liability on their balance sheet
B) They do not have to list standby credit letters when assessing the risk exposure to a single
credit customer
C) They must apply the same credit standards for approving standby credit letters as direct loans
D) They can apply lower capital standards to standby credit letters than loans
E) None of the above is true
100. Regular collateralized debt obligations (CDO) have been surpassed by:
A) Credit swaps
B) Credit options
C) Credit default swaps
D) Total return swaps
E) Synthetic collateralized debt obligations
101. According to research, off-balance-sheet standby credit letters reduce risk by:
A) Increasing diversification of assets
B) Reducing the need for documentation
C) Reducing probability of losses
D) Avoiding capital requirements
E) Increasing concentration of risk exposure
102. What is the advantage of credit swaps for each partner?
A) Broaden the number of markets
B) Broaden the variety of markets from which they collect loan revenues and principal
C) Spread out the risk in the loan portfolio
D) Avoiding capital requirements
E) A, B, and C
103. What are the ways to reduce the risk of standby credit letters?
A) Avoid renegotiating the terms of loans of SLC customers
B) Specialize in SLCs issued by the same region and industry
C) Sell participations in standbys in order to share risk with other lending institutions
D) Do not count standbys as loans when assessing the bank’s risk exposure
E) All of the above are the ways to reduce the risk
104. The lesson(s) of the credit crisis of 2007-2009 is that the “bankruptcy remote” arrangement of the
special-purpose entity (SPE):
A) Reduces the need for securitization
B) Eliminates the probability of bankruptcy of the originator institution
C) May create problems if the underlying loans go bad in great numbers
D) Eliminates the need for a trustee
E) All of the above are correct
105. The lesson from the credit crisis of 2007-2009 is that securitized assets and credit swaps are:
A) Complex financial instruments
B) Difficult to correctly value and measure in terms of risk exposure
C) Affected by cyclically sensitive markets in which financial problems may spread and result in
a financial contagion
D) Possible to set in motion a financial contagion that cannot be easily stopped without active
government intervention
E) All of the above are correct