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Answers to Chapter 24
Questions:
1. Loan securitization has increased in volume as a result of the creation of an active secondary market and the
implicit and explicit government guarantees on pass-through securities. The loan sales market has suffered from
2. Loans sold without recourse means that after selling the loan the originator of the loan can take it off the balance
sheet. In the event the loan is defaulted, the buyer of the loan has no recourse to the seller for any claims,
3. Short-term loan sales usually consist of maturities between one and three months and are secured by the assets of
a firm. They are usually sold in units of $1 million or more and are made to firms that have investment grade credit
4. Commercial paper issuers are generally blue chip corporations that have the best credit ratings. Banks may sell
the loans of less creditworthy borrowers, thereby raising required yields. Indeed, since commercial paper issuers
5. In a loan participation, the buyer does not obtain total control over the loan, while in an assignment, all rights are
transferred upon sale, thereby giving the buyer a direct claim on the borrower. Transactions costs are higher for loan
assignments than for loan participations since the loan must be transferred via a Uniform Commercial Code filing.
6. A highly leveraged transaction is a loan to finance an acquisition or merger. Often the purchase is a leverage
7. The buyers of loans are:
i. Investment banks (since they are often involved with the initial transaction that leads to the issuance of the debt);
ii. Vulture funds (since they invest in portfolios of risky loans);
The sellers of loans are:
i. Major money center banks (to reduce capital requirements, diversify the loan portfolio, reduce reserve
requirements, and increase liquidity);
8. The reasons for an increase in loan sales, apart from hedging credit risk, include:
(a) Removing loans from the balance sheet by sale without recourse reduces the amount of deposits necessary to
fund the FI, which in turn decreases the amount of regulatory reserve requirements that must be kept by the FI.
9. The three levels of taxes faced by FIs when making loans are; a) capital requirements on loans to protect against
default; b) reserve requirements on demand deposits for funding the loans; and c) deposit insurance to protect the
11. At the conclusion of the securitization process, the FI will have (1) exchanged a loan balance for cash, (2)
12. Prepayment is the process of paying principal on a debt before the due date. In the case of an amortized loan
that has fixed periodic payments, prepayment means that the lender will receive fewer of the fixed periodic
13. A CMO is a series of pass-through securities that have been allocated into different groups or tranches. Each
tranche typically has a different interest rate (coupon), and any prepayments on the entire CMO typically are
14. Mortgage backed bonds differ from collateralized mortgage obligation in two key ways. CMO help banks and
15. In the process of intermediation on behalf of its customers, the FI assumes risk exposure. The FI can reduce that
risk exposure by altering its product base, thereby affecting the portfolio mix obtained in the course of
intermediation. However, this is likely to be quite costly in terms of customer good will and loss of business.
16. Buyers of CMOs incur prepayment risks depending upon the class of tranches they have purchased. Purchasers
of Tranche A incur the most risk because all prepayments will be passed on to them. Prepayments usually occur
17. Conceptually, the answer is that they can, so long as doing so is profitable or the benefits to the FI from
Problems:
c. If sold with recourse and expected probability of default is taken into account, it should expect to receive:
b. The prices of these loans are being quoted at 88 cents and 89 cents to the dollar. In the case of the above loan, it
3. a. The duration of the existing loan is:
b.
c. Tranche A: 9%/4 x $50 million = $1,125,000 quarterly
d. Regular Tranche A payments are $1.125 million quarterly. If there are no prepayments, then the regular GNMA
quarterly payment of $5.272 million is distributed among the three tranches. Five million is the total coupon
payment for all three tranches. Therefore, $.272 million of principal is repaid each quarter, even if there are no
prepayments. Tranche A receives all principal payments. Tranche A cash flows are $1.125 million + $.272 million =
$1.397 million quarterly.
e. Quarterly prepayments on the entire mortgage pool are $10 million. They are credited entirely to Tranche A until
all principal is paid off. The payments are distributed as follows:
f. The way the terms of the CMO are structured, the average coupon rate on the three classes equals the mortgage
b. (Fixed) Interest Principal Remaining
d. Regular tranche A interest payments are $250,000 quarterly. If there are no prepayments, then the regular GNMA
quarterly payment of $1,613,350 is distributed among the three tranches. Five million is the total coupon interest
Tranche A amortization schedule:
Interest Principal Remaining
e. The quarterly prepayments of $5 million will be credited entirely to tranche A until tranche A is completely
retired. Then prepayments will be paid entirely to tranche B. The amortization schedule for tranche A for the first
year is shown below. This amortization schedule assumes that the trustee has a quarterly payment amount from the
mortgage pool of $1,613,350.
Interest Principal Remaining
However, since some of the mortgages will be paid off early, the actual payment received by the trustee from the
mortgage pool will decrease each quarter. Thus, the payment for the second quarter will decrease from $1,613,350 to
$1,532,385 (n = 119 quarters, i = 5 percent, mortgage principal = $94,636,500). The CMO amortization schedule for
tranche A given that the mortgage payments decrease with the prepayments is given below. The revised mortgage
payment for each quarter is shown in the last column.
Interest Principal Remaining Mortgage
f. The amortization schedules for tranches A and B are shown below. Again the mortgage payments from the
mortgage holders are assumed to decrease as the prepayments occur.
Amortization schedule for tranche A:
Tranche Interest Principal Remaining Mortgage
Amortization schedule for tranche B:
Tranche Interest Principal Remaining Mortgage
8. a. There are 180 monthly payments (15 years x 12 months). The GNMA monthly coupon rate is 8.5% - 0.5% = 8
b. Assume that the GNMA is only half amortized. There is a lump sum payment at the maturity of the GNMA that
equals 50 percent of the mortgage pool's face value.
