CFA Level 2 - Fixed Income Session 15 - Reading 57 Mortgage-Backed Sector of the Bond Market-LOS m

CFA Level 2 – Fixed Income, Session 15-Reading 57

Mortgage-Backed Sector of the Bond Market-LOS m

(Notes, Practice Questions, Sample Questions)

1. 1. Which of the following statements is most accurate concerning the effect of defeasance on the quality of a Commercial mortgage-backed securities (CMBS) loan pool? Defeasance:

A) increases the quality of a CMBS loan pool by requiring fees for late payments.

B) decreases the quality of a CMBS loan pool by selling some of the pool as payments come due.

C) increases the quality of a CMBS loan pool by reinvesting any prepayments in Treasury securities

Explanation: C) Defeasance increases the quality of a CMBS loan pool by reinvesting any prepayments in Treasury securities

2. Commercial Mortgage-Backed Securities (CMBS) provide structural call protection through which of the following key repayment terms?

A) Losses of principal are allocated to specific tranches, rather than to the CMBS overall.

B) Sequential repayment of the CMBS tranches and the allocation of losses of principal to specific tranches, rather than to the CMBS overall.

C) Sequential repayment of the CMBS tranches

Explanation: B) CMBS securities provide structural call protection through sequential repayment of the CMBS tranches, as well as the allocation of losses of principal to specific tranches rather than to the overall CMBS

3. Which of the following regarding key credit enhancement features of defeasance as prepayment protection is least accurate?

A) No distributions are made when the defeasance takes place, so there is no issue concerning how prepayment penalties will be disbursed.

B) The duration of the defeasance funds reduces the credit risk of the commercial mortgage-backed securities (CMBS).

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C) The cash flow from the defeasance funds is substituted for payments made by the borrower

Explanation: B) Duration is related to interest rate risk; it is not related to credit risk

4. Commercial mortgage-backed securities (CMBS) provide call protection through loan-level and individual mortgage call protection. Which of the following are least likely forms of call protection?

A) Borrowers are charged the amount of interest lost by the lender had the loan not been prepaid.

B) Penalty fees assessed against the borrower for prepayment.

C) If borrowers prepay their loan, proceeds are distributed to investors

Explanation: C) Loan-level call protection includes: defeasance, prepayment penalty charges, prepayment lock out period, and yield maintenance charges. Prepayment proceeds should not be distributed to investors. When borrowers prepay, the mortgage loan can be “defeased” – the loan proceeds are received by the loan servicer and invested in U.S. Treasuries to create cash collateral against the loan

5. The strongest form of prepayment protection is:

A) yield maintenance charges.

B) a one year prepayment lockout.

C) defeasance

Explanation: C) Defeasance occurs when prepayment loan proceeds received by the loan servicer are invested in U.S. Treasury securities. When the defeasance period ends, the U.S. Treasuries are liquidated and the proceeds are used to repay the mortgage. The collateral provided by the U.S. Treasuries is of higher quality than the underlying asset; therefore, defeasance represents the greatest level of prepayment protection for an investor