Bionic Turtle FRM Practice Questions

P1.T3. Financial Markets & Products

Bruce Tuckman, Fixed Income Securities:

Tools for Today’s Markets, 3rd Edition
By David Harper, CFA FRM CIPM
www.bionicturtle.com
TUCKMAN, CHAPTER 20: MORTGAGES AND MORTGAGE-BACKED SECURITIES ........... 3
P1.T3.500. RESIDENTIAL MORTGAGE PRODUCTS....................................................................... 3
P1.T3.501. MORTGAGE-BACKED SECURITIES............................................................................ 5
P1.T3.502. DOLLAR ROLL ........................................................................................................ 8
P1.T3.503. PREPAYMENT MODELING AND MONTE CARLO SIMULATION .......................................11

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Tuckman, Chapter 20: Mortgages and Mortgage-Backed
Securities
P1.T3.500. Residential mortgage products
P1.T3.501. Mortgage-backed Securities
P1.T3.502. Dollar roll
P1.T3.503. Prepayment modeling and Monte Carlo simulation

P1.T3.500. Residential mortgage products

Learning Objectives: Describe the various types of residential mortgage products.
Calculate a fixed rate mortgage payment, and its principal and interest components.

500.1. Sally is meeting with her real estate agent in order to prepare her application for a
mortgage loan. The real estate agent makes the following four statements. Each of these
statements is true, or at plausible, EXCEPT which is clearly false?

The initial interest rate on a 3/1 hybrid adjustable rate mortgage (ARM) is less than the
rate on a 30-year fixed rate mortgage (FRM)
A conforming loan meets guidelines set by agencies such as Fannie Mae and Freddie
Mac and include limits on the loan size
A "jumbo" is a mortgage loan with an amount above the conforming (aka, agency) loan
limit; interest rates on a jumbo loan may be higher or even lower than (otherwise-
equivalent) conforming loans
In a low interest environment, an adjustable rate mortgage (ARM) is generally advised
because the borrower can always decide to refinance at a later date

500.2. Which is nearest to the principal component of the first monthly payment on a 30-year
fixed rate mortgage (FRM) with an original balance of $140,000 when the interest rate is
3.60%?

$39.00
$216.50
$420.00
$636.50

500.3. After five years (60 months), which is nearest to the outstanding scheduled principal
balance on a 30-year fixed rate mortgage (FRM) with an original balance of $200,000 and a
mortgage interest rate of 3.60%?

$152,300
$165,800
$179,700
$182,500

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Answers:

500.1. D. False. This was a lesson of the subprime crisis: many borrowers who planned to
refine ARMs were subsequently unable to do so when home prices unexpectedly declined.
 Tuckman: "Given the role of the subprime crisis, some further comment is in order.
Borrowing and lending in the subprime market revolved around the following strategy. A
relatively low-credit borrower would take out an ARM that carried a particularly low initial
rate, called a teaser, which would reset higher after two or three years. In that time,
however, should the credit of the borrower improve or should housing prices increase,
the borrower would be able to pay off that first mortgage and borrow through a
subsequent mortgage at a fixed rate that would have been unattainable at the start. This
strategy worked well until the peak of housing prices in 2006. In fact, most subprime
mortgage originations occurred between 2004 and 2006. In any case, the subsequent
decline in housing prices and the resetting of ARMs to higher rates led to a significant
number of defaults: by May 2008 the delinquency rate for ARMs reached 25%. The
resulting foreclosures put further downward pressure on housing prices. By September
2008, the average home price had declined 20% from its 2006 peak. By September
2009, about 14.4% of all U.S. mortgages were either delinquent or in foreclosure, and, in
2009–2010, between 4% and 5% of the total number of mortgages ended in
repossessions. Finally, by September 2010, principal balance exceeded home price for
23% of mortgages outstanding, with the percentages in the worst-performing real estate
markets even worse (e.g., California at 32.8% and Florida at 46.4%)."

 In regard to (A), (B) and (C), each is TRUE.

500.2. B. $216.50. As the monthly payment is $636.50 and the interest component is $420.00 =
$140,000 * 0.0360/12, the principal component is $216.50 = $636.50 - $420.00.

500.3. C. $179,700. As the monthly payment is $909.29, the PV of the annuity is given by
[PMT*(12/r)]*{1-[1/(1+r/12)]^n}. In this case, [$909.29*(12/0.036)]*{1-[1/(1+0.036/12)]^300} =
$179,701

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P1.T3.501. Mortgage-backed Securities
Learning Objectives: Describe the mortgage prepayment option and the factors that
influence prepayments. Summarize the securitization process of mortgage backed
securities (MBS), particularly formation of mortgage pools including specific pools and
TBAs. Calculate weighted average coupon, weighted average maturity, and conditional
prepayment rate (CPR) for a mortgage pool.

501.1. After five years (60 monthly payments), the outstanding balance on a mortgage is
$89,850.00 when the original balance was $100,000. The mortgage is a 30 year fixed rate
mortgage (FRM) and each monthly payment is $454.65. As Tuckman explains, "The
prepayment option is valuable when mortgage rates have fallen. In that case, as mentioned
previously, the present value of the remaining monthly payments exceeds the principal
outstanding."

If we ignore transaction costs, according to Tuckman's principle, what is the highest mortgage
rate at which prepayment (for example, refinance) is financially desirable?

1.99%
2.75%
3.60%
4.29%

501.2. If a pool of mortgages starts the year with a principal balance of $10.0 million and the
single monthly mortality rate, SMM(n), is constant at 1.0%, which is nearest to the principal that
prepays over the next twelve months (not including scheduled principal)?

$1,136,151
$1,200,000
$8,800,000
$8,863,849

501.3. In regard to mortgages and mortgage-backed securities, each of the following is

true EXCEPT which is false?

In a mortgage pass-through, the cash flows from the underlying mortgages (i.e., interest,
scheduled principal, and prepayments) are passed from the borrowers to the investors
A recourse loan is better for the borrower because it means that the borrower can seek a
so-called short sale if the value of the house is less than the outstanding principal
balance on the mortgage loan
Mortgage servicers manage the flow of cash from borrowers to investors in exchange for
a fee taken from those cash flows; mortgage guarantors guarantee investors the
payment of interest and principal against borrower defaults, also in exchange for a fee

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 When a borrower does default, the guarantor compensates the pool with a lump-sum
payment and then, through the servicer, pursues the borrower and the underlying
property to recover as much of the amount paid as possible

Answers:

501.1. C. 3.60%
We simply want the interest rate, expressed in monthly compound frequency, which
prices the remaining payments equal to the balance. In this case,
N = 300, PV = -89850, PMT = 454.65, FV = 0 and CPT I/Y = 0.30 and we multiply by 12 to get
the yield of 3.60%.

If the interest rate drops below 3.60%, then the present value of the stream of outstanding
monthly payments increases about the outstanding balance and it becomes financially optimal
(ignore transaction costs and friction) for the borrower (homeowner) to exercise the call option.

501.2. A. $1,136,151. Principal* [1-(1 - SMM)^12] = $10.0 mm * [1-(1 - 0.01)^12] = $10.0 mm

* 0.113615128. Note the prepaid principal here is less than 12*1%*$10.0 million just as CRP(n)
= 1 - [1 - SMM(n)]^12.

501.3. B. False. A non-recourse loan is better for the borrower. Recourse allows the lender
to go after personal assets, in addition to the house. A short sale is when the lender agrees (at
their discretion) to accept less than the full amount of the loan payoff; depending on the
state/country laws, the lender may have recourse to pursue the remaining balance after the
short sale.
 In regard to (A), (C) and (D), each is TRUE.

 Tuckman: "Mortgage-backed Securities: Until the 1970s banks made mortgage loans
and held them until maturity, collecting principal and interest payments until the
mortgages were repaid. The primary market was the only mortgage market. During the
1970s, the securitization of mortgages began. The growth of this secondary market
substantially changed the mortgage business. Banks that might have had to restrict
mortgage lending, either because of limited capital or risk appetite, could now continue
to make mortgage loans since these loans could be quickly and efficiently sold. At the
same time, investors gained a new security type through which to lend their surplus
funds. Of course, one of the policy questions raised by the 2007–2009 financial crisis
was whether the mortgage securitization process, for any of several reasons, had
created too much systemic risk.

Issuers of MBS gather mortgage loans into pools and then sell claims on those pools to
investors. In the simplest structure, a mortgage pass-through, the cash flows from the
underlying mortgages, that is, interest, scheduled principal, and prepayments, are
passed from the borrowers to the investors with some short processing delay. Mortgage
servicers manage the flow of cash from borrowers to investors in exchange for a fee
taken from those cash flows. Mortgage guarantors guarantee investors the payment of
interest and principal against borrower defaults, also in exchange for a fee. When a
borrower does default, the guarantor compensates the pool with a lump-sum payment
and then, through the servicer, pursues the borrower and the underlying property to

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 recover as much of the amount paid as possible. By the way, in comparison with U.S.
lenders, European lenders have easier recourse to borrower assets that are not part of
the mortgaged property.

The Overview reported that U.S. mortgage debt was a little over $14 trillion in 2010. Of this total,
$7.5 trillion had been securitized. This securitized amount is further subdivided into $5.4 trillion
of agency securities, i.e., securities guaranteed or issued by such entities as GNMA, FNMA,
and FHLMC, and the remainder private-label securities issued by private financial institutions.
These amounts outstanding are misleading, however, with respect to new issuance. Since the
2007–2009 crisis to the time of this writing, agency securities comprised almost all of new MBS
issuance."

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P1.T3.502. Dollar roll
Learning Objectives: Describe a dollar roll transaction and how to value a dollar roll.

502.1. Consider an investor who wants to finance the purchase of a mortgage pool over a one
month period. One alternative is to sell an MBS repo, in which case the investor could sell the
pool today while simultaneously agreeing to repurchase it after a month. This trade has the
same economics as a secured loan: the investor effectively borrows cash today by posting the
pool as collateral, and, upon paying back the loan with interest after a month, retrieves the
collateral. An alternative is the "dollar roll." In the dollar roll, the buyer of the roll sells a TBA for
one settlement month (the "earlier month") and buys the same TBA for the following settlement
month (the "later month").

For example, the investor who just purchased a 30-year 4% FNMA pool might sell the FNMA
30-year 4% January TBA and buy the FNMA 30-year 4% February TBA. Delivering the pool just
purchased through the sale of the January TBA, which raises cash, and purchasing a pool
through the February TBA, which returns cash, is very close to the economics of a secured
loan.

But there are two important differences between dollar roll and repo financing:
I. The buyer of the roll may not get back in the later month the same pool delivered in the
earlier month. The buyer of the roll delivers a particular pool, for example, in January but
will have to accept whatever eligible pool is delivered in the next February. By contrast,
an MBS repo seller is always returned the same pool that was originally posted as
collateral.
II. The buyer of the roll does not receive any interest or principal payments from the pool
over the roll. For example, the buyer of the Jan/Feb roll, who delivers the pool in
January, does not receive the January payments of interest and principal. By contrast, a
repo seller receives any payments of interest and principal over the life of the repo.
While the prices of TBA contracts reflect the timing of payments, so that the buyer of a
roll does not, in any sense, lose a month of payments relative to a repo seller, the risks
of the two transactions are different. The buyer of a roll does not have any exposure to
prepayments over the month being higher or lower than what had been implied by TBA
prices while the repo seller does.

Which of these two differences is (are) CORRECT?

Neither are correct

I. is true but II. is incorrect
I. is incorrect but II. is true
Both are correct

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502.2. Consider the scenario (a variation on Tuckman's example) illustrated below. Suppose
that the TBA prices of the Fannie Mae 6% for July 9 and August 9 settlements are $103.00 and
$102.60, respectively. The accrued interest to be added to each of these prices is 9 actual/360
days of a month's worth of a 6.0% coupon, i.e., 100 × (9/30) × 6.0%/12 or $0.150. Let the
expected total principal paydown, that is, scheduled principal plus prepayments, be 2.0% of
outstanding balance and let the appropriate short-term rate be 1.0%.

If an investor rolls a balance of $10.0 million, proceeds from selling the July TBA are $10.0
million × (103.00 + 0.150)/100 or $10,315,000.00. Investing these proceeds to August 9 at 1.0%
earns interest of $10,315,000.00 × (31/360) × 1.0% or $8,882.36. Then, purchasing the August
TBA, which has experienced a 2.0% principal paydown, costs $10.0 million × (1 - 2.0%) ×
(102.60 + 0.150)/100 or $10,069,500.00. The net proceeds from the roll, therefore, are
$10,315,000.00 + $8,882.36 - $10,069,500.00 or $254.382.36. If the investor does not roll, the
net proceeds are the coupon plus principal paydown: $10,000,000.00 × (6.0%/12 + 2.0%) or
$250,000.00.

Given this scenario, which of the following is TRUE?

The roll trades above carry (i.e., the value of the roll is positive) and this might be
rationally explained by delivery options of TBAs
The roll trades above carry (i.e., the value of the roll is positive) and this might be
rationally explained by the relatively low short-term interest rate
The roll trades below carry (i.e., the value of the roll is negative) and this might be
rationally explained by delivery options of TBAs
The roll trades at breakeven (i.e., the value of the roll is zero) and this is expected in
efficient markets

502.3. Which of the following is most likely to exhibit a dollar value of an 01 (DV01) that is
negative?

Principal-only (PO) at high yields

Interest-only (IO) strip at low yields
Interest only (IO) strip at high yields
Planned amortization class (PAC) bond at low yields

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Answers:

502.1. D. Both are correct

502.2. A. The roll trades above carry (i.e., the value of the roll is positive) and this might
be rationally explained by delivery options of TBAs
The value of the roll is positive. The roll is $4,382.36 = $254,382.36 - 250,000.00.

 In regard to false (B), the short-term interest rate should factor into the carry; further a
lower rate, ceretis paribus, actually decreases the roll because it decreases the net
proceeds so even directionally it doesn't quite make sense.

502.3. B. Interest-only (IO) strip at low yields

Tuckman: "The price-rate curve of the IO is, of course, the pass-through curve minus the PO
curve, but it is instructive to describe the IO curve independently. When rates are very high and
prepayments low, the IO is like a security with a fixed set of cash flows. As rates fall and
mortgages begin to prepay, the cash flows of an IO vanish. Interest lives off principal. Whenever
some principal is paid off there is less available from which to collect interest. But, unlike
callable bonds or pass-throughs that receive such prepaid principal, when prepayments cause
interest payments to stop or slow the IO gets nothing. Once again, its cash flows simply vanish.
This effect swamps the discounting effect so that, when rates fall, IO values decrease
dramatically. The negative DV01 or duration of IOs, an unusual feature among fixed income
products, may be valued by traders and portfolio managers in combination with more regularly
behaved fixed income securities."

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tuckman.8494/

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P1.T3.503. Prepayment modeling and Monte Carlo simulation
Learning Objectives: Explain prepayment modeling and its four components:
refinancing, turnover, defaults, and curtailments. Describe the steps in valuing an MBS
usingMonte Carlo Simulation. Define Option Adjusted Spread (OAS), and explain its
challenges and its uses.

503.1. According to Tuckman, "A prepayment model uses loan characteristics and the economic
environment (i.e., interest rates and sometimes housing prices) to predict prepayments. The
most common practice identifies four components of prepayments, namely, in order of
importance, refinancing, turnover, defaults, and curtailments. These components are typically
modeled separately and their parameters estimated or calibrated so as to approximate available
historical data." About these four components, each of the following is true EXCEPT which is
false?

Refinancing is often modeled with an incentive function for a pool or group of loans in a
pool, and then prepayments due to refinancing are defined as a nondecreasing function
of that incentive; an example of an incentive function is I = [WAC - R]*WALS*A-K
Turnover is primarily a function of interest rates and tends to be independent of
seasonality but highly responsive to the so-called media effect
Defaults are a source of prepayments in the sense that mortgage guarantors pay
interest and principal outstanding when a borrower defaults
Curtailments are partial prepayments by a particular borrower. These tend to be most
important when loans are older and balances are low

503.2. According to Tuckman, the valuation of a mortgage-backed security (MBS) is well-suited

to a Monte Carlo simulation because the model can incorporate each of the following
features EXCEPT which of these is difficult for the Monte Carlo simulation?

Path-dependent cash flows

Burnout and media effects
Measures of interest rate sensitivity
American- or Bermuda-style options

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503.3. Tuckman writes that the "Option Adjust Spread (OAS) is the most popular measure of
relative value for MBS." In the context of a Monte Carlo valuation of a mortgage-backed security
(MBS), each of the following is true about the OAS EXCEPT which is false?

If the assumption for interest rate volatility increases in the MBS Monte Carlo valuation
model, then the OAS should increase also
To the extent that the MBS Monte Carlo valuation model accounts correctly for
scheduled cash flows and prepayments, the OAS represents the deviation of a security’s
market price from its fair value
The practical challenge of using models and OAS to measure relative value is in
determining when OAS really does indicate relative value and when it indicates that the
model is misspecified
d. Because the MBS Monte Carlo valuation model is supposed to account completely for
the effects of interest rates on cash flows and discounting, the OAS should be
uncorrelated with interest rate movements

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Answers:

503.1. B. False. Turnover is mostly independent of interest rates (except for the lock-in
effect) but dependent on seasonality; the "media effect" is associated with refinancing.

 In regard to (A), (C) and (D) each is TRUE.

Tuckman: "Modeling the refinancing component of prepayments often starts with an

incentive function for a pool or group of loans in a pool and then defines prepayments due to
refinancing as a nondecreasing function of that incentive. A simple example of an incentive
might be I = (WAC-R)*WALS*A-K, where (WAC) is the weighted average coupon of the pool,
(R) is the current mortgage rate available to borrowers, (WALS) is the weighted-average loan
size of the pool, (A) is an annuity factor that gives the present value of an annual dollar payment
from the average loan (i.e., from a loan with a remaining maturity equal to the average maturity
of the loans being modeled), and (K) is an estimate of the fixed cost of refinancing. The current
mortgage rate is actually lagged by a month or two in an incentive function to reflect lags in
initiating and processing a refinancing application.

… Prepayments due to turnover occur when borrowers sell houses to relocate, to change to a
bigger or smaller house, as a result of a divorce, or in response to other personal
circumstances. This driver of prepayments typically accounts for less than 10% of overall
prepayment rates. A turnover model for a particular group of loans begins with a base rate that
is adjusted to account for the seasonality of relocations, e.g., higher in summer, lower in winter.
The model would then add a seasoning ramp. Households are very unlikely to move just after
taking out a mortgage. A typical average assumption would be that turnover starts at zero at the
time of initiation and increases to the base rate after 30 months. The steepness of the
seasoning ramp is often made to depend on several factors. For example, less creditworthy
borrowers are more likely to prepay sooner after taking out a mortgage as some will experience
improvements to their creditworthiness.

… Defaults are a source of prepayments in the sense that mortgage guarantors pay interest
and principal outstanding when a borrower defaults. Over the most recent cycle of increasing
real estate values, modeling defaults had been less important and had received less attention.
This changed dramatically, of course, in reaction to falling housing prices in the run-up to and
progression of the 2007–2009 crisis. In addition, mortgage modifications, which did not exist
previously, have become an important part of the landscape. From the modeling perspective,
more effort is being dedicated to using pertinent variables, e.g., initial LTV ratios, FICO scores,
and SATO (which are not usually updated after mortgage issuance), and to incorporating the
dynamics of housing prices into the analysis.

… Curtailments are partial prepayments by a particular borrower. These tend to be most

important when loans are older and balances are low. This driver of prepayments is modeled as
a function of loan age and can, with only a couple of years remaining to maturity, rise to a CPR
of about 5%."

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503.2. D. American- or Bermuda-style options
Tuckman: "Monte Carlo Simulation: Suppose for a moment that a one-factor tree
implementation of a term structure model was used to value MBS. The cash flows at any node
of the tree would be determined by scheduled cash flows and the prepayment model. Then, the
value of the MBS at any node would be the cash flow on that date plus the expected discounted
value of the MBS on the subsequent date. The problem with this approach, however, is that it
assumes that the cash flows at any node depend only on the short-term rate at that node, or,
equivalently, on the term structure of interest rates at that node. But what if prepayments at
particular nodes depend on the history of interest rates on the way to that node, as models of
burnout require. In that case the tree implementation fails because it does not naturally recall,
for example, whether a node five periods from the start was reached by two down moves
followed by three up moves, by three up moves followed by two down moves, or by the
sequence up-down-up-down-up. But the burnout effect says that prepayments at a particular
node will be less if that node was reached by passing through a node with a relatively low
interest rate. In the jargon of valuation models, the tree implementation assumes that cash flows
are path independent while the cash flows from a burnout model are path dependent.

The most popular solution to pricing path-dependent claims is Monte Carlo simulation. To price
a security in this framework, proceed as follows. First, generate a large number of paths of
interest rates at the frequency and to the horizon desired. For this purpose paths are generated
using a particular risk-neutral process for the short-term rate. Second, calculate the cash flows
of the security along each path. In the mortgage context this would include the security’s
scheduled payments along with its prepayments. Note that burnout and media effects can be
implemented because each path is available in its entirety as cash flows are calculated. Third,
starting at the end of each path, calculate the discounted value of the security’s cash flows
along each path. Fourth, compute the value of the security as the average of the discounted
values across paths ...

Two more comments will be made about the Monte Carlo framework. First, measures of interest
rate sensitivity can be computed by shifting the initial term structure in some manner, repeating
the valuation process, and calculating the difference between the prices after and before the
interest rate shift. Second, while the Monte Carlo approach does accommodate path-dependent
cash flows, it has two major drawbacks. One, it is more computationally and numerically
challenging than pricing along a tree. Two, it is difficult in the Monte Carlo framework to value
American- or Bermuda-style options. (Examples in the mortgage context include mortgage
options, mentioned earlier, and callable CMOs.) For these options, which allow early exercise,
the value of the option at each node is the maximum of the value of exercising the option
immediately and the value of the option not exercised. In a tree methodology, which starts at
maturity and works backwards, both of these values are available at each node. Along a Monte
Carlo path, however, the value of immediate exercise is always known, but the value of the
unexercised option is very difficult to compute. Starting a new Monte Carlo pricing simulation at
a particular date on a particular path so as to compute the value of the unexercised option for
that date and path is possible, but doing so for every exercise date on every path is not
computationally feasible."

503.3. A. False. Because Option cost = Zero-volatility OAS - OAS, an increase in the option
cost (which captures the prepayment risk), reflected by increased volatility, should be
associated with a decrease in the OAS.

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