Test Bank for Options Futures And Other Derivatives 9th Edition By John C. Hull

Chapter 8: Securitization and the Credit Crisis of 2007

Multiple Choice Test Bank: Questions with Answers

Which of the following tends to lead to an increase in house prices?

An increase in interest rates

Regulators specifying a maximum level for the loan-to-value ratio on mortgages

Banks reducing the minimum FICO score that borrowers are required to have

An increase in foreclosures

Answer: C

An increase in interest rates tends to lower house prices because buyers have higher financing costs. Limiting the loan-to-value ratio means that some potential buyers cannot get the mortgages they require and there is less demand for houses with the result that  prices tend to decline. An increase in foreclosures increases supply and this also lowers prices. However, if banks relax their lending standards (e.g. by reducing the minimum FICO scores they require) demand should increase because more people can get mortgages. As a result prices will increase.

Which of the following is true of a non-recourse mortgage?

The house buyer, if unable to make payments, can lose all his or her possessions

The house buyer has an American-style put option on the house

The house buyer has a European-style put option on the house

The lender is less likely to lose money on the mortgage

Answer: B

In a non-recourse mortgage a lender cannot seize other assets of the borrower besides the house in order to be repaid. This means that if the price of the house declines below the balance outstanding on the mortgage the borrower can in principle give the house to the lender in return for tearing up the mortgage. The borrower therefore has an American style put option to sell the house for the amount outstanding on the mortgage.

Which of the following is NOT true

The bonus structure at banks can lead to short-term horizons for decision making

Securitization involves the transfer of risk

The term “agency costs” describes the situation where the incentives of two parties in a business relationship are not perfectly aligned

Correlations decrease in stressed market conditions

Answer: D

A, B, and C are true. D is not because correlations tend to increase, not decrease, in stressed markets,

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches:  senior  80%, mezzanine 10%, and equity 10%. (The portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from the mezzanine tranches with the same allocation of principal. Losses on the  mortgage portfolio prove to be 16%. What, as a percent of tranche principal, are losses on the mezzanine tranche of the ABS

50%

60%

80%

100%

Answer: B

10% out of the 16% loss is absorbed by the equity tranche. The remaining 6% is absorbed by the mezzanine tranche. The total size of the mezzanine tranche is 10%. It is therefore 60% wiped out.

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches:  senior  80%, mezzanine 10%, and equity  10%. (The portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from the mezzanine tranches with the same allocation of principal. Losses on the  mortgage portfolio prove to be 16%. What, as a percent of tranche principal, are losses on the mezzanine tranche of the ABS CDO

50%

60%

80%

100%

Answer: D

As the answer to the previous question shows, the mezzanine tranches are 60% wiped out. The first 10% out of this 60% is absorbed by the equity tranche of the ABS CDO. The next 10% is absorbed by the mezzanine tranche of the ABS CDO. The remaining 40% is absorbed by the senior tranche of the ABS CDO. The mezzanine tranche of the ABS CDO is therefore 100% wiped out

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches:  senior  80%, mezzanine 10%, and equity 10%. (The portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from the mezzanine tranches with the same allocation of principal. Losses on the  mortgage portfolio prove to be 16%. What, as a percent of tranche principal, are losses on the senior tranche of the ABS CDO

50%

60%

80%

100%

Answer: A

As the answer to the previous question shows the senior tranche of the ABS CDO absorbs 40% losses. It is therefore 40%/80% or 50% wiped out.

AIG lost money because

It bought tranches created from mortgages

It invested heavily in real estate

It invested heavily in the stock market

It insured AAA tranches of ABS CDOs

Answer: D

AIG insured the AAA tranches of ABS CDOs.

Which of the following survived the crisis without declaring bankruptcy or being taken over by another financial institution?

Bear Stearns

Morgan Stanley

Lehman Brothers

Merrill Lynch

Answer: B

Morgan Stanley survived. Bear Stearns was taken over by JPMorgan and Merrill Lynch was taken over by Bank of America. Lehman Brothers of course declared bankruptcy.

What are teaser rates

Interest rates that appear lower than they are

Interest rates that depend on LIBOR

Interest rates on mortgages with a very long amortization period

Interest rates that apply only for the first two or three years

Answer: D

Teaser rates are low interest rates that apply for the first two or three years of a mortgage. Some house purchasers felt that they could afford mortgage payments based on teaser rates and it was hoped by both borrower and lender that refinancing would be possible at the end of the teaser rate period.

Which of the following describes the waterfall typically used for mortgages pre-crisis?

A distribution of cash flows to tranches with priority given to tranche with the highest rating

A distribution of cash flows to tranches in proportion to their outstanding principals

A distribution of losses to tranches so that tranches bear losses in proportion to their outstanding principals

None of the above

Answer: A

The effect of the waterfall was usually that repayments went first to the most senior (highest rated) tranche, then to the next-most-senior tranche, and so on

In 2008 the TED spread reached a high of

About 150  basis points

About 250 basis points

About 450 basis points

About 550 basis points

Answer: C

The TED spread is the spread between the three-month LIBOR rate and the three-month Treasury rate. It reached about 450 basis points.

Which of the following were introduced before the credit crisis that started in 2007

Basel II

Dodd-Frank

Basel III

Requirements for living wills

Answer: A

Basel II was first proposed in 1999 and implemented in most parts of the world in about 2007. The others were introduced after the crisis had started.

Which of the following is true as the correlation between mortgage defaults increases?

Equity tranches are almost certain to incur losses

Senior tranches become more likely to incur losses

The expected number of defaults increases

Equity tranches are unaffected

Answer: B

If the correlation between mortgage defaults is very low the senior tranche is safe, but as the correlation increases it becomes more likely that it will experience losses. Suppose that the default probability is 2%. When correlation is zero, we expect roughly 2% of mortgages to default each year and there is virtually no chance of the senior tranche bearing losses. In the limit when default correlation between mortgages is perfect, the senior tranche has a 2% chance of bearing losses in any given year.

Which of the following describes the S&P/Case-Shiller index?

A stock market index

An index of interest rates on mortgages

An index of house prices

An index showing the dollar amount of mortgages granted each month

Answer: C

The S&P/Case-Shiller index is an index of house prices

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches:  senior 85%, mezzanine 10%, and equity  5%. (The portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from the mezzanine tranches with the same allocation of principal. How high can losses on the mortgages be before the mezzanine tranche of the ABD CDO bears losses?

5.0%

5.5%

6.0%

6.5%

Answer: B

If losses are 5.5%, the mezzanine tranches of ABSs lose 0.5/10 or 5% of their principal. The mezzanine tranche of the ABS CDO is then safe (just).