CHAPTER 9

TRUE/FALSE QUESTIONS

(T) 1. Mortgage insurance was an important factor in the development of secondary mortgage
markets.

(T) 2. Commercial banks and thrifts are the largest private institutional investor in mortgages.

(F) 3. Since the financial crisis the Federal National Mortgage Association (FNMA) has been a
privately owned corporation with a line of credit from the U.S. Treasury.

(F) 4. Investors in CMO securities are not exposed to prepayment risk.

(T) 5. Mortgage originators may retain the servicing right and fees even though the mortgage
has been sold.

(T) 6. A lender with a fixed-rate mortgage bears the risk of future inflation.

(F) 7. Like corporate and municipal bonds, mortgages are issued in standard denominations.

(F) 8. Unlike mortgage-backed securities, individual mortgages are issued in standard

denominations.

(T) 9. Most mortgage loans are amortized over the maturity of the loan with interest computed
on the declining principal.

(T) 10. In a conventional mortgage agreement the borrower owns the mortgaged home; the
lender takes a lien against the home.

(F) 11. An ARM, compared to a FRM, shifts the interest rate risk from the borrower to the
lender.

(F) 12. CMO residual tranches have the first claim on the cash flow from a pool of mortgages.

(T) 13. Mortgage-backed securities are more liquid than individual mortgages.

(T) 14. Mortgage pool securities have encouraged individuals, insurance companies, and pension
funds to provide indirect mortgage financing.

(T) 15. Home equity credit lines are a form of second mortgage financing.

(T) 16. Pass-through mortgage securities have standard denominations but uncertain cash flow.

(F) 17. Pass-through securities pass through all principal and interest payments collected from
homeowners, providing a fixed stream of cash flow to the investor.

(F) 18. REMIC securities are a form of collateralized mortgage obligations that provide tax-free
income to an investor.

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(F) 19. FHMLC buys only FHA/VA insured mortgages from loan originators.

(T) 20. Lifetime interest rate caps limit the size of the increase in the loan rate over the loan’s
life.

(T) 21. A subprime mortgage is a mortgage made to a borrower who has a below normal credit
rating.

(T) 22. On a fixed rate mortgage the dollars of interest the homeowner pays falls each year the
mortgage is outstanding.

(T) 23. The process of packaging and/or selling mortgages that are then used to back publicly
traded debt securities is called securitization.

(T) 24. The major regulator for the GNMA (Ginnie Mae), FNMA (Fannie Mae), and Federal
Home Loan Banks is the Federal Housing Finance Agency.

(T) 25. Since 2008 the fastest growth in mortgage holdings has been by the federal government.

(F) 26. FNMA and FHLMC securitize mortgages but do not provide any final financing of
mortgages.

(F) 27. The CPR on a mortgage pool refers to the expected default rate per year on mortgages in
the pool.

(T) 28. To avoid taxation a pool organizer will structure a CMO as a REMIC.

(T) 29 When interest rates fall investors in a mortgage pass-through security will likely receive
greater cash flows than expected.

(T) 30. Agency backed CMOs are designed to help investors better choose the amount of
prepayment risk they wish to face.

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 MULTIPLE CHOICE QUESTIONS

(d) 1. Which of the following types of mortgages would be most advantageous to have on your
house if you expected the annual rate of inflation would be higher than most
people thought?
a. roll-over mortgage
b. interest-only mortgage
c. adjustable-rate mortgage
d. fixed-rate mortgage

(a) 2. Which one of the following is not true about privately issued passthroughs (PIP)
a. They are similar to “Ginnie Maes” in that they are backed by mortgages that
qualify for FHA or VA guarantees.
b. PIPs are issued by private institutions or mortgage bankers.
c. They are similar to “Ginnie Maes” except that they are backed by conventional
mortgages that do not qualify for FHA or VA guarantees.
d. They are typically used to securitize large, non-conforming mortgage loans
called jumbo loans.

(b) 3. A contract designed to use the equity in a home for retirement income without making
any required payments is called a(n)
a. rollover mortgage
b. reverse annuity mortgage
c. adjustable-rate mortgage
d. home equity loan

(b) 4. The largest sector of the long term debt market is associated with
a. corporate bonds
b. mortgages
c. state and municipal bonds
d. U.S. Treasury debt

(b) 5. To the nearest dollar, what is the monthly payment on a $200,000 conventional fixed-rate
mortgage, 7 percent, financed for 15 years?
a. $1830
b. $1798
c. $1679
d. $1721

(d) 6. If a 15-years monthly-payment $200,000 mortgage has a 7 percent annual percentage

rate. What is the loan balance after 10 years if all payments are made on time as agreed?
a. $92,721
b. $83,581
c. $85,492
d. $90,785

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(b) 7. What is the monthly payment on a $100,000 fixed rate loan with a 6.5% rate with a term
of 30 years?
a. $657
b. $632
c. $638
d. $612

(a) 8. If you added $100 to the monthly payment on a 30-year, $100,000 fixed-rate loan with a
6.5% rate, how soon would your loan be paid off?
a. 249 months
b. 227 months
c. 185 months
d. 278 months
e. 360 months

(c) 9. You have just purchased a home and borrowed $250,000, 4.5 percent for 30 years,
payable monthly. What is your monthly payment?
a. $1211
b. $1279
c. $1267
d. $1298

(e) 10. What will be the amount of interest paid in the tenth month of a $250,000, 4.5 percent, 30
year loan?
a. $340
b. $857
c. $1012
d. $764
e. $926

(c) 11. How long does it take to repay one-half of the principal on a $70,000, 7 percent, 15 year
mortgage loan if all payments are made on time?
a. 75 months
b. 90 months
c. 113 months
d. 123 months
e. 131 months

(c) 12. The 2010 Dodd‐Frank Act requires originators to retain 5 percent of certain mortgages to
reduce
a. prepayment risk
b. extension risk
c. default risk
d. inflation risk

(a) 13. Prepayment burnout refers to the

a. decrease in prepayments that occurs after a large number of refinancings.
b. increase in refinancings that occurs after an interest rate decrease.
c. increase in loan extensions that occurs after an interest rate decrease.
d. decrease in mortgage sales that occurs after a large number of prepayments.

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(b) 14. An increase in prepayment speed of a pass-through mortgage backed security (MBS) will
result in
a. an increase in the duration of the MBS.
b. a decrease in the duration of the MBS.
c. an increase in the principal earned by MBS investors.
d. a decrease in the mortgage coupon rate.

(a) 15. An increase in prepayment speed of a pass-through mortgage backed security (MBS) will
result in
a. a reduction in interest earned over the life of the pass-through.
b. an increase in principal earned over the life of the pass-through.
c. an increase in the rate of return over the investor’s original investment horizon.
d. no change in principal but an increase in interest earned over the life of the pass-
through.

(d) 16. Which of the following is not a reasonable expectation for investors in agency backed
pass-through mortgage securities?
a. The securities are readily marketable.
b. They have little default risk.
c. The investor receives cash flows in proportion to his/her ownership proportion.
d. The timing of the cash flow return from the securities is known.

(a) 17. Which of the following is not a mortgage-backed security?

a. a jumbo mortgage
b. a Ginnie Mae pass-through
c. a collateralized mortgage obligation
d. a real estate mortgage investment conduit (REMIC)

(c) 18. State and local governments make mortgage loans at below-market rates of interest
because
a. they want to compete with the thrifts.
b. they want to help local thrift institutions.
c. they can obtain funds for mortgage financing cheaply by selling tax-exempt
securities.
d. they lend to lower income, larger home buyers.

(d) 19. Agency backed mortgage backed securities (MBSs) have interest rates above Treasury
rates because MBSs
a. are more liquid.
b. have substantially more default risk.
c. are tax advantaged investments.
d. have prepayment risk.

(d) 20. Private mortgage insurance protects the

a. seller of the home.
b. FHA.
c. borrower.
d. lender.
e. government.

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(d) 21. Which of the following is true about a sequential pay agency backed CMO?
a. Interest and principal from borrowers are passed through untransformed to all
CMO investors.
b. All CMOs are backed by federally insured imply mortgage loans.
c. CMO investors have no prepayment risk.
d. CMO investors can choose to have better prepayment protection than a pass-
through.

(c) 22. A savings and loan with a very low net worth position would most likely take which
action?
a. invest in conventional fixed-rate loans
b. invest in variable-rate loans
c. make and sell eligible loans to the FHLMC
d. make equity-participation mortgages

(b) 23. What is the monthly payment on a home costing $150,000, if the borrower pays 30
percent down, and takes out a 25 year mortgage at a 9 percent APR?
a. $636.09
b. $881.16
c. $763.31
d. $677.82

(c) 24. What will be the amount of interest paid in the first month if you put 30 percent down on
a home costing $150,000 with a 25-year, 9% loan?
a. $881.16
b. $702.32
c. $787.50
d. $726.31
e. $583.33

(e) 25. If you put 30 percent down on a home costing $150,000 with a 25-year, 9% loan, what is
the remaining balance on the mortgage after five years?
a. $ 81,450
b. $100,666
c. $ 79,097
d. $84,000
e. $ 97,936

(c) 26. A savings and loan issuing ARMs and expecting mortgage interest rates to decrease in
the future would want
a. an interest rate "cap" on their loans.
b. a second mortgage on the home.
c. to lengthen the "adjusting" time period.
d. no limits on the variability of the rates.

(b) 27. Which of the following is not used to adjust ARM rates?
a. Treasury security rates
b. Dow Jones Mortgage Rate Index
c. S&L cost of funds index
d. current fixed-rate mortgage index
e. LIBOR

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(d) 28. What is most likely to happen to an ARM in a decreasing rate environment?
a. The borrower's payments will increase.
b. The maturity of the loan will be extended.
c. The principal of the loan will increase.
d. The borrower's payments will decrease.

(a) 29. Which of the following statements about REMIC securities is false?
a. REMIC securities provide tax-free income to investors.
b. REMIC securities provide cash flows similar to CMOs.
c. REMIC securities may be backed by pass-through securities issued by FHLMC
or FNMA.
d. The Tax Reform Act of 1986 encouraged the use of REMICs.

(a) 30. Just like other capital market segments, mortgage markets
a. bring together borrowers and suppliers of long-term funds.
b. are always secured by the pledge of real property.
c. are characterized by small, risky borrowers.
d. issued in standard denominations.

(c) 31. Amortizing a mortgage loan means that

a. a long-term is converted to a short-term loan.
b. the equity in the house declines as the loan is paid down.
c. the balance of the loan is reduced with each payment.
d. interest is paid first entirely, and then the principal

(b) 32. If negative amortization occurs on a mortgage this means that

a. the monthly payment due on the mortgage has fallen.
b. the amount due on the loan has increased.
c. the interest rate on the mortgage has risen.
d. the interest rate on the mortgage has fallen.

(a) 33. Hybrid ARMs provide both lenders and borrowers with some protection from interest
rate risk because
a. the mortgage payment stays fixed for a time before it begins to vary with interest
rates.
b. hybrid ARMs guarantee the lender a fixed return and borrowers a fixed payment
for the life of the contract.
c. rates and house payments will not change.
d. these mortgages are insured by the FHA.

(d) 34. Hybrid ARMs would be preferred by borrowers

I. seeking a rate lower than comparable fixed rates.
II. who may be selling their home soon.
III. seeking a fixed payment for a few years.
IV. who desire a fixed payment for the life of the mortgage.
a. I and IV
b. I, II and IV
c. II and IIII
d. I, II and III

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(b) 35. In a four tranche sequential pay CMO with a $100 million total principal a Class A
Tranche holder will initially receive
a. all principal payments on the $100 million, excluding any prepayments and
interest.
b. all principal payments on the $100 million, including any prepayments and
interest due on their portion.
c. only interest on the principal amount of their investment.
d. nothing until all other classes have been paid.

(c) 36. A standard ARM has a cap such that the rate cannot increase more than 1 percent per
year and 5 percent over the life of the mortgage. What will the mortgage rate be
after three years if the initial rate is 5%, and interest rates increase by 2% in each of
the first three years of the contract?
a. 6%
b. 7%
c. 8%
d. 9%
e. 10%

(b) 37. The original purpose of the Federal Home Loan Mortgage Corporation (Freddie Mac)
was to
a. make home loans to low income individuals.
b. purchase conventional mortgages from mortgage originators.
c. purchase FHA insured mortgages from financial institutions.
d. purchase mortgages created by Ginnie Mae.

(b) 38. Which of the following is not an advantage of investing in mortgage-backed bonds
(MBBs) compared to investing in direct mortgages?
a. MBBs are issued in standard denominations.
b. MBBs have more prepayment risk.
c. MBBs are usually insured and highly collateralized.
d. MBBs have cash flow returns similar to corporate bonds.

(b) 39. Interest rate caps on mortgage loans

I. limit the size of the increase in the loan rate in any year.
II. limit the size of the increase in the loan rate over the life of the loan.
III. are required on all ARMs.
a. I only
b. I and II only
c. II and III only
d. I, II and III

(b) 40. Which of the following statements is true?

a. All fixed-rate mortgages have interest rate caps.
b. All adjustable-rate-mortgages have a cap.
c. An interest rate cap on a mortgage reduces the lender’s interest rate risk
exposure.
d. Usually, an annual interest rate cap on a mortgage is 5%, and a lifetime cap is 1-
2%.

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(b) 41. The CPR on a mortgage backed security increases when
a. interest rates increase
b. interest rates decrease
c. default rates increase
d. default rates decrease

(a) 42. As interest rates rise, the value of PO strips _______ by ______ than the value of a
standard corporate bond.
a. decreases; more
b. increases; more
c. decreases; less
d. increases; less

(a) 43. If interest rates fall, causing a large change in prepayment patterns, the value of IO strips
are likely to _______.
a. decrease
b. increase
c. stay the same
d. rise then fall
e. fall then rise

(b) 44. A prepayment option on a mortgage is similar to a _______ option on a bond.

a. put
b. call
c. conversion
d. default

(c) 45. The primary risk to an investor who holds a GNMA pass through is _______ risk.
a. default
b. inflation
c. prepayment
d. liquidity

(b) 46. Which of the following is not associated with tightened mortgage credit standards?
a. More time on the current job required.
b. An increase in the required loan/value ratio.
c. A decrease in the maximum total debt payments per month per amount of
monthly income.
d. Decreased maximums in the payment/income ratio of borrowers.

(b) 47. Which of the following is associated with a loosening of mortgage credit standards?
a. Increased down payments.
b. Increased loan/value ratios.
c. Decrease in maximum total debt to income ratios
d. Required use of mortgage insurance

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(c) 48. Which of the following is typically associated with determining the creditworthiness of a
mortgage borrower?
I. income stability
II. ethnicity
III. job stability
IV. prior credit history
a. I and III only
b. II and IV only
c. I, III and IV only
d. I, II, III and IV

(a) 49. Mortgage bankers usually do not

a. permanently fund mortgages
b. originate mortgages
c. service mortgages
d. collect monthly payments from borrowers

(a) 50. Mortgage bankers are most likely to be involved in the _______ of a mortgage contract.
a. origination
b. funding
c. servicing
d. insuring

(b) 51. Mortgage rates, relative to other capital market rates,

a. tend to be independent of other capital market rates.
b. tend to be higher than Treasury bond rates.
c. are identical across the country.
d. are never greater than the 30 year Treasury rate.

(b) 52. Which of the following is not true about interest-only mortgages?
a. The low payments in initial years only includes interest on the borrowed amount.
b. The low payments in initial years only includes principal repayment on the
borrowed amount.
c. After initial period, payments increase such that entire loan amount is amortized
by the end of 30 years.
d. Over the 30 years the borrower will pay more interest overall.

(b) 53. Which of the following is not true about construction-to-permanent mortgages?
a. Bridge financing is provided by the lender over the time frame required by the
borrower to purchase land and construct the house.
b. Both interest and principal payments are typically made until construction is
completed.
c. The loan is financed in increments as construction payments have to be made.
d. On completion of the construction, the loan balance is rolled over into the type of
mortgage contract desired by borrower.

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(d) 54. Which of the following is true about reverse annuity mortgages (RAMs)?
I. RAMs allow homeowners to borrow against the equity on their homes.
II. Typically obtained by older people whose home loans have been paid off that need
some additional income in their retirement.
III. The term could be for borrower’s lifetime.
IV. The homeowners’ equity declines over time.
a. I, and II only
b. I, II and III only
c. II, III and IV only
d. I, II, III and IV

(d) 55. Which of the following statements about home equity loans is true?
a. The borrower cannot already have a mortgage on the house.
b. If the borrower already has a mortgage the home equity loan is a first mortgage.
c. In the event of default the home equity loan would be paid off before any other
mortgage on the house.
d. The interest paid on home equity loans is tax deductible.

(d) 56. Which of the following statements about FHA and VA mortgages is false?
a. They are insured by the government.
b. The FHA charges for their insurance.
c. These mortgages have low or no down payments.
d. The borrower is protected in case of default.

(b) 57. You purchase a house for $255,000 and pay 20% down. You obtain a 30-year fixed rate
mortgage in which the annual interest rate is 5.85%. What is your monthly
payment?
a. $1,215.27
b. $1,203.48
c. $1,194.45
d. $1,367.22

(b) 58. You purchase a house at $331,250 and pay 20% down. The 15-year mortgage is fixed-
rate 6.25% annually. In addition to the principal and interest paid, you must pay
0.1% of the house purchase price per month into an escrow account for insurance
and taxes. What is the total monthly payment (to the nearest dollar)?
a. $2,272
b. $2,603
c. $2,557
d. $2,707

(b) 59. Formosan Freedom Co. purchased an office at newly built World Trade Center for
$2,812,500. The Company obtained a 30 year fixed rate mortgage at a 7.2%
annual rate and paid 20% down. After five years, the Company had
excess cash and decided to pay off the remaining balance. At that time the
Company could obtain a mortgage with an annual interest rate at 7%. How much
must the Company pay to retire the mortgage (to the nearest dollar)?
a. $2,225,330
b. $2,122,426
c. $2,015,678

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 d. $1,999,998

(d) 60. Which one of the following entities is a government agency charged with overseeing
mortgage finance?
a. GNMA
b. FNMA
c. FHLMC
d. FHFA

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 ESSAY QUESTIONS

1. What is a subprime mortgage? What makes a mortgage ‘subprime?’ How were these mortgages
involved in the 2007-2008 financial crisis?

Answer: A subprime mortgage is a mortgage made to a homeowner who is a high credit risk.
There is no hard and fast definition of what makes a mortgage subprime. FICO credit scores of
less than 620 are sometimes used to indicate a subprime mortgage. Prime credit quality
borrowers may also choose a nonstandard mortgage that is considered riskier such as a mortgage
with a high loan to value ratio or a high payment-to-income ratio. Also, a mortgage in an area
that has suffered large home price declines could be considered subprime. These mortgages were
involved in the financial crisis when home prices began falling many subprime borrowers could
not repay their mortgages and leveraged holders of mortgage backed securities, including
Lehman Brothers, Bear Stearns and others took large losses. As home prices began falling, even
some prime credit mortgagors had trouble making payments and the crisis spread to the broader
housing market.

2. Explain the ways in which the federal government fostered the development of the secondary
mortgage markets.

Answer: The VA and FHA insurance plus the Fannie Mae, Ginnie Mae, and Freddie Mac, who
provide a secondary market and liquidity for mortgage securities, has been the major areas of
assistance for mortgage markets. Nowadays, lenders combine qualifying mortgages into pools,
and sell the securities backed by the pool. Mortgage backed securities (MBS), unlike individual
mortgages, have characteristics that make secondary market trading easy: standard
denominations, well-known borrowers and insurers, and repayment schedules similar to those of
other debt securities. The government’s activity has created a national market for mortgage
credit.

3. Why do mortgage-backed securities guaranteed by Federal government agencies often have

yields above U.S. Treasury bond rates?

Answer: The demand for a prepayment risk premium, in case interest rates decline significantly
in the investment period, is the primary reason for the higher yields on mortgage-backed,
guaranteed securities. These securities are also less liquid than Treasuries and this results in a
higher yield as well.

4. List three ways in which a change in the rate of an adjustable-rate mortgage can affect the
borrower's mortgage.

Answer: A mortgage may be adjustable a number of ways including monthly payments, varying
maturity, and loan expansion/contraction adjustments.

5. Mortgages may now be originated, funded, serviced, and insured by different parties. What
developments are associated with this unbundling of loan cash flows in recent years?

Answer: Increased computing technology, competition, and desire for unbundling by financial
institutions and investors have been the major factors behind the separation of origination,
servicing, and funding of mortgages.

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6. In July 2006, Forrest purchased a town house at $325,000 and paid 25% down. The
mortgage that he obtained is a 30-year fixed-rate with an annual percentage interest rate of
5.75%. In July 2011, due to a fall in interest rates, he decided to refinance and obtained a
mortgage at a 5.1% annual interest rate for 25 years. After he refinanced, how much is the
payment reduced assuming that all payments were made on time?

Answer:
The original monthly payment can be solved by the following:

The payment is 1,422.46.

After 5 years, the balance of the mortgage is $226,107.83 (found as the present value of the
remaining payments at the original interest rate), the new monthly payment is

The new payment is 1,335.01. This means Forrest can save $1,422.46 – $1,335.01 = $87.45 per
month.

6. When might an investor prefer an agency backed sequential pay CMO to a standard mortgage
pass-through security backed by insured mortgages?

Answer: A CMO allows the investor to choose the amount of prepayment risk, or alternatively,
the likely maturity of their investment with a higher degree of certainty than with a pass-through
security. A pass-through receives a pro-rata or proportionate share in all principal and interest
payments, including any prepayments on the entire pool. CMOs set up different classes or
tranches that provide some prepayment protection for certain classes and have a narrower range
of estimated maturity than a pass-through.

7. Why is a PO mortgage-backed security more price volatile than a standard non-callable bond?

Answer: When interest rates decline prepayments accelerate and principal will be received by the
investor more quickly than anticipated. Thus the present value of expected cash flows is
increased due to the lower interest rate and because additional principal will be received more
quickly than anticipated. These two affects work in the same direction and lead to a large price
change for the PO. In a standard non-callable bond the present value of the cash flows will
increase with a drop in interest rates, but the expected cash flows themselves do not change. Thus
the PO is more price volatile than a standard non-callable bond.

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8. When might an IO mortgage-backed security exhibit a price increase when interest rates
increase?

Answer: When interest rates increase mortgage prepayments are slower than expected and
principal will be repaid more slowly than anticipated. With the principal amount outstanding on
the mortgage pool for a longer time period, more interest overall will be received by the IO
holder. Thus, even though the present value of the cash flows is decreased due to the higher
interest rate, more interest will be received over the life of the security than originally anticipated.
These two effects work in opposite directions on the value of the IO. If the additional interest to
be received from the reduced prepayments is large enough to offset the lower present value due to
the higher interest rate, the value of the IO can increase with an interest rates increase rather than
fall like a typical non-callable bond.

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