Investment Solution

Chapter 8

Securitization and the Credit Crisis of 2007

Practice Questions

Problem 8.1.

What was the role of GNMA (Ginnie Mae) in the mortgage-backed securities market of the

1970s?

GNMA guaranteed qualifying mortgages against default and created securities that were sold

to investors.

Problem 8.2.

Explain what is meant by a) an ABS and b) an ABS CDO.

An ABS is a set of tranches created from a portfolio of mortgages or other assets. An ABS

CDO is an ABS created from particular tranches (e.g. the BBB tranches) of a number of

different ABSs.

Problem 8.3.

What is a mezzanine tranche?

The mezzanine tranche of an ABS or ABS CDO is a tranche that is in the middle as far as

seniority goes. It is ranks below the senior tranches and therefore absorbs losses before they

do. It ranks above the equity tranche (so that the equity tranche absorbs losses before it does).

Problem 8.4.

What is the waterfall in a securitization?

The waterfall defines how the cash flows from the underlying assets are allocated to the

tranches. In a typical arrangement, cash flows are first used to pay the senior tranches their

promised return. The cash flows (if any) that are left over are used to provide the mezzanine

tranches with their promised returns. The cash flows (if any) that are left over are then used to

provide the equity tranches with their promised returns. Any residual cash flows are used to

pay down the principal on the senior tranches.

Problem 8.5.

What are the numbers in Table 8.1 for a loss rate of a) 12% and b) 15%?

Losses on

underlying assets

12%

15%

Losses to

mezzanine

tranche of ABS

46.7%

66.7%

Losses to equity

tranche of ABS

CDO

100%

100%

Losses to mezzanine Losses to senior

tranche of ABS CDO tranche of ABS

CDO

100%

17.9%

100%

48.7%

Problem 8.6.

What is a subprime mortgage?

A subprime mortgage is a mortgage where the risk of default is higher than normal. This may

be because the borrower has a poor credit history...