Commercial Banking - Solution Manual for Exam 1 | FRL 460, Exams of Banking and Finance

Download Commercial Banking - Solution Manual for Exam 1 | FRL 460 and more Exams Banking and Finance in PDF only on Docsity! Chapter 9 Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives Fill in the Blank Questions 1. When a bank sets aside a group of income-earning assets and then sells securities based upon those assets it is ________________________ those assets. Answer: securitizing 2. Often when loans are securitized they are passed on to a _________________________ who pools the loans and sells securities. Answer: special purpose entity 3. A(n) _________________________ allows a homeowner to borrow against the residual value of their residence. Answer: home equity loan 4. _________________________ allow the bank to generate fee income after they have sold a loan. The bank continues to collect interest and principal from the borrowers and passes these collections to the loan buyers. Answer: Servicing rights 5. In a _________________________ an outsider purchases part of a loan from the selling financial institution. Generally the purchaser has no influence over the terms of the loan contract. Answer: participation loan 6. A(n) _________________________ is a contingent claim of the bank that issues it. The issuing bank, in return for a fee, guarantees the repayment of a loan received by its customer or the fulfillment of a contract made by its customer to a third party. Answer: standby credit agreement 7. A(n) _________________________ occurs when two banks agree to exchange a portion or all of the loan repayments of their customers. Answer: credit swap 8. A(n) __________________ guards against the losses in the value of a credit asset. It would pay off if the asset declines significantly in value or if it completely turns bad. Answer: credit option. Rose/Hudgins, Bank Management and Financial Services, 8/e1 9. A(n) _________________________ combines a normal debt instrument with a credit option. It allows the issuer of the debt instrument to lower its loan repayments if some significant factor changes. Answer: credit linked note 10. The _________________________ of a standby letter of credit is a bank or other investor who is concerned about the safety of funds committed to the recipient of the standby letter of credit. Answer: beneficiary 11. A(n) _________________________ guarantees the swap parties a specific rate of return on their credit asset. Bank A may agree to pay the total return on the loan to Bank B plus any appreciation in the market value of the loan. In return Bank A will often get LIBOR plus a fixed spread plus any depreciation in the value of the loan. Answer: total return swap 12. The ________________________ is the party that is requesting a standby letter of credit. Answer: account party 13. The __________________ is the bank or financial institution which guarantees the payment of the loan in a standby letter of credit. Answer: issuer 14. A(n) _________________________ is a loan sale where ownership of the loan is transferred to the buyer of the loan, who then has a direct claim against the borrower. Answer: assignment 15. Another type of loan sale is a(n) _________________________ which is a short dated piece of a longer maturity loan, entitling the purchaser to a fraction of the expected loan income. Answer: loan strip 16. A relatively new type of credit derivative is a CDO which stands for __________________. Answer: collateralized debt obligation 17. Insurance companies are a prime __________ of credit derivatives. Answer: seller 18. A(n) is an over-the-counter agreement offering protection against loss when default occurs on a loan or other debt instrument. Answer: credit derivative Test Bank, Chapter 92 T F 39. The buyer of a loan participation must watch both the borrower and the seller bank closely. Answer: True T F 40. Under an assignment ownership of a loan is transferred to the buyer, though the buyer still holds only an indirect claim against the borrower. Answer: False T F 41. Loan sales are generally viewed as risk-reducing for the selling financial institution. Answer: True T F 42. In a CMO, the different tiers (or tranches) of security purchasers face the same prepayment risk. Answer: False T F 43. A standby letter of credit substantially reduces the issuing bank's interest rate risk and liquidity risk. Answer: False T F 44. Securitization of loans can easily be applied to business loans since these loans tend to have similar cash flow schedules and comparable risk structures. Answer: False T F 45. The advantage of a credit swap is that it allows each bank in the swap to broaden its market area and spread out its credit risk on its loans. Answer: True T F 46. Bank use of credit derivatives is dominated by the largest banks. Answer: True T F 47. The credit derivatives market has grown nine-fold during the recent years. Answer: True T F 48. Banks are the principal sellers of credit derivatives. Answer: False T F 49. Banks are one of the principal buyers of credit derivatives. Answer: True Rose/Hudgins, Bank Management and Financial Services, 8/e5 T F 50. Insurance companies are one of the principal sellers of credit derivatives. Answer: True Multiple Choice Questions 51. Securitized assets carry a unique form of risk called: A) Default risk B) Inflation risk C) Interest-rate risk D) Prepayment risk E) None of the above Answer: D 52. Short-dated pieces of a longer-term loan, usually maturing in a few days or weeks, are called: A) Loan participations B) Servicing rights C) Loan strips D) Shared credits E) None of the above Answer: C 53. The party for whom a standby credit letter is issued by a bank is known as the: A) Account party B) Beneficiary C) Representative D) Credit Guarantor E) None of the above Answer: A 54. When a bank issues a standby credit guarantee on behalf of one of its customers, the party receiving the guarantee is known as the: A) Account party B) Beneficiary C) Obligator D) Servicing agent E) None of the above Answer: B Test Bank, Chapter 96 55. Securitization had its origin in the selling of securities backed by _____________ A) Credit card receivables B) Residential mortgage loans C) Computer leases D) Automobile loans E) Truck leases Answer: B 56. Loan-backed securities, which closely resemble traditional bonds, carry various forms of credit enhancements, which may include all of the following, EXCEPT: A) Credit letter guaranteeing repayment of the securities. B) Set aside of a cash reserve. C) Division into different risk classes. D) Early payment clauses. E) None of the above. Answer: D 57. In some instances, a bank will sell loans and agree to give the loan purchaser recourse to the seller for all or a portion of those loans that become delinquent. In this case, the purchaser, in effect, gets a: A) Call option. B) Put option. C) Forward contract. D) Futures contract E) None of the above. Answer: B 58. The key advantages of issuing standby letters of credit include which of the following: A) Letters of credit generate fee income for the bank. B) Letters of credit typically reduce the borrower's cost of borrowing. C) Letters of credit can usually be issued for a relatively low cost. D) The probability is low that the issuer of the letter of credit will be called upon to pay. E) All of the above. Answer: E 59. Banks that issue standby letters of credit may face which of the following types of risk? A) Prepayment risk. B) Interest-rate risk. C) Liquidity risk. D) All of the above. E) B and C only. Answer: E Rose/Hudgins, Bank Management and Financial Services, 8/e7 64. A bank that wants to protect itself from higher credit costs due to a decrease in its credit rating might purchase _________________________ . A) A credit risk option B) A standby letter of credit C) A credit linked note D) A credit swap E) None of the above Answer: A 65. When two banks simply agree to exchange a portion of their customers' loan repayments, they are using: A) A credit option B) A standby letter of credit C) A credit linked note D) A credit swap E) None of the above Answer: D 66. A debt instrument which allows the issuer to lower its coupon payments if some significant factor changes is called: A) A credit option B) A standby letter of credit C) A credit linked note D) A credit swap E) None of the above Answer: C 67. Which of the following is a risk of using credit derivatives? A) Credit derivatives do not protect against credit risk exposure B) The partner in the swap or option contract may fail to perform C) Regulators may decide to lower the amount of capital needed for banks using these derivatives D) Regulators may decide that these derivatives make the bank more stable and efficient E) All of the above are risks of using credit derivatives Answer: B 68. A securitized asset where the asset used to back the securities is a loan based on the residual value of a homeowner's residence is called: A) A mortgage backed security B) A credit card backed security C) An automobile backed security D) A loan backed bond E) A home equity loan backed security Answer: E Test Bank, Chapter 910 Rose/Hudgins, Bank Management and Financial Services, 8/e11 69. A financial institution plans to issue a group of bonds backed by a pool of automobile loans. However, they fear that the default rate on the automobile loans will rise well above 4 percent of the portfolio – the projected default rate. The financial institution wants to lower the interest payments if the loan default rate rises too high. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: A 70. A bank is about to make a $50 million project loan to develop a new oil field and is worried that the petroleum engineer's estimates of the yield on the field are incorrect. The bank wants to protect itself in case the developer cannot repay the loan. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: B 71. A bank plans to offer new subordinated notes in the open market next month but knows that its credit rating is being reviewed by a credit rating agency. The bank wants to avoid paying sharply higher credit costs. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: C 72. A bank is concerned about excess volatility in its cash flows from some recent business loans it has made. Many of these loans have a fixed rate of interest and the bank's economics department has forecast a sharp increase in interest rates. The bank wants more stable cash flows. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: D Test Bank, Chapter 912 82. Someone who collects the payments on the securitized loans and passes those payments on to the trustee is called: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer Answer: D 83. Investors in securitized loans normally receive added assurance that they will be repaid in the form of guarantees against default issued by: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer Answer: E 84. When an issuer of securitized loans divides them into different risk classes or tranches, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above Answer: A 85. When an issuer of securitized loans includes a standby letter of credit with the securitized loans, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above Answer: B 86. When an issuer of securitized loans sets aside a cash reserve to cover loan defaults, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above Rose/Hudgins, Bank Management and Financial Services, 8/e15 Answer: A 87. Which of the following is an advantage of securitizing loans? A) Diversifying a lender’s credit risk exposure B) Reducing the need to monitor each individual loan’s payment stream C) Transforming illiquid assets into liquid securities D) Serving as a new source of funds for lenders and attractive investments for investors E) All of the above are advantages of securitizing loans Answer: E 88. Why are securitized loans often issued through a special purpose entity? A) Because the securitized loans often add risk to the bank and need to be held separately B) Because the securitized loans are not profitable for the bank and need to be held separately C) Because the special purpose entity might fail and this prevents the failure of the bank D) Because the bank might fail and this protects the credit status of the securitized loans E) All of the above Answer: D 89. A group of pooled loans used is expected to yield a return of 23%. The coupon rate promised to investors on securities issued against the pool of loans is 8%. The default rate on the pooled loans is expected to be 4.5%. The fee to compensate a servicing institution for collecting payments on the loans is 2%. Fees to set up credit and liquidity enhancements are 3%. The fee for providing advising how to set up the pool of securitized loans is 1%. What is the residual income on this pool of loans? A) 18.5% B) 9% C) 4.5% D) 2% E) None of the above Answer: C 90. The coupon rate promised investors on securities issued against a pool of loans is 6.5%. The default rate on the pool of loans is expected to be 3.5%. The fee to compensate a servicing institution for collecting payments on the loan is 2%. Fees to set up credit and liquidity enhancements are 5%. The residual income on this pool of loans is 7%. What is the expected yield on this pool of loans? A) 24% B) 12% Test Bank, Chapter 916 C) 10% D) 6.5% E) None of the above Answer: A 91. In a collateralized mortgage obligation (CMO) a tranche: A) Promises a different return (coupon) to investors B) A liquidity enhancement C) Carries a different risk exposure D) A and C above E) All of the above Answer: D 92. What is one of the advantages of using loan-backed bonds? A) Loans used as collateral for the bonds can be sold before the maturity of the bonds B) Loan-backed bonds have longer maturities than deposits C) Banks do not have to meet regulatory capital requirements on loans used as collateral D) Banks can use less loans as collateral than the amount of bonds issued E) All of the above are advantages of loan-backed bonds Answer: B 93. What is one of the disadvantages of using loan backed bonds? A) The cost of funding often rises B) There is greater default risk on the bonds C) Loans used as collateral for the bonds must be held until the bonds reach maturity D) Loan backed bonds have shorter maturities than deposits E) All of the above are disadvantages of loan-backed bonds Answer: C 94. According to the textbook, what is the minimum size of the loan-backed securities offering that are likely to be successful? A) $1 million B) $10 million C) $25 million D) $50 million E) $1 trillion Answer: D Rose/Hudgins, Bank Management and Financial Services, 8/e17