CMA - Certified Mortgage Advisor Mortgage-Backed Securities Overview Questions and Answers 1 — Questions and Answers
Question 1: Which of the following best describes the primary purpose of the mortgage securitization process for the mortgage lending industry?
- To bundle individual mortgages into tradable securities, which increases the pool of capital available for new lending. (Correct answer)
- To eliminate default risk for lenders by transferring it entirely to government-sponsored enterprises (GSEs).
- To allow mortgage servicers to set the interest rates on the underlying loans in a mortgage-backed security (MBS).
- To provide a government guarantee on every mortgage loan originated in the primary market.
Correct answer: To bundle individual mortgages into tradable securities, which increases the pool of capital available for new lending.
The process of securitization involves pooling mortgage loans and converting them into securities that can be sold to investors. This process provides liquidity to the original lenders, allowing them to sell their loans on the secondary market and use the proceeds to fund new mortgage loans for other borrowers.
Question 2: What is the primary distinction between a Ginnie Mae (GNMA) mortgage-backed security and an MBS issued by Fannie Mae (FNMA) or Freddie Mac (FHLMC)?
- GNMA securities are composed of conventional loans, while FNMA/FHLMC securities are composed of government-insured loans.
- GNMA does not purchase loans but guarantees securities backed by government loans, which carry the full faith and credit of the U.S. government. (Correct answer)
- GNMA securities are only available to institutional investors, whereas FNMA/FHLMC securities are available to individual investors.
- GNMA directly originates the FHA and VA loans that back its securities, unlike Fannie Mae and Freddie Mac.
Correct answer: GNMA does not purchase loans but guarantees securities backed by government loans, which carry the full faith and credit of the U.S. government.
Ginnie Mae, a government-owned corporation, does not buy or sell loans. Instead, it guarantees the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans (like FHA, VA, and USDA loans). This guarantee is explicitly backed by the full faith and credit of the U.S. government, which is considered a stronger guarantee than that of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.
Question 3: An investor holding a high-coupon agency MBS is concerned because a sharp drop in market interest rates has led to a wave of homeowner refinancing. This investor is primarily exposed to which type of risk?
- Extension Risk
- Credit Risk
- Prepayment Risk (Correct answer)
- Liquidity Risk
Correct answer: Prepayment Risk
Prepayment risk is the risk that homeowners will pay off their mortgages faster than expected, typically by refinancing when interest rates fall. For an investor holding a higher-coupon MBS, this is detrimental because their high-yielding investment is returned to them early, forcing them to reinvest the principal at the new, lower rates, thus reducing their overall return.
Question 4: A mortgage advisor sees that yields on newly issued agency mortgage-backed securities are rising. What is the MOST likely immediate effect on the interest rates offered to new mortgage applicants?
- Mortgage rates will likely remain unchanged as they are tied to the 10-Year Treasury note.
- Mortgage rates will likely decrease to attract more borrowers into the market.
- Mortgage rates will likely increase. (Correct answer)
- The availability of adjustable-rate mortgages will increase while fixed rates remain stable.
Correct answer: Mortgage rates will likely increase.
The interest rates offered to consumers are directly tied to the yields on mortgage-backed securities in the secondary market. If investors demand a higher yield (return) to purchase MBS, the cost of funds for lenders increases. This higher cost is passed on to borrowers in the form of higher mortgage interest rates.
Question 5: Which of the following is a key characteristic of a private-label mortgage-backed security (PLS) when compared to an agency MBS?
- They are composed exclusively of government-insured loans, such as FHA and VA.
- They typically carry a higher degree of credit risk for the investor. (Correct answer)
- They are guaranteed by a Government-Sponsored Enterprise (GSE) like Fannie Mae.
- They are only backed by conforming loans that meet strict underwriting guidelines.
Correct answer: They typically carry a higher degree of credit risk for the investor.
Private-label securities (PLS), also known as non-agency MBS, are issued by private entities like investment banks and are not guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac. Therefore, the investor bears the credit risk—the risk that the homeowner will default on the underlying mortgage payments.
Question 6: What defines a 'pass-through' security in the context of mortgage-backed securities?
- A security where payments are passed from a senior tranche to a subordinate tranche.
- A security where monthly principal and interest payments from the underlying mortgage pool are distributed directly to investors. (Correct answer)
- A security that passes all default risk from the issuer directly to the U.S. Treasury.
- A security that only pays investors interest, with the full principal amount returned at maturity.
Correct answer: A security where monthly principal and interest payments from the underlying mortgage pool are distributed directly to investors.
A pass-through is the simplest form of MBS, where payments of principal and interest from the underlying pool of mortgages are collected by a servicer and 'passed through' to the security holders on a pro-rata basis.
CMA - Certified Mortgage Advisor Mortgage-Backed Securities Overview Questions and Answers 1
Which of the following best describes the primary purpose of the mortgage securitization process for the mortgage lending industry?