Hull: Options, Futures, and Other Derivatives, Tenth Edition

Chapter 8: Securitization and the Credit Crisis of 2007

Multiple Choice Test Bank: Questions with Answers

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

A. An increase in interest rates
B. Regulators specifying a maximum level for the loan-to-value ratio on mortgages
C. Banks reducing the minimum FICO score that borrowers are required to have
D. 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.

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

A. The house buyer, if unable to make payments, can lose all his or her possessions
B. The house buyer has an American-style put option on the house
C. The house buyer has a European-style put option on the house
D. 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.

3. Which of the following is NOT true

A. The bonus structure at banks can lead to short-term horizons for decision making
B. Securitization involves the transfer of risk
C. The term “agency costs” describes the situation where the incentives of two parties in a
business relationship are not perfectly aligned
D. 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,
4. Suppose that an ABS is created from a portfolio of subprime mortgages with the following
allocation of the principal to tranches: senior 80%, mezzanine 10%, and equity 10%. 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
A. 50%
B. 60%
C. 80%
D. 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.

5. 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 of the ABSs 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
A. 50%
B. 60%
C. 80%
D. 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

6. 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
A. 50%
B. 60%
C. 80%
D. 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.
7. AIG lost money because
A. It bought tranches created from mortgages
B. It invested heavily in real estate
C. It invested heavily in the stock market
D. It insured AAA tranches of ABS CDOs

Answer: D

AIG insured the AAA tranches of ABS CDOs.

8. Which of the following survived the crisis without declaring bankruptcy or being taken over by
another financial institution?
A. Bear Stearns
B. Morgan Stanley
C. Lehman Brothers
D. 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.

9. What are teaser rates

A. Interest rates that appear lower than they are
B. Interest rates that depend on LIBOR
C. Interest rates on mortgages with a very long amortization period
D. 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.

10. Which of the following describes the waterfall typically used for mortgages pre-crisis?
A. A distribution of cash flows to tranches with priority given to tranche with the highest
rating
B. A distribution of cash flows to tranches in proportion to their outstanding principals
C. A distribution of losses to tranches so that tranches bear losses in proportion to their
outstanding principals
D. 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

11. In 2008 the TED spread reached a high of

A. About 150 basis points
B. About 250 basis points
C. About 450 basis points
D. 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.

12. Which of the following were introduced before the credit crisis that started in 2007
A. Basel II
B. Dodd-Frank
C. Basel III
D. 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.

13. Which of the following is true as the correlation between mortgage defaults increases?
A. Equity tranches are almost certain to incur losses
B. Senior tranches become more likely to incur losses
C. The expected number of defaults increases
D. 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.

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

A. A stock market index
B. An index of interest rates on mortgages
C. An index of house prices
D. 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

15. 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?
A. 5.0%
B. 5.5%
C. 6.0%
D. 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).

16. 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 senior tranche of the ABS CDO bears losses?
A. 5.5%
B. 6.0%
C. 6.5%
D. 7.0%

Answer: C

If losses are 6.5%, the mezzanine tranches of ABSs lose 1.5/10 or 15% of their principal. The
senior tranches of the ABS CDO is then safe (just).

17. Suppose that ABSs are created from portfolios of subprime mortgages with the following
allocation of the principal to tranches: senior 94.5% (rated AAA), mezzanine 0.1% (rated BBB),
and equity 5% (rated C) . The portfolios of subprime mortgages have the same default rates. An
ABS CDO is then created from the mezzanine tranches. Which of the following is true?
A. The ABS CDO tranches should have ratings ranging from AAA to C
B. The ABS CDO tranches should all be rated BBB
C. The ABS CDO tranches should all be rated C
D. The ABS CDO tranches are almost worthless because the mezzanine tranches are so thin

Answer: B
 Because they are so thin, the mezzanine tranches of the ABS are either all safe or all wiped out.
The tranches created from them are therefore essentially the same.

18. Which of the following describes regulatory arbitrage?

A. Finding a way of reducing capital requirements without changing the risks being taken
B. Buying products that are not subject to regulation
C. Shorting products that are not subject to regulation
D. Trading with the government

Answer: A

Regulatory arbitrage involves organizing trading and accounting so that regulatory capital is
reduced without the risks being taken changing.

19. Which of the following describes a subprime mortgage?

A. The rate of interest is less than the prime rate of interest
B. The loan-to-value ratio is below average
C. The life of the mortgage is less than 25 years
D. The credit risk is high

Answer: D

There is no precise definition of a subprime mortgage. But one thing we can be sure of is
that it has more credit risk than a normal mortgage.

20. Which of the following would be described by the term “liar loan”?
A. A situation where the lender concealed information from the borrower
B. A situation where the lender lied to the borrower about the interest rate
C. A situation where the borrower lied about the his or her income
D. None of the above

Answer: C

A liar loan is a loan where the borrower lied in some way on the application form.