"Fixed Income":Collateral return

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Questions 1:

Two years ago, a homeowner took out a $1 million home mortgage from a bank. The current principal on the loan is $750,000, and the homeowner has defaulted on the loan. Following foreclosure proceedings, the bank sells the property for $600,000 and is only entitled to use these funds to satisfy the loan obligation. The homeowner most likely had a:

A 、bullet loan.

B、 non-recourse loan.

C、 recourse loan.

Questions 2:

Which scenario is most likely to result in a competitive return to a CDO equity holder?

A 、The collateral earns a higher yield than the bond classes.

B 、The senior bond class experiences early principal repayment.

C 、The debt funding costs are higher than the CDO return.

View answer resolution

【Answer to question 1】B

【analysis】

B is correct. The bank does not have a claim against the borrower for the shortfall of $150,000 on the mortgage balance outstanding relative to the proceeds received from the property’s sale, indicating that the home mortgage is a non-recourse loan.

A is incorrect because a bullet loan is a type of interest-only mortgage loan in which there are no principal payments over the term of the loan. The loan balance outstanding is less than the original mortgage amount, so it is unlikely that this was a bullet loan.

C is incorrect because in the case of a recourse loan the bank would have been entitled to make a claim for the shortfall of $150,000 against the borrower.

【Answer to question 2】A

【analysis】

A is correct. The benefit of the return on collateral in excess of what is paid out to the bond classes accrues to the equity holders and to the CDO manager.

B is incorrect because when the senior bond class experiences early principal repayment the CDO manager isn’t meeting pre-specified tests requiring the prepayment of low cost senior debt, deleveraging the CDO and making it harder for the subordinated tranche to earn a competitive return.

C is incorrect because if debt funding costs are higher than the CDO return, no return will accrue to the subordinated tranche.

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