Suppose that the First United Bank of America has two loans. Each is due to be repaid one period hence and has independent and identically distributed cash flows. Each loan will repay $300 with a probability of 0.8 and $150 with a probability of 0.2. However, while the bank knows this, the investors cannot distinguish this loan from that of the Third TransAmerica Bank, which has the same number of loans, but will pay $300 with a probability of 0.5 and $150 with a probability of 0.5. There is a prior belief of 0.5 that the First United Bank of America has the higher-valued portfolio. Suppose that the First United wished to securitize these loans, and if it does so without a credit enhancement, the cost of communicating the true value is 7.5% of the true value. Assume that the discount rate is zero and that everybody is risk-neutral. Consider the following securitization scenario. The First United can create two classes of bondholders in a senior- subordinated structure or junior-senior structure. Class A bondholders will receive the first tranche and are entitled to $300 in aggregate. After they are paid off, class B bondholders are entitled to receive $300 or the residual cash flow, whichever is smaller. Suppose First United can find a credit enhancer. With credit enhancement, class B bondholders can be guaranteed to receive $300. The market for credit enhancement is competitive. Ignoring the possibility of default by the credit enhancer, how much will the First United have to pay the credit enhancer? $122 $68 $60 $75
Suppose that the First United Bank of America has two loans. Each is due to be repaid one period hence and has independent and identically distributed cash flows. Each loan will repay $300 with a probability of 0.8 and $150 with a probability of 0.2. However, while the bank knows this, the investors cannot distinguish this loan from that of the Third TransAmerica Bank, which has the same number of loans, but will pay $300 with a probability of 0.5 and $150 with a probability of 0.5. There is a prior belief of 0.5 that the First United Bank of America has the higher-valued portfolio. Suppose that the First United wished to securitize these loans, and if it does so without a credit enhancement, the cost of communicating the true value is 7.5% of the true value. Assume that the discount rate is zero and that everybody is risk-neutral. Consider the following securitization scenario. The First United can create two classes of bondholders in a senior- subordinated structure or junior-senior structure. Class A bondholders will receive the first tranche and are entitled to $300 in aggregate. After they are paid off, class B bondholders are entitled to receive $300 or the residual cash flow, whichever is smaller. Suppose First United can find a credit enhancer. With credit enhancement, class B bondholders can be guaranteed to receive $300. The market for credit enhancement is competitive. Ignoring the possibility of default by the credit enhancer, how much will the First United have to pay the credit enhancer? $122 $68 $60 $75
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Transcribed Image Text:Suppose that the First United Bank of America has two loans. Each is due to be repaid one period
hence and has independent and identically distributed cash flows. Each loan will repay $300 with a
probability of 0.8 and $150 with a probability of 0.2. However, while the bank knows this, the
investors cannot distinguish this loan from that of the Third TransAmerica Bank, which has the
same number of loans, but will pay $300 with a probability of 0.5 and $150 with a probability of
0.5. There is a prior belief of 0.5 that the First United Bank of America has the higher-valued
portfolio. Suppose that the First United wished to securitize these loans, and if it does so without a
credit enhancement, the cost of communicating the true value is 7.5% of the true value. Assume
that the discount rate is zero and that everybody is risk-neutral. Consider the following
securitization scenario. The First United can create two classes of bondholders in a senior-
subordinated structure or junior-senior structure. Class A bondholders will receive the first tranche
and are entitled to $300 in aggregate. After they are paid off, class B bondholders are entitled to
receive $300 or the residual cash flow, whichever is smaller. Suppose First United can find a credit
enhancer. With credit enhancement, class B bondholders can be guaranteed to receive $300. The
market for credit enhancement is competitive. Ignoring the possibility of default by the credit
enhancer, how much will the First United have to pay the credit enhancer?
$122
$68
$60
$75
00
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