Which of the following regarding key credit enhancement features of defeasance as prepayment protection is least accurate? A) No distributions are made when the defeasance takes place, so there is no issue concerning how prepayment penalties will be disbursed. B) The duration of the defeasance funds reduces the credit risk of the commercial mortgage-backed securities (CMBS). C) The cash flow from the defeasance funds is substituted for payments made by the borrower. Your answer: B was correct! how does the duration of the defeasance affect interest rate risk? duration goes down, pre PMTs goes up, price sensitivity (interest rate risk) goes up?
they are talking of credit risk - not interest rate risk. any prepayments are reinvested in treasury securities - so the credit risk goes down.
The answer specifically states that duration affect interest rate risk, not credit risk.
B) The duration of the defeasance funds reduces the credit risk of the commercial mortgage-backed securities (CMBS). where pray???
agreed cpk that you invest in treasuries so the credit risk should decrease. then is it the “duration” part of that answer that makes it least accurate? b/c the treasuries prob will be shorter duration than the mortgage backed stuff, so it’s not duration but maybe better said the quality there?
if (B) said “prepayment risk” instead of “credit risk” then the statement would be accurate. rememeber that credit enhancements not only reduce credit risk but can also reduce prepayment risks (i.e. senior/ subordinated structures)
I think the question is trying to test you on the following concept: when duration decreases - this is interest rate risk - when does that happen - interest rates fall - so prepayment happen on the CMBS. But the prepayments get diverted to the treasury securities which are purchased - hence though duration decreases - credit risk also reduces. does that make sense in the terms on this question ?