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Answer: KMAC has a reserve in the amount of $10 million that will remain on KMAC's balance sheet.
## Explanation In asset-backed securities (ABS), credit support mechanisms protect investors from losses. Let's analyze each option: **A. Total auto loans of $125 million** - This provides overcollateralization ($125M vs $120M total tranches), which enhances credit quality for all tranches including Tranche X. **B. Weighted average interest rate of 6.4%** - This creates excess spread (6.4% pool rate vs 5.9% weighted tranche rate), which can absorb losses and improve credit quality for subordinated tranches. **C. Tranche Z absorbs defaults first** - This is subordination where Tranche Z acts as a first-loss position, directly protecting Tranche X from initial losses. **D. $10 million reserve on KMAC's balance sheet** - This would NOT affect Tranche X's credit quality because: - The reserve remains on KMAC's balance sheet, not dedicated to the ABS - In case of KMAC bankruptcy, this reserve may not be available to ABS investors - It doesn't provide direct credit enhancement to the specific ABS structure Credit support mechanisms must be dedicated to the ABS structure to effectively protect investors. External reserves that remain on the originator's balance sheet do not provide reliable credit enhancement for ABS tranches.
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King Motors Acceptance Corporation (KMAC), the finance arm of King Motors, issues an auto-loan asset-backed security that consists of a senior tranche, denoted Tranche A in the amount of $50 million and an interest payment of 5 percent, and two subordinated tranches, denoted Tranches X and Z respectively, each with a face amount of $35 million. Tranche X pays investors annual interest at a rate of 6.5 percent while Tranche Z pays investors annual interest at a rate of 7.5 percent. Which of the following methods of credit support would NOT affect the credit quality of subordinated Tranche X?
A
The total amount of the auto loans that make up the asset-backed issue is $125 million.
B
The weighted average interest rate on the auto loans making up the pool is 6.4 percent.
C
Any defaults on the part of King Motor's customers will be first absorbed by Tranche Z.
D
KMAC has a reserve in the amount of $10 million that will remain on KMAC's balance sheet.