Deutsche Bank is introducing a hedging mechanism that could address both regulatory and prepayment risks in Canadian MBS structures, targeting mortgages that don't fall under Canada Mortgage Housing Corporation (CMHC)'s new housing program.

However, there is little need for this type of technology to be used for regulatory purposes because Canadian mortgages generally carry a government guarantee and thus have a zero-risk weighting.

There is interest, though, in using the mechanism to hedge prepayment risk. Deutsche is currently working with one of the Canadian Schedule 1 banks to use the new technology for this purpose.

This hedging mechanism would enable the bank to take a pool of mortgages and to enter into a swap with Deutsche to hedge the interest-rate component on their fixed-rate mortgages. The morgages would be funded with the lender's short-term deposit base. As the individual mortgages in the pool prepay, the swap would amortize in conjunction with actual prepayments.

For instance, if there were 43 individual mortgages within the pool that were to prepay at the end of a month and the total was $235, 400, the swap principal amount would decline by the same amount.

This immunization technology would apply to mortgages that are not currently under the Canada Mortgage Bonds (CMB) program. CMBs are semi-annual, fixed rate, triple-A rated, bullet maturity bonds that carry a full government guarantee given through the CMHC. These bonds will be issued via a special purpose trust called Canada Housing Trust (CHT).The first deal under the program, which came to market recently, had a five-year term.

Though the CMB program would be an effective means for mortgage lenders to manage prepayment risk, currently the program is not available for seasoned mortgages and for mortgages that do not have a five-year term.

"I think over time, as the CMB program matures and grows, the potential for the use of the technology we're discussing may dissipate," said Michael Ford, senior vp at Deutsche Bank Canada. "But there is currently asubstantial existing market for it to be applied against. We think that the application would be for existing mortgages that are now on the books of mortgage lenders and for new mortgages with maturities that cannot currently be sold into the Canada Housing Trust."

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