Variable Rate MBS

The Canada Housing Trust (“CHT”) will raise funds by issuing Canada Mortgage Bonds and use the proceeds to purchase VRMBS’s from Approved Sellers. For each VRMBS purchased CHT will also enter into a swap, where it pays the MBS interest and reinvestment income to the swap counterparty and receives fixed coupon cashflows, which are used to service the CMB. CHT will also pay CMHC an up-front guarantee fee for each CMB issuance. In return CMHC provides a guarantee for the CMB’s.

The purpose of the first calculator is to determine the fair value of a VRMBS that is eligible for the new CMB program. This calculator will be used to assist the CHT when purchasing a VRMBS.

The purpose of the second calculator is to estimate CHT’s credit exposure to a swap counterparty. In particular, it estimates the maximum loss should a swap counterparty default, as well as the expected loss based on the probability of default. This calculator will be used by CMHC when setting the guarantee fee for the CMB’s issued by CHT.

It is important to note that the approach used by the Credit Risk Calculator works, only because it is estimating the credit risk of an interest rate swap with no option-like features, such as caps, floors, or cancellation option. Variable rate mortgages commonly contain such features, and therefore so would the associated swap. The approach used by the Credit Risk Calculator would not be suitable for estimating the credit risk of such a swap.

We recommend that the choice of yield curve to use for discounting the VRMBS cashflows be investigated further. Two possibilities have already been proposed, the CMB yield curve and the Approved Seller’s cost of funds curve

The CMB yield curve is a bullet bond curve that does not account for the additional undiversifiable risks inherent in a mortgage-backed security. It is likely to overprice the VRMBS.

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