Ontario Home Funding

The Canada Mortgage and Housing Corporation is about to purchase a C$1 billion pool of mortgage loans from several banks in Ontario. Your team has been placed in charge of the funding and risk management of this pool. The goal is to issue a mortgage-backed security that will appeal to investors, in such a way as to closely match the risk characteristics of pool. The details of the pool, simplified for computational purposes, are shown below.

ONTARIO MORTGAGE LOAN POOL

Pool total	C$1000 million
Pool interest rate	7.3%
Pool maturity date	10 years
Principal amortization	Equal-payment amortizing loans
Principal amortization period	25 years
Pool payment frequency	Annual
Historical default rate	0.4%-1.2%
Assumed annual principal prepayment	C$20 million

The following chart illustrates the paydown structure of the loan pool.

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Assignments:

Your task is to arrange funding and manage the interest rate and credit risks of the mortgage loan pool using securitization techniques.

• First, recommend a conventional bond that could be issued to fund the pool. The bond must be a fixed coupon, bullet maturity noncallable bond. CMCH can issue such bonds at a coupon rate of 3.75%. You may use this spreadsheet: loan_amortization.xls. What is the duration mismatch between the asset and the liability? Who bears the credit risk?
  
• Next, assume that the pool can be securitized by setting up a SPV and issuing 5 tranches of mortgage-backed securities. Please design such a mortgage-backed security, in such a way as to minimize any interest rate risk or credit risk to CMCH, which will hold the "residual" tranche.