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Prepay Derivatives Offer Lenders Another Tool

In the complex business of hedging portfolios of mortgage assets against interest rate risk, lenders and investors have long been searching for tools that provide a strong correlation to the unique prepayment characteristics of mortgage loans.

Now, the Goldman Sachs Group, which in cooperation with Deutsche Bank began offering derivatives on broad economic indicators, is starting a market for derivatives based on mortgage prepayment speeds. Goldman Sachs hopes the instruments will prove popular with mortgage servicers trying to protect themselves against the borrower's inherent option to refinance when rates fall.

The first auction of options and futures on prepayment speeds was scheduled to take place last month. Thereafter, Goldman Sachs hopes to conduct the auctions on the second and fourth Thursday of each month.

Each month, all extant options will effectively reopen as existing contracts, Goldman Sachs said.

Goldman Sachs executives say that creating a market for prepayment derivatives will provide a better hedge for mortgage prepayment risk.

"The key for the success or failure of this product is can we get mortgage servicers to participate," said Allen Brazil, managing director for mortgage and ABS research at Goldman Sachs.

Ian McDonald, a vice president for interest rate product research at Goldman Sachs, told MSN the timing is good because the ongoing refinancing boom means that "prepayment risk is front and center" in the minds of market participants.

He said prepayment derivatives are particularly well suited for mortgage servicers, because they are the ones primarily subject to prepayment risk.

"We are going to be taking our cues from the market," said Bill Cassano, vice president, prepayment derivatives. He said the liquidity for mortgage prepayment options and futures will build as the market grows.

Buyers for the forwards and options will likely be mortgage servicers. Sellers of the derivatives are likely to include Wall Street firms, hedge funds and other mortgage investors. Goldman Sachs believes that prepayment options and forwards offer "better isolation of prepayment risk from general interest rate risk" and increased transparency of prepayment speed expectations.

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