Mortgage hedging strategists are turning away from the Treasury market and using more mortgage products to reduce their exposure to losses in their servicing portfolios.
When interest rates drop, prepayments increase, causing servicing portfolios to shrink.
To make up for servicing losses, mortgage companies use financial instruments - such as Treasury floors - that increase in value when interest rates drop. Some servicers rely on production to replenish a portfolio, but most of the large servicers are more aggressive in protecting the servicing asset.
But the Treasury market has been more volatile than the mortgage market recently, causing hedging strategists leery of Treasury volatility to turn to mortgage products, according to experts.
A principal-only swap is an increasingly popular hedge for those switching from rate-sensitive ones, said Robert N. Husted, principal at MIAC Risk Management, New York.
"But they have to rebalance those positions," Mr. Husted said. Two products Mr. Husted's clients are buying are principal-only strips - called POs - and super-POs.
These instruments are securities that receive only principal payments from pools of mortgages. When prepayments climb, holders receive the payments faster.
"Their cash flow and value appreciate with the interest rate drop, and work the same as Treasury floors, but the difference is that POs are directly linked to prepayments," Mr. Husted said.
One Wall Street salesman said that his customers are buying options that entitle them to buy or sell mortgage products at a fixed price. They are even paying a small premium for the options because of volatility in the Treasury market.
