Derivatives linked to principal payments on mortgages are coming back in vogue as hedging instruments to protect servicing portfolios, according to industry experts.
The instruments' potential volatility has made commercial bank units leery of using them, but a surge of popularity is pushing them back into use as hedges.
Because the performance of these instruments is tied directly to loan prepayments, they are useful for protecting the servicing asset.
A risk management consultant said the derivatives are often used in swap form, so the users don't actually hold the instrument but get the cash flow from it.
Robert N. Husted, a principal at MIAC Risk Management Services, New York, said securities dealers were financing the swap agreements, allowing mortgage bankers to keep the transactions off their balance sheets. And by keeping the securities in swap form, they are permitted to use the instruments as a hedge, which is otherwise prohibited under hedge accounting rules.
The derivatives increasingly used as hedging instruments are principal- only securities, super principal-only derivatives, and inverse floaters.
"Some of these securities have good hedge properties to them," Mr. Husted said. "Something like servicing has interest rate sensitivity, so a super PO (principal-only derivative) or other derivatives can have desirable counter properties."
Principal-only instruments receive only the principal payments on the underlying mortgages. Prepayments mean holders receive the income faster, and thus the derivatives increase in value as interest rates fall. A super principal-only instrument is comparable, but the prepayment amounts are magnified. Similarly, an inverse floater is a variable-rate instrument whose interest payments rise as other key rates decline.
A Wall Street mortgage products dealer said the rising popularity of mortgage-related securities during the past six months has made them extremely expensive. Nevertheless, large, sophisticated hedgers are buying them up, in part to diversify their hedging instruments.
"Conventional wisdom is usually 'buy low, sell high,' but with these, we tell our customers to buy high and sell higher," the dealer said. "Everyone is completely loaded up with Treasuries, so now they are migrating toward hedges that are prepayment-linked."
But Chemical Residential Mortgage, which ranks among the top 10 servicers, does not use mortgage derivatives to hedge because of their potential risk.
"I think there is an appropriate time to use them, and now might be such a time," said Luke Hayden, executive vice president at Chemical's mortgage unit. "But the average life of a principal-only (derivative) changes dramatically when interest rates change marginally, and this brings into question how appropriate they are for a bank-owned unit."
