Citicorp's surprising writedown of mortgage-servicing assets serves as a powerful reminder that the mortgage refinancing boom is not without perils.
Most banks active in mortgages say they don't expect to take any big, sudden hits, the way Citicorp did. But they acknowledge that at least some writedowns of servicing assets are inevitable as homeowners pay off existing mortgages to take out new ones at lower rates.
A week ago, Citicorp restated its second-quarter earnings to reflect a writedown on the roughly $1 billion of servicing assets on its books. The banking giant says regulators forced it to write down the assets by $50 million, on top of a $45 million writedown it had taken voluntarily.
With the change, Citicorp's second quarter profit fell 16% from the previously announced level, to $143 million.
Sounding an Alarm
"It was a good wake-up call for the mortgage industry," said Jack Schakett, partner in charge of mortgage banking practices for Ernst & Young, the big accounting firm.
Not only are current interest rates threatening the value of servicing assets, but as the Citicorp case suggests, bank and thrift regulators are giving increased attention to the issue.
"It's a very hot item on their list," Mr. Schakett said.
Mortgage servicing, a fee business that forms the backbone of many banks' mortgage operations, entails collecting monthly payments from homeowners and passing them on to holders of mortgages-backed securities. Servicers also coordinate payment of homeowners' property tax and insurance bills.
Historically, banks have built their servicing businesses by originating mortgages, selling them to the secondary market, and retaining the rights to service the loans. In such a strategy, the rights are treated as off-balance-sheet assets and thus are not vulnerable to writedowns.
Shift in Strategy
But in recent years, most big players have supplemented their originations with purchases of servicing rights from other lenders. In such transactions, the rights are recorded as an asset on the bank's books -- based on the purchase price -- and amortized over the expected life of the loans. If the expected life subsequently shortens, the assets must be written down accordingly.
Another, more complex type of servicing asset is "excess servicing fees receivable." This arises when lenders that sell loans, but retain the servicing rights, recognizes a portion of future revenues in the current period. The amount is booked as an asset and, like purchased rights, is amortized over the expected life of the loans.
The pitfall with both assets is that homeowners have the option to pay off their loans whenever they want. And when interest rates fall markedly, homeowners frequently exercise that option to refinance -- forcing servicing to write down assets.
"As far as the third quarter goes, there's no question that banks are going to be writing down mortgage servicing assets," said David Berry, an analyst at Keefe, Bruyette & Woods Inc. "It's just part of the business when rates go down."
Further Hit Foreseen
In fact, Citicorp itself probably will take "some additional charge," on servicing assets for the third quarter, said principal financial officer Thomas Jones. He refused to predict the size, however.
While the problem is pervasive, many bankers and analysts say that servicing writedowns often are more than offset by the increased loan production that comes with low interest rates.
Originations can mean more fees, more gains on sales of loans, and increased net interest income from holding mortgages for short periods before sale. Moreover, experts say, the new servicing business that banks are generating is unlikely to be hit by heavy prepayments unless mortgage rates -- already at a 20-year low of 8% -- drop another 200 basis points or so.
All in all, a mortgage executive who complains about servicing writedowns "is sort of like the owner of a department store complaining during the Christmas season that his returns of merchandise are up," said Jonathan Gray, a thrift and mortgage banking analysts at Sanford C. Bernstein & Co. "Well, yes, but sales are up, too."
Drop to No. 12 Originator
Citicorp, however, has not been released with the bountiful mortgage "Christmas" that many of its rivals have enjoyed. That's because it pulled back sharply on new mortgages over the past year after a runup in delinquencies.
Ranked as the nation's sixth-largest originator last year, Citicorp slipped to No. 12 in the first half of this year, writing $4.5 billion of mortgages, according to the newsletter Inside Mortgage Finance.
Citicorp's servicing writedowns "would have been partially offset if there had been a vigorous flow of new mortgages," Mr. Jones acknowledged.
"Volume may or may not pick up," he added. "We're focusing on credit quality, and volume is to some extent secondary."
While many mortgage bankers are content to let increased origination profits offset their writedowns, some go a step further and actively hedge their servicing assets.
They typically purchase such instruments as options on Treasury bonds or by mortgage securities that offer only the payments of principal from a pool of mortgages. Both instruments tend to rise in value when interest rates fall.
Another alternative is "prepayment insurance," a specialized product pushed by a handful of Wall Street firms. When loan prepayments hit a specified level, the Street firms start making cash payouts to the servicer. Each policy is supposedly tailored to the specific need of the servicer.
Citicorp declined to discuss hedging strategies, but Chase Manhattan Corp., for one, has been a regular user of prepayment insurance. And the effort has apparently paid off.
Despite rising prepayments and writedowns this year, Chase Home Mortgage Corp. has suffered only modest economic losses, officials of the unit say.
Others, including Fleet Financial Group, have been helped by their own conservative amortization schedule.
By amortizing servicing assets rapidly in early years, they avoid having to take big writedowns when prepayments pick up, analysts say.
"We've had to adjust our amortization, but it's been minimal," said Robert Denton, an executive vice president at the mortgage unit of Michigan National Bank. "It's not like a tidal wave that's swooping down on us."
In Citicorp's case, public attention focused on the servicing assets when the giant attributed its restatement of earnings to the forced writedowns.
Shares of Citicorp fell 10% since the announcement at the close of trading last Friday. Citicorp also revealed in a regulatory filing that day that it signed a memorandum of understanding with regulators.
Mr. Jones, the principal financial officer, said Citicorp and the regulators that forced the writedowns differed in their projections for interest rates and, consequently, in their predictions for loan prepayments.
(Citicorp, which is regulated by the Federal Reserves and the Office of the Comptroller of the Currency, has decline to specify which agency forced the action.)
"To the extent that rates decline further, they will have been proved rights," he said. "To the extent that rates spike up at all, we will have been proved right."
The conflict that Citicorp experienced with regulators may become increasingly common if the refinancing boom persists.
Though accounting rules give banks broad latitude in valuing servicing assets, experts say that banking regulators have indeed been forcing banks to use conservative assumptions about interest rates and prepayments.
"Some examiners have wanted to extrapolate the prepayment experience of the past few months to infinity, rather than assume it will taper off," said Dorsey Baskin, a partner at Arthur Andersen & Co.
Added Mr. Schakett of Ernst & Young: "Clearly we're seeing negotiations with regulators and people taking writedowns they wouldn't have taken without the regulatory involvement."
Leonora Cross, spokeswoman for the Office of the Comptroller of the Currency, said that servicing assets "are obviously something that we look at when we go into a bank."
Likewise, Robert Miailovich, assistant director of supervision for the Federal Deposit Insurance Corp., said his agency has informally alerted its examiners to the risks of servicing assets.
"It's something we're aware of, but it's by no means a red alert or anything like that," he said.