Colonial Bancgroup is adopting more sophisticated mortgage hedging techniques after a $30 million writedown of its servicing portfolio.
Colonial is the latest in a string of mortgage servicers to take hits because of falling interest rates and higher-than-expected prepayments.
But unlike other lenders -including BankAtlantic Corp. and Capstead Mortgage-that are leaving the business, the Montgomery, Ala., banking company has started using Treasury futures and options to hedge prepayment risk.
These hedges tend to increase in value when interest rates fall, offsetting the depreciation of the servicing assets, said Flake Oakley, chief financial officer of the $9 billion-asset company.
"We had looked at various hedging instruments but felt that the cost of those instruments was too great," Mr. Oakley said. "In hindsight the cost of not having them was greater."
Colonial, which has a $16 billion servicing portfolio, previously relied on originations to make up for prepayments, Mr. Oakley said. The company expects to have originated $3.5 billion to $4 billion of loans by yearend.
The adoption of financial hedges is imperative for smaller servicers to survive, experts said.
But fewer than half of servicers have adopted these methods, said Austin Tilghman, managing director at United Capital Markets, Denver.
"I expect that to change dramatically in 1999," said Mr. Tilghman, whose company is advising Colonial on its new hedge program.
In another response to the prepayment problem, Colonial is considering selling some of its servicing portfolio. This would reduce risk to an acceptable level for a smaller company, Mr. Oakley said. "That may entail reducing the size of the mortgage company relative to the bank's size," he added.
This approach defies the conventional wisdom that bigger is better and that scale brings down the cost of servicing.
However, Mr. Oakley said that Colonial's cost to service a loan is $40 to $45 per year-one of the lowest in the industry. And its costs were in that range even when the portfolio was only $10 billion, he said.