When Robert N. Husted and Paul T. Van Valkenburg started Mortgage Industry Advisory Corp. Risk Management in 1989, they had to knock on mortgage companies' doors to persuade people to hedge portfolios of servicing rights.
Today, lenders are knocking on their door.
The need to manage the risk of servicing portfolios has come to the forefront because of the recent change in accounting rules for originated mortgage servicing rights. They are now an asset on the lender's books, just as purchased servicing rights have always been. As a result, MIAC and a handful of other consulting firms are in more demand, along with hedging products from Wall Street firms.
The rule has meant higher reported income for some lenders. But it also requires that rights be marked to market, and this has introduced the potential for earnings volatility that didn't exist previously.
Companies have adopted two different approaches to solving this problem. Some are concerned only with accounting and want to avoid reporting paper losses. Others are more concerned with protecting the real-world economic value of the servicing asset, Mr. Van Valkenburg said.
"The new accounting treatment is driving many people to recognize this problem that they hadn't previously had," he said. It was always a good idea for servicers to protect the servicing asset, he added, but some companies are only now coming to that realization because of the accounting standards.
But the change in accounting rules is not the only influence on mortgage servicing. The trend of big servicers to become even larger through acquisitions has led them to seek hedging advice before purchasing a portfolio.
MIAC tests the portfolio under a number of interest rate scenarios with different hedging strategies, so the client can base a purchase decision on the risk involved and the cost to hedge the asset.
"Those are career decisions for people, whether or not to lay the money on the line and make money on this acquisition," Mr. Van Valkenburg said.
Two servicers now have portfolios of more than $100 billion: Countrywide Credit Industries and G.E. Capital Mortgage Corp. The merged Chase and Chemical will top that threshold. And a successful bid for Prudential's servicing would also put either BancBoston Mortgage or Norwest Mortgage over the $100 billion mark.
Norwest has worked with MIAC since 1991 in analyzing its portfolio risk in concert with its own risk management department. Mr. Husted said that MIAC uses its tools to analyze Norwest's portfolio for tax and accounting implications, allowing Norwest's own risk management people to decide on a hedging approach to protect the servicing asset.
While holders of large servicing portfolios concur on the need for hedging, their techniques can be quite different.
Countrywide, still the largest servicer at the moment, has had a hedging program in place since 1991, long before changes in the accounting rule were even being discussed, and an executive there says accounting rules should not affect a company's hedging strategy.
The company's hedging approach has always been to treat servicing as an asset that needs to be protected, said John Dolphin, senior vice president. Mr. Dolphin said he doesn't think the change in accounting standards should change a company's approach to hedging, but understands that FAS 122 has put servicing in the spotlight.
The new rule "doesn't change the way we manage the hedge," Mr. Dolphin said, "but it becomes more important."
He said that the refinancing boom in 1992 and 1993 showed servicers that they needed to protect the servicing asset. Servicing can run off quickly when prepayment speeds pick up, as it did during the refi boom, when interest rates dropped to the lowest level since the late '60s and many mortgage holders prepaid their loans. Companies without a hedging program suffered great losses during that time.
Mr. Dolphin said that the wisdom of hedging became apparent during that year.
Another large servicer, North American Mortgage, hedges, but not with Wall Street instruments, said Dorothy Beattie, senior vice president.
"We continue to evaluate strategies they come up with," Ms. Beattie said, but North American has not found a Wall Street instrument it finds more helpful than the cash trades it currently uses.
She concurred with Mr. Dolphin that the new accounting rules shouldn't change a hedging program. Ms. Beattie said North American had always treated the servicing portfolio as an economic asset, and hedges to protect the asset, not strictly for financial statement purposes.
Mr. Husted said that such large-scale servicers have always been aware of the risk associated with the servicing asset. But with the Financial Accounting Standards Board's new rule 122, under which servicing is put on the balance sheet as it is originated, the servicers are quicker to hedge it.
"Now with FAS 122, simply the fact that they will have more assets coming on to the balance sheet is motivation enough to look at hedging strategies," Mr. Van Valkenburg said.
"We help structure hedges, help value hedges, and help determine the most effective hedge at the lowest price possible on the least amount of the portfolio required," Mr. Husted said. "This is at odds with the Wall Street goal of trying to sell hedges."
But as a risk management consultant, Mr. Husted said his company has a good relationship with Wall Street because it recommends Wall Street's hedging products to clients.
