I enjoyed your article "Servicer Hedging Costs to Grow, Even if Rates Don't" [March 30]. As a veteran of 20 years hedging mortgage servicing rights at several large servicers, I thought I might add my perspective.

Servicing costs are likely to rise, but perhaps not necessarily for the reason you cite. The end of the Federal Reserve's mortgage-backed securities purchase program most likely will widen mortgage spreads to other fixed-rate investments, such as Treasuries and interest rate swaps, but the effect is likely to be less severe than originally feared, as other traditional buyers of MBS are at present underweight their usual level. For this reason and because of the fundamentals supporting MSR valuations, I would be surprised if MSR hedgers drastically reduce their MBS holdings.

MSR valuations are primarily affected by the level of refinance opportunity available to consumers, indicated by retail mortgage rates. These rates are most closely related to the yield on MBS (secondary yields). Because MBS yields are the key factor affecting the refinance rates, the use of MBS to hedge MSR risk does not add to the risk of the portfolio; properly constructed, it mitigates the risk.

The last few quarters have produced very favorable MSR hedging results (as evidenced by financial disclosures). There is reason to believe that this period of favorable results may end, and hedging cost rise. A few of the drivers of higher hedging costs, as I see them, include interest rates and the slope of the yield curve. With rising interest rates (as indicated by the yield curve), MSR portfolios will gravitate toward more negative levels of convexity. This could mandate an increase in options usage as a portion of the portfolio and increase cost

The slope of the yield curve is near all-time highs. As the yield curve flattens, most likely by the Fed raising short-term interest rates, the carry advantage associated with all hedge instruments will be reduced

The onset of a tightening cycle, coupled with termination of the actions to stabilize mortgage yields, will likely increase market volatility. Increased interest rate volatility makes MSR more difficult and costly to hedge whether you use mortgages or other interest rate products.

Going forward, servicing hedgers will likely find it more expensive to offset their risks. One of the wildcards that is difficult to predict is how quickly individuals are able to transition to a more normal refinance pattern, overcoming combined loan to value [ratio] and credit barriers. Hedgers will need the best tools, the most robust risk-reducing frameworks, and perspective.

Greg Harris
Mountain View Risk Advisors

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