Among the small tribe of analysts and consultants who follow such things, Wells Fargo & Co. holds a reputation for savvily hedging the value of its mortgage servicing portfolio. In most years, that means that the company's hedges tidily cancel out any losses in the value of its mortgage servicing rights.

Last year, however, Wells didn't come out even. Its combined portfolio booked $6.3 billion. In the fourth quarter alone it logged not only a $1.1 billion servicing gain — but another $800 million from its hedge against it.

Had Wells erred in setting up its hedges, or worse yet, was it putting itself at risk of posting big speculation losses?

The answer is probably neither. Wells and other major servicers' traditional hedging practices have thrived because of peculiarities of the mortgage servicing industry, MSR fair-value accounting and a yield curve that is unusually steep,

Wells has taken by far the largest — or at least the most visible — gains, though regulators, accountants and servicing-rights consultants say the conditions have been favorable to all of the nation's biggest banking companies. JPMorgan Chase & Co. gained $1.5 billion from its combined MSR and hedging positions last year, and Bank of America Corp. realized $1 billion within the first nine months — it did not provide a breakout in its fourth-quarter financial statement. Citigroup Inc. does not disclose those figures.

These conditions have raised questions about the sustainability of such earnings, and even Wells acknowledges they won't last forever. But they have provided a boost at a crucial time, and they're widely expected to extend into the current quarter.

That Wells or any other major institution could potentially reap large profits on derivatives without the risk of posting equally sized losses is a concept that fuels skepticism. But that is the position of their primary regulator, the Office of the Comptroller of the Currency.

"When you just see what shows up in the earnings releases and the 10Qs, you aren't seeing the whole story," said the OCC's lead mortgage analyst for large-bank supervision Bruce Krueger, speaking of banks' MSR valuations in general. As a result of "unique market conditions," he said, banks using certain instruments have been able to protect against servicing losses while leaving themselves open to substantial hedging gains.

A Value Add
The explanation for that good fortune begins with the underlying portfolio, in Wells' case the right to collect and process payments on $1.7 trillion in residential mortgages.

Servicers hold those rights at fair value — for Wells, a St. Louis-based home mortgage team values them at $16 billion — and they're one of the more volatile items on the bank's balance sheet. Since the right to service a loan only lasts as long as the loan does, MSR portfolios can lose billions when a significant mortgage rate drop causes borrowers to refinance. Conversely, when rates rise, refinancings slacken, boosting the value of the portfolio.

But determining the fair value of a servicing portfolio, while never easy, has become far more challenging of late. Along with interest rate volatility and prepayment speeds, said PricewaterhouseCoopers Managing Director Steve Robertson, banks must consider the effects from home-underwater borrowers, defaults, loan modification activity, and an MSR secondary market that continues to be inactive.

Servicing rights are considered a level 3 asset, meaning there are no "observable inputs" to determine value. In the Financial Accounting Standards Board's words, prices "reflect the reporting entity's own assumptions about the assumptions that market participants would use."

The major servicers' actual marks bear out that subjectivity. At the end of the fourth quarter, Wells valued its servicing rights at 91 basis points on the mortgage dollar; Bank of America was at 101.

One change is true for everyone: the risk of prepayment if mortgage rates drop further are less severe than they used to be.

"Normally you'd think in a time period of interest rates being this low, that would lead to pretty high prepayment speeds," said Andrew Davidson, president of the MBS consultant Andrew Davidson & Co. "But because of the disruption [in the mortgage market], the prepayment speeds are much lower than they would normally be."

Special Hedge
Still, the exposure gets hedged, largely by buying derivatives and other credit instruments with values that rise and fall along with interest rates.

The exact instruments used vary, and a major servicer would likely use an array that changes by the day, from options to receiver swaps to forward positions in Treasuries and mortgages.

If mortgage rates tank, the hedge pulls in income from a widening interest spread, and if rates rise, mark-ups of the servicing portfolio neutralize any balance-sheet losses.

Even if rates stay the same, banks make money. For the few months the positions last, the servicer holding them pays short-term borrowing costs and receives payments based on much higher yielding longer-term rates. It's carry income — the same as an institution would get from borrowing short term and buying 10-year bonds — just held off balance sheet and for far shorter durations. Making it especially attractive has been the government's intervention to keep the interest rate curve steep.

Though this has played to the advantage of everyone, Wells' stated preference for hedges based on mortgage-backed-securities yields - rather than options or derivatives based on Treasuries or Libor — likely added to its earnings. John Coleman, managing director of fixed income at R.J. O'Brien & Associates, said that any bank hedging primarily with mortgage-based derivatives would have greatly benefited as the spread between mortgages and Treasuries tightened over the past year.

"If you were willing to be a liquidity provider, you were picking up positions very cheaply," he said.

Hedging has allowed Wells to benefit from the steepness of the interest rate curve even as it has cut back on carry income in other segments of its business. Wells' on-balance-sheet fixed-interest holdings have shrunk by more than $30 billion in the last two quarters, an amount on which the company estimates it could have pulled in 400 basis points of carry income.

"We don't believe in the carry trade, and we do want to preserve some powder in case rates do go up," CFO Howard Atkins told analysts on Wells' earnings call last month.

Keeping its carry positions short term doesn't avoid the issue of interest rate risk, of course. But had rates suddenly jumped, losses would have been counteracted not only by rises in the estimated value in a bank's servicing portfolio but by the carry income that the bank had been collecting throughout. (An example is Wells' second quarter, when it posted a $1.3 billion hedging loss that was more than offset by a $2.3 billion servicing portfolio gain.)

The strategy was hardly a secret.

For all of last year, Wells has noted in its quarterly earnings that it made a killing on carry income and expected the situation to continue.

But the unusual circumstances became harder to ignore in the second half of the year as interest rate volatility slowed and the carry-trade revenue overwhelmed changes in the value of the underlying derivatives.

In the fourth quarter, the company claims, its hedging positions did decrease in value — just not by anywhere near enough to absorb more than $800 million in carry-trade income.

If a bank wanted to hedge its position without getting so much carry income, of course, it could hedge by primarily buying options up front. Those would help neutralize interest rate changes, too — and preserve more of the upside for the servicing portfolio. But when the Federal Reserve is spending in excess of a trillion dollars to keep the yield curve steep and mortgage rates low, say hedging consultants, a short-term carry trade looks extremely attractive.

David Stephens, chief financial officer for United Capital Markets, which provides hedging services to smaller servicers, said that many of the firm's clients also had a great quarter because of the fairly constant rates.

"Nothing happens, and we still get paid carry," he said. "That's our favorite scenario."

Is it fair to call this hedging? Not under the technical sense of the word; FASB does not recognize the existence of an "economic hedge," a general term for guards against unfavorable economic swings. But the OCC does.

"[I]n terms of the economic hedge, we expect that banks look at all the factors that could negatively affect servicing rights, including defaults, modifications, and higher costs to service, and set up a structure to protect against them," Krueger said.

This gives banks a lot of leeway to take positions that protect against an increase in the costs of servicing delinquent mortgages, for example. It's up to management and the board to determine whether the hedge is economically "effective," said Robertson, though it is likely that regulators' growing focus on interest rate risk may bring such matters more attention.

Inflated Earnings?
Among equity analysts, Wells' earnings have already been the occasion for a minor scuffle. In October, Rochdale Securities analyst Richard Bove downgraded Wells' stock over concerns that hedge income accounted for too much of its earnings. Oppenheimer & Co. analyst Chris Kotowski attacked that conclusion the next day in a research note announcing a "buying opportunity" on Wells.

Even some analysts who see such "economic hedges" as a smart move in the current environment have earnings-quality concerns, however.

Because of Wells' excellent liquidity position and its conservative marks on its MSR portfolio, FBR Capital Markets analyst Paul Miller said, Wells has been able to take more aggressive hedging positions than most of its competitors.

Even in a worst-case scenario in which rates suddenly rise, any losses should be more than covered by MSR write-ups, not to mention Wells' previous gains.

"If rates go from 5 to 6, there's enough juice in their MSRs to offset that loss," he said.

But while Miller praises Wells for a well-executed strategy, he said the hedging proceeds should be considered as far less valuable than the bank's steadier streams of income.

"They're getting commercial-bank multiples for doing investment-bank-type operations inside their commercial bank," he said.

There's hardly a problem, however, if the carry income goes away as earnings from the rest of Wells' businesses return to take its place. The average interest rate of mortgages in Wells' portfolio is now 5.7%, a four-year low. And as an economic recovery takes hold — or it becomes apparent that the current interest rate environment is coming to an end — Wells' MSR hedging will likely fade into the background.

"There may come a time where mortgage rates are so low that the risk of mortgage rates going up is greater than the risk of it going down further," Atkins said in an interview last month. "And that normally would be the time when we would begin to reduce the size of the hedge."

For the meantime, however, it's hard to see what Wells would want to change.

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