Mortgage servicers are crossing their fingers and holding their breath about the surge in refinancings in the last month.
In contrast to loan origination executives, who are rejoicing about the loans they are writing to meet demand for lower interest rates, servicing executives see peril in times like these.
"This is clearly an environment where we see the risk of writedowns," said David M. Applegate, chief financial officer of GMAC Mortgage, Horsham, Pa.
As the last refinancing wave demonstrated, bank earnings are vulnerable to hits as servicers adjust the valuation of portfolios to reflect loan runoff.
Most servicers have now initiated hedging strategies to financially offset the risk. How those strategies are working is sure to be the topic of the hour at the Mortgage Bankers Association of America's servicing conference beginning today in New Orleans.
"All of us that have hedged in the past few years are going to find out how effective these hedges have been," said William B. Naryka, chief financial officer of Fleet Mortgage Group, Columbia, S.C.
In the past, lenders relied solely on new loans they produced to replace loans that had run off, but now lenders are buying interest rate floors and options on Treasury bonds, among other derivatives contracts. These instruments tend to rise in value when rates fall, so they at least partially offset the effect lower rates have on the value of servicing.
Today's low interest rates have generated a quick surge of prepayments as financially savvy consumers scramble to lock in favorable rates. It will be the first major test for these new strategies.
There is a lot at stake.
In the last refinance boom, Citicorp took a $100 million writedown in 1992, and Fleet Financial Group and Chase Manhattan Corp. took sizable writedowns the next year.
Norwest Corp. has the most to lose if it has to report a writedown. Its Norwest Mortgage subsidiary owns the largest servicing portfolio with nearly $208 billion of mortgages.
Mortgage banking income accounted for 11% of Norwest Corp.'s 1997 earnings. Barbara S. Brett, funding manager for Norwest Corp., said the value of servicing booked on the Minneapolis bank's balance sheet was nearly $3 billion at yearend.
"If you own a servicing portfolio as large as ours, we're always concerned about" risk management, Ms. Brett said.
Since the refinancing boom of 1993, accounting rules have changed. Mortgage servicers now have more at stake because they have to book loans they purchase and those they originate on their balance sheets.
As a result, companies that did not hedge in 1993 now are forced to do so.
Mr. Naryka referred to the new accounting standards as addictive accounting, because lenders will have to keep originating more or purchasing more in order to avoid writedowns.
Others maintain that the accounting changes are the least of lenders' problems. Luke S. Hayden, an executive vice president with Chase Manhattan Mortgage, Edison, N.J., blamed writedowns in 1993 on lenders' underestimation of the level refinancing would reach.
"In 1993, virtually everybody's prepayment model broke. The risk we have is that happening again," Mr. Hayden said.
The current refinance boom is only two months old so the jury is still out on whether lenders made the same mistake again. But the sudden onset of refinancings could exacerbate any runoff problems, Mr. Hayden said.
This is especially true because once a loan leaves the portfolio, it takes about 90 to 120 days before any new loan volume will be capitalized on the balance sheet, Mr. Naryka said.
Still, few believe that the larger servicers will need to take substantial charges, mainly because of the increased adoption of hedging.
Price Waterhouse surveyed 125 servicers in 1993 and found that only 11 were hedging, said Timothy F. Ryan, a partner.
Now a majority of mortgage servicers and all the large companies are hedging, Mr. Ryan said.
"The evolution in risk management strategies in the last three or four years for top players is revolutionary," he said.
Norwest, for example, did not have a hedging strategy for its mortgage division in 1993, Ms. Brett said. But in 1993, Norwest Mortgage was not the servicing behemoth it is now. Its portfolio was about $45.6 billion and it originated $33.7 billion.
Observers said the larger servicers that will have the most trouble are those that do not have a substantial origination network.
GMAC Mortgage would fit this category. It originated about $5.1 billion last year and had a servicing portfolio of about $58 billion. So it only originated enough to replace about 10% of its portfolio.
Mr. Applegate said GMAC's goal is a 25% replenishment ratio-annual originations as a percentage of total servicing volume-which would put it at about the same level as Chase and Norwest. He said GMAC expects to originate more than $8.7 billion this year.
If GMAC hits that target, it would be able to replace 15% of its servicing, assuming there is no growth in the portfolio. Other servicers said continued growth of the portfolio is vital because servicing is a scale business.
"Do you just want to replenish or do you want to grow beyond that?" asked Chase's Mr. Hayden. Chase has a portfolio of about $173 billion.
And it may be difficult for lenders to grow if the refinance boom lingers, because runoff concerns could lower the price lenders are willing to pay for servicing. Last year, lenders paid rich premiums for servicing.
Prices have not diminished much yet, but servicing brokers said they are starting to notice signs of wariness among buyers because of the low interest rates.
"We've seen a more cautious prepayment assumption by potential buyers in the past 30 days," said Geoffrey R. Glick, executive vice president of Hamilton, Carter, Smith & Co., a Beverly Hills servicing broker. "The continuation of the rate decline has commanded servicing purchasers' attention."