The Federal Reserve Board has proposed regulations to establish capital requirements for interest rate risk. The Mortgage Bankers Association has advised the Fed to make some changes in the proposed regulations. Following are excerpts from the MBA's comment letter.
Servicing--Of significant concern to MBA is the use of modified duration for measuring the value of mortgage servicing rights. Duration-based models are designed to measure the volatility in market values for bonds; duration of "x" implies that for a 100 basis point shift in the yield curve, the market price of the particular bond, will move "x" percent in the opposite direction. Unfortunately, this duration measurement fails to properly track changes in the value of servicing assets resulting from movements in interest rates. Servicing reacts similarly to interest only strips (although they do not have identical properties). As interest rates rise, the value of mortgage servicing rights increases because prepayment speeds on the underlying loans decrease. The opposite occurs in falling interest rate environments due to refinances. Unfortunately, the model as drafted would not recognize that mortgage servicing acts as a hedge against fixed-rate loans held in portfolio, inventory or traveling in the pipeline. To properly reflect the interest rate risk associated with on-balance sheet servicing rights, the methodology must incorporate the proper estimation of negative duration of servicing.