As the Federal Reserve officially leaves the mortgage-backed securities market this week, mortgage servicers will likely step up their hedging efforts to shield portfolios from any major rise in interest rate volatility.

Interest rates have fallen to historic lows and have been unusually steady since the Fed began buying large quantities of MBS in late 2008, prompting many servicers to pare back their hedging. But servicers fear that, without the Fed's stabilizing influence, rates will go up, boosting the value of their portfolios but also increasing their need to hedge against unexpected gyrations in mortgage rates.

"Now that the Fed will be out of the picture, there is a perception that mortgage rates could be going higher along with other rates and widening in relation to other rates," said an executive at a top servicing company. Servicers "might be increasing their hedge [activities]."

Like his rivals, the mortgage-servicing executive said the key consideration in determining his company's hedging strategy is the expected prepayment rate on a portfolio, which is largely dictated by what a borrower pays in interest. "You have to be very careful to calibrate your models to what the borrower's rate is," he said. The servicer requested anonymity because of the sensitive nature of sharing his hedging strategies.

An increase in hedging activity means higher costs for servicers. "What you can start to see is more volatility in the market, which generally makes the cost of hedging more expensive," the executive said. The servicer has been reevaluating its hedging strategy since the Fed announced in September its plans to wind down its purchases of MBS.

To be sure, it is not axiomatic that the Fed's pullback will lead to higher interest rates.

Fed Chairman Ben Bernanke said last week during a congressional hearing that the central bank had been concerned mortgage rates could pop once it stopped its MBS purchases. "But so far there seems to be very little negative reaction, which is encouraging," he said.

Most analysts though are expecting at least a slight increase.

"I think the prevailing expectation is, the interest rate is going to go up when the Fed backs out," said Rob Kessel, managing director and co-founder of Compass Analytics LLC, a San Rafael, Calif., company that develops mortgage analytics and provides risk management advisory services.

Even the perception that rates could edge upward is enough to lead servicers to increase hedging.

"While the Fed was buying, they stabilized the prices of those securities. Servicers and other participants didn't have to hedge price volatility … too much," said Greg Reiter, senior agency MBS strategist at Royal Bank of Scotland's RBS Securities Inc. "It would have been wasteful to hedge with the Fed buying."

Servicers can hedge interest rate and prepayment speed volatility in a handful of ways, usually by buying derivatives, Treasurys or other securities or by entering into swap transactions.

The idea is to protect the servicing portfolio, if mortgage rates drop, by pulling in income from investments. If rates rise, income from the servicing portfolio should offset any investment losses.

When rates fall, the value of a servicing portfolio declines because borrowers are more likely to refinance their mortgages, which reduces the duration of the loan in the portfolio. When rates rise, the servicing portfolio becomes more valuable as borrowers become less likely to refinance, preserving the loans within a portfolio.

Since the Fed began buying MBS in late 2008, mortgage rates have fallen to historic lows. The average rate on a 30-year, fixed-rate mortgage in October 2008, just before the Fed announced plans to buy MBS, was 6.20%, according to Freddie Mac. Within a few months, the rate had fallen under 5%. In February, the average stood at 4.99%.

Servicers' hedging strategies are closely monitored and constantly changing. And each servicer's strategy is different.

Citigroup Inc., for example, said in a regulatory filing last month that it "hedges a significant portion of the value of its MSRs (mortgage servicing rights) through the use of interest rate derivative contracts, forward purchase commitments of mortgage-backed securities and purchased securities classified as trading (primarily mortgage-backed securities including principal-only strips)."

The change in value of these instruments does not perfectly align with the change in value of MSRs, Citigroup said, so it reviews "the mix of various hedging instruments … on a daily basis."

Because the Fed's exit has been well-telegraphed, it is not something that should catch large servicers like Citigroup off guard, said Frank Pallotta, an executive vice president and managing partner of Loan Value Group LLC, an advisory firm in Rumson, N.J.

"I don't think anyone is blindsided by this," he said.

"If rates back up, let's just say it is 20 basis points, that is going to mean some slowdown in refinancing activity," he said. "Any tiny thing that affects that market will absolutely factor in to how they hedge their portfolios. Will it be significant? I would say no."

Sachit Kumar, a managing director at Mortgage Industry Advisory Corp., a New York risk management and advisory firm for the mortgage industry, said volatile interest rates are more likely to affect smaller servicers than their big counterparts.

"The large servicers have tools to manage the risk," he said. "Lately, the small guys have started retaining servicing. For those folks, they need some kind of services to help manage this risk. Many of them have not been equipped well to manage the risk of servicing assets."

To the amazement of many market participants, so far, the MBS market has been fairly stable since the Fed first announced last fall that it would wind down its purchases by the end of the first quarter. Some traditional buyers that were pushed out of the market when the Fed came in, including hedge funds, pension funds and investment bankers, have been accumulating cash and waiting to put it to use. And Fannie Mae and Freddie Mac's repurchases of delinquent loans from their portfolios are not only making the market more attractive but also returning principal to investors that can be reinvested in the market.

In February, the government-sponsored enterprises announced plans to buy back nearly all securitized loans in their portfolios that were seriously delinquent — nearly $200 billion in total.

However, there is still the chance that rates will creep up.

"The chances of [the mortgage rate] going up is much higher than going down," Kumar said. "When it goes up, then you're not taking a bet against servicing value going up, you're taking a bet against the rate going down. The activity will be more when the rate goes up. They all had huge gains on the servicing asset, they want to protect those gains."

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