Mortgage servicers say they are better hedged than the hedge funds that recently took a bath on interest-only mortgage securities.
Just like interest-only mortgage securities, the servicing rights that mortgage companies hold on their balance sheets can lose value when interest rates fall and borrowers refinance.
During the last major refinancing wave, in 1993, many servicers were forced to write down the value of their servicing. But these days, servicers are taking preventive measures.
"There are a lot of rather disciplined servicing hedgers out there," said Tom Millon, managing director for risk management services at Tuttle & Co. "The last time around, you saw few if any companies hedging servicing. The rate decline woke everybody up."
Another reason hedging is more widespread during the current refinancing wave is that new accounting rules effectively mandate it. In 1995 the Financial Accounting Standards Board began requiring mortgage banks to book the servicing rights for loans they originate on balance sheet.
That "introduced accounting risk in addition to economic risk," said Terry McCoy, who runs risk management activities at FT Mortgage, Dallas.
"From an economic perspective you may have additional loan production, but from an accounting standpoint you're forced to recognize the loss in value of servicing but you can't recognize an increase in value from higher production. Although you may be retaining economic value, you may be exposed to accounting risk."
FT Mortgage is among the many mortgage banks that have been hedging their portfolios with interest rate derivatives "that would give us an increase in market value as interest rates drop," Mr. McCoy said.
Indeed, financial risk-management instruments are an increasingly important part of the mortgage business. "Even 23-year-old MBAs, if they know IOs, POs, and hedges, can pretty much name their salary" at mortgage banks, said Jeffrey Levine, director of investment banking at Bayview Financial Trading Group.
Large mortgage banks like Norwest also use their status as leaders in both origination and servicing as a "natural" or "macro" hedge. If borrowers in the servicing portfolio refinance, they can be replaced because origination volume is brisk.
"To the extent that we can capture some of that because of the retail franchise, it acts as a good offset," said Mohan Chellaswami, vice president for capital markets at Norwest Mortgage.
Furthermore, he said, at current low interest rates, replacing borrowers who have refinanced can be seen as "getting rid of a risky asset" because the new loans are less likely to prepay.
Another strategy is to use conservative assumptions when booking servicing, said Gary Gordon, analyst at PaineWebber. That can give a mortgage bank "a lot of cushion in the asset in case there's a big runoff."
But none of these hedges are guaranteed to be successful. Many lenders use some combination. "Prepayments are such an uncertain thing and nobody models them perfectly," said Mr. Chellaswami. "You don't want to put all your eggs in one basket."
