The theory is that mortgage banking companies have a natural hedge that tends to stabilize their earnings. When interest rates rise, the reasoning goes, loan originations fall but servicing portfolios become more valuable because of declines in prepayment speeds.

That's in normal times. But the past 12 months have been far from normal. The unusually swift turnaround in interest rates early this year has meant a messier and costlier transition to fewer originations than anyone expected, and the mortgage stocks have paid the price, especially with the waning of takeover speculation.

One view of the market is that the rising value of cash flows from servicing has been pushed aside by severe investor disappointment over quarterly earnings.

Worst May Not Be Over

Tom O'Donnell, a securities analyst who follows mortgage banking for Smith Barney Inc., New York, says the worst isn't yet over and even more disappointments are likely as originations continue to slump and profits remain weak.

"Markets tend to overreact," he said.

"The stocks were bought with the view they were from structural changes in the mortgage market as the secondary market expanded, that cyclicality in the business was no longer as great, that servicing provided protection against a downturn in originations, and that costs were under control because of the use of brokers and wholesale purchases."

But the huge surge in originations last year led to overcapacity, and investors felt let down as the consequences took their toll on earnings, he said. So it seems to be a case of once-burned, twice-cautious, and it may be some time before the merits of a hefty servicing portfolio become obvious to the market again.

Jonathan Gray, an analyst with Sanford C. Bernstein & Co., New York, believes investors have digested the servicing-hedge idea. "There's a good conceptual understanding that servicing is a negative-duration element," he said, referring to the reduction of servicing volatility as interest rates rise.

But he added that investors did not seem to be aware that the servicing gains achieved when rates rise are smaller than the losses when rates fall.

Neutral Recommendation

Meanwhile, he says, stocks appear to be fairly priced, reflecting most of the negative developments, so he has a neutral recommendation on major issues such as Countrywide and North American. But he agrees with Mr. O'Donnell that there is little reason to expect much good news in coming months.

But he adds that shares of Fleet Mortgage Group are expected to outperform the market in coming months. "They have more exposure to the rebound in servicing values than to the collapse of production," he said.

He points out that Fleet has about $70 billion in its servicing portfolio, while he estimates production volume at about $15.2 billion. It made substantial servicing amortization charges that dragged down earnings last year. This year, amortization costs will drop sharply.

Fleet has said publicly it intends to acquire mortgage companies and servicing portfolios.

David Dusenbery, who follows mortgage banking for Salomon Brothers, New York, believes that servicing will indeed begin to drive earnings again, starting later this year and continuing into 1995.

"We expect revenues as a percentage of total pretax income to reach each company's historical level in 1995, muting the earnings volatility experienced over the past two years," he said.

Servicing Sales Reduce Prices

But one hurdle will have to be overcome beforehand, he adds. Pressures on earnings have driven many companies to sell servicing, and the heavy supply has forced prices down, he says.

"We feel this divergence between market and economic values is temporary and is directly related to the recent onslaught of product dumped onto the market at the end of the first quarter of 1994," he says.

He says Countrywide, Fleet, and others have been buying bulk servicing at a cost as favorable as generating servicing through retail originations. The oversupply should dwindle as more companies choose to bypass the fierce competition in the origination market.

The value of servicing, meanwhile, may be affected significantly by changes in the accounting rules. But the effects on different companies are uneven, and the new rules appear to be a complexity that the market would rather not deal with right now.

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