Increased volatility has driven up the cost of certain derivative instruments, making it more expensive for mortgage bankers to hedge their servicing portfolios.

The increase in prices of derivatives contracts that are used to offset servicing runoff comes as falling rates threaten to spark another wave of refinancings.

"It's an expensive time now to buy prepayment risk protection," said Paul Van Valkenburg, principal at Mortgage Industry Advisory Corp., a New York risk-management firm. "The wrong time to buy fire insurance is always after the fire."

In the past, mortgage bankers relied solely on new production to replace loans that had run off. But in recent years they have been supplementing the so-called "macro hedge" with derivative instruments, such as interest rate floors and Treasury options, that tend to rise in value when interest rates fall.

Accounting rules that took effect in 1995 require mortgage bankers to record on their books servicing rights on loans they originate, just as they had always been required to do with purchased servicing rights.

Late Friday the 10-year Treasury note yielded 4.70%, down from 5.39% a month earlier. Many have noted that mortgage rates have not moved in lockstep with Treasuries.

But according to Freddie Mac, the average rate on 30-year mortgages fell last week to 6.66%, the lowest in the 30 years data have been kept.

Mortgage bankers anticipate a turning point ahead.

"There's a greater potential for loss," said Steven Hozie, senior vice president for servicing portfolio risk management at Fleet Mortgage Group, Columbia, S.C.

The increase in options prices is a mixed blessing for servicers, Mr. Hozie said. "It's bad if you're adding coverage, but for existing coverage it's good news."

"From a historical perspective volatility is still very low," he added. "Hedging is cheaper today than a year ago or two years ago, even if it's more expensive than it was in July."

Because declining market volatility reduces the value of an option, prices of options are generally expressed in terms of volatility. An option's implied volatility is derived from its price and other factors.

For most of this year volatility has fallen. But in recent weeks it has increased sharply.

According to Salomon Smith Barney, implied volatility on a one-year option on a 10-year swap was at 13.5% Thursday, up 1.5 percentage point from a month before.

Analysts attributed much of the recent rise in volatility to indications from the Federal Reserve that it had opened its mind to cutting short-term interest rates.

"The sense earlier was that the Fed was on hold," said Michael Schumacher, a derivatives analyst at Salomon Smith Barney. "Now the view is that the Fed is more likely to act sooner than later, and that's pushed volatility up a bit, especially on short-dated options."

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