Mortgage-backed securities are finding a new niche as tools that help lenders manage their servicing portfolios. Industry experts say that, from a trickle two years ago, billions of dollars of derivative mortgage securities are now routinely bought and sold to hedge against prepayment runoff, the bane of every mortgage servicer.
"We've seen a dramatic increase" and expect the use of mortgage derivatives to grow, said Michael H. Koegler, vice president of the Chase Securities unit that helps lenders set up hedging programs.
A recent accounting change known as FAS 122 made accounting requirements more stringent for hedging, prompting servicing managers to step up their efforts. "Now, you regularly have to put on your balance sheet the value of your servicing portfolio," Mr. Koegler said. "So, if there is a loss, you have to offset it."
Mortgage securities called principal-only strips, or POs, are especially good for hedging portfolios, Mr. Koegler said. The products consist of principal payments from pools of mortgage-backed securities but not interest payments.
POs increase in value when rates fall. This is because prepayments increase, thus speeding principal payments to the investor. This makes up for a drain on servicing portfolios that occurs when people rush to refinance, cutting off the income stream to investors.
And conversely, the products lose value when rates increase, and that decline is offset by a slowdown in prepayments.
The use of mortgage securities for hedging benefits lenders because it creates more buyers for loans that are sold to Wall Street. And the fact that mortgage derivatives are being employed-successfully-will help rebuild their reputation, observers said.
The products were connected earlier this decade to large losses that institutional investors suffered when interest rates moved sharply. Now chastened, investors are learning to diversify to avoid problems from interest-rate fluctuation, industry observers said.
Hedging is especially important for lenders whose servicing portfolios are too large to count on new originations to offset prepayments, said Steven H. Buisson, vice president with the hedging operation at Fleet Mortgage Group, Columbia, S.C.