Industry observers and regulators have taken note of Wells Fargo's dominance among the titans of the mortgage market.

With more than a third of mortgage originations in the first quarter of 2012 and a strategy targeting 40% down the road, the company has benefitted from solid if not always stellar execution in mortgage production and servicing as well as from the stumbles of key competitors, leaving Wells Fargo well out in front of the pack. In the wake of the JPMorgan trading loss, senior Wells Fargo executives have been touting the virtues of the bank's mortgage business, including a little-understood but highly volatile segment, namely mortgage servicing rights. 

Should we be nervous?

Today, Wells Fargo controls about $1.8 trillion in mortgage servicing. MSR valuation is an inherently tricky business as mortgage cash flows do not act like normal fixed income instruments such as Treasuries due to the potential for borrowers to prepay their mortgages.  This "free" option to homeowners allows them to refinance their mortgage whenever interest rates go down sufficiently to make it economically attractive for them to do so. Thus as interest rates decline, prepayments accelerate, generally causing the expected future cash flows from the mortgage to decline, hence hurting the value of MSRs. 

Why would a bank like Wells Fargo want such a volatile asset in the first place? It can earn sizable servicing fees for handling and disbursing a homeowner's mortgage payment each month as well as a variety of ancillary fees and float income that may accrue to the servicer between the time the payment arrives and when it has to be paid out to investors, tax authorities or insurance companies.

Central to the MSR process is a group that hedges the interest rate risk of this asset. This may conjure up all sorts of comparisons to JPMorgan's Chief Investment Office macro-hedge strategy gone awry, but there are significant differences and, yes, parallels worth pointing out.

On the positive side, MSR hedging is an activity that would and should be allowed by the Volcker Rule in that it is clearly designed entirely to offset the interest rate risk of the underlying MSR position.  Moreover, these hedging activities tend to be compartmentalized away from the rest of the business, making the temptation to engage in any form of proprietary "hedging" more remote. 

And while $1.8 trillion in mortgages serviced sounds like a gargantuan figure, in the case of Wells Fargo, the fair value of the MSR position was estimated at nearly $14 billion as of the first quarter.  Against total assets of about $1.3 trillion, it is unlikely that a fatal flaw in MSR hedging would do irreparable harm to the company. 

That said, there are some aspects of MSRs that can make it an asset not for the faint of heart.

The regulators clearly don't like MSRs, greatly restricting the amount that such assets can count toward Tier 1 capital.  One reason for their jaundiced view of the MSR asset is that it is extremely hard to value. In fair value accounting parlance it is treated as a Level 3 asset, i.e., one where no good market pricing exists and where valuation is reliant on – you guessed it – the accuracy of highly complex mortgage valuation models. 

One of the most difficult valuation exercises in the mortgage business is figuring out just how fast or slow prepayments will be over a period of time. The drivers of prepayment include not only the relative spread between a borrower's current mortgage rate and offer rates in the market, but on a host of demographic, economic and behavioral factors.  In the past many erstwhile "sophisticated" mortgage servicers have posted billion dollar quarterly losses due to poor hedging and/or misvaluations.

Compounding the problem is that mortgages have a very long potential horizon for which monthly cash flows need to be estimated. MSR valuation and hedging is thus dependent on models that simulate cash flow outcomes based on hundreds if not thousands of possible interest rate scenarios over time. The adoption of option-adjusted spread models to support MSR hedging and valuation activities is as complicated as value-at-risk modeling is for market risk measurement. Complicating the prepayment estimation problem these days are various efforts to encourage underwater borrowers to prepay their mortgages.

Finally, MSR hedging is not simple. The use of a variety of different hedge instruments such as swap contracts, options, forwards and futures requires a great deal of sophisticated analysis that even the best quants cannot always peg.

So if a senior mortgage executive tells you "there's nothing to worry about, we've got exceptional controls and a great track record in measuring and managing MSRs," it is probably worth getting a second opinion. We've heard that story before, just a different genre.

When Wells Fargo announces second-quarter earnings on July 13, MSRs are very likely to take a back seat to other, more visible parts of the company's business.  But Wells' position as a systemically-important institution, coupled with its mortgage market dominance, requires greater scrutiny of this side of the business – especially how MSRs are valued and hedged. 

Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.