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Luminent Says Hedge Accounting Not Worth Cost

If you believe that mortgage rates have finally come out of a trough and are likely to edge up over the course of 2006 - as many economists do - then it isn't surprising that some lenders are managing their portfolios to reflect this change.

But that "repositioning," like a lot of New Year's resolutions, may involve some pain before any gain is achieved. And in the case of at least one mortgage company, the repositioning includes a change of heart on hedge accounting.

Luminent Mortgage, a REIT that trades on the New York Stock Exchange, is among the portfolio lenders that are making a transition on its balance sheet. But Luminent is doing more than just selling part of its portfolio. The company has also decided to abandon hedge accounting.

Luminent said that effective at the end of last year, it will no longer use hedge accounting as defined in Financial Accounting Standard 133, which defines accounting rules for derivatives and hedging instruments. That does not mean that Luminent is abandoning hedging its portfolio, but it does mean the company will have to recognize changes in the value of its hedging instruments in its quarterly consolidated statement of operations.

Essentially, Luminent decided that the benefits of easing volatility in its results was outweighed by the cost associated with hedge accounting.

To make sure investors understand its operations, Luminent said it will continue to present REIT taxable net income results in addition to GAAP results, including a reconciliation of the two. In doing so, Luminent is joining a long list of company's that don't want GAAP to be seen as the sole measure of their financial results. Fannie Mae, for instance, in the past has presented "core operating" results alongside its GAAP results to highlight the impact of various accounting anomalies.

In the case of Luminent, company officials noted that taxable REIT net income ultimately determines the amount of its dividend payment to stockholders.

Luminent said its portfolio repositioning, which will require it to sell some of its existing portfolio, will accelerate the company's transition "into high-yielding residential mortgage credit investment" and facilitate higher returns on equity over the long run. While the company said its repositioning will "meaningfully improve earnings and dividend prospects for 2006 and beyond," it also warned that the move may pressure results for the first quarter of this year.

Citing "severe yield curve flattening and ongoing increases in short-term funding costs," Luminent said that its dividend paying capacity would be hampered in the absence of any portfolio repositioning.

Gail Seneca, chairman and CEO of the company, said in a company announcement that the repositioning signals Luminent's intention to move into higher-yielding investments that are less rate sensitive.

"As we reposition our portfolio in 2006, we aim to deliver strong and stable returns for our shareholders through carefully underwritten prime mortgage credit with limited interest rate exposure," he said.

But the repositioning comes with a price tag, of course. Luminent said it will record a non-cash charge of about $112 million related to its spread portfolio of MBS in the fourth quarter of 2005.

The decision is a change in strategy, Luminent acknowledged. Previously, the company had intended to hold the MBS that are currently at an unrealized loss position for a period of time until the company could see a recovery in fair value. The change in strategy means that the unrealized losses will now be considered "other than temporary impairments" as defined by Financial Accounting Standard 115, which covers certain investments in debt and equity investments. That means Luminent is required under generally accepted accounting principles to recognize the unrealized losses on these available-for-sale securities. Those hedges include interest rate swaps and euro-dollar futures contracts.

Luminent said the accounting change will significantly reduce administrative costs related to hedge accounting. But the change comes at a price. The company expects that by abandoning hedge accounting, changes in the market value of hedge instruments will add some volatility to its GAAP financial results.

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