IndyMac's Servicing Is Not Just a Hedge

IndyMac Bancorp, the fast-growing mortgage lender based in Pasadena, Calif., is known more for its loan origination acumen than its emphasis on loan servicing. But this focus on the company's growing share of the loan origination market obscures an equally important part of IndyMac's success story: it's loan servicing operation.

In fact, IndyMac executives say they want mortgage servicing to be much more than just a "macro-hedge" for the company's loan origination shop. During a conference call to discuss third-quarter results, chairman and CEO Michael Perry said IndyMac wants its servicing shop to contribute to the company's earnings in a variety of interest rate environments. Traditionally, many mortgage companies were content to reap profits from rising mortgage servicing right valuations when rates rise, offsetting lower loan origination volume. When rates fall? Well, lost MSR value is usually more than made up in greater loan production income.

But the way Mr. Perry sees things, IndyMac has way too much capital invested in mortgage servicing to think of it as a back-burner part of the business.

The company also posted a loan servicing milestone in the third quarter, with its portfolio of loans serviced for others rising to $124 billion at Sept. 30, up 69% compared with the third quarter of 2005.

That reflects the company's growing share of the mortgage origination market. Even more impressive, perhaps, is that IndyMac's loan servicing operation was strongly profitable in the third quarter, when falling interest rates took a toll on the servicing performance of some competitors. IndyMac said mortgage servicing contributed $30 million to the company's third-quarter earnings.

Mr. Perry said the servicing portfolio is aggressively hedged to try to make it neutral to interest rate conditions, a move that helps make it more than just a hedge against the mortgage origination segment.

"We need to try to earn stable returns in all interest rate environments in our servicing segment," Mr. Perry said.

IndyMac ended the quarter with a $134 million loss related to its mortgage servicing rights and interest-only assets, reflecting the impact of lower interest rates on the value of these assets. But that loss was more than offset by hedge gains totaling $138 million. Mr. Perry described the performance of IndyMac's servicing executives as "phenomenal," especially in comparison to what other big mortgage companies reported for the third quarter.

"We decided long ago that we were not going to have our servicing asset be a macro hedge to loan production."

Mr. Perry said that cash-flow earnings from the servicing portfolio and retained assets totaled $125 million, illustrating why the company has invested more than $400 million of capital in the asset.

While the return on equity from the servicing asset would be extremely volatile as interest rate changes, hedging the asset helps to limit that volatility, he said.

In an interview with MSN, Richard Wohl, president of IndyMac Bank, said that the strategy does increase the cost of hedging the servicing asset, especially when the yield curve is as flat as it has been of late.

But the strategy paid off in the third quarter. Some industry peers that might follow more of a macro-hedge strategy suffered a double whammy. Because rates fell by the end of the quarter, servicing income was down. But in many cases origination volume fell as well, so there was no offset to those MSR losses.

"For people who choose not to hedge and use that macro-hedge, they suffered something of a double whammy," Mr. Wohl said.

He said IndyMac is pleased with new accounting rules that allow the company to account for servicing and derivative instruments used in hedging on a mark-to-market basis. That allowed IndyMac and many other lenders to avoid the "lower of cost or market" accounting that used to pertain to mortgage servicing.

"We think it's a better way to go from a disclosure standpoint. It's a more open way to go."

While EPS growth in the third quarter was limited, in part because IndyMac made a strategic decision to reduce loan sales, that move may put the company in position for a strong fourth quarter. Mr. Wohl said the lower volume of loan sales reflected both a strategic decision to put more loans in portfolio as well as the timing of some loan settlements that pushed sales activity into the fourth quarter.

He said IndyMac received feedback from investors suggesting the company should grow its thrift balance sheet to create more steady spread income.

"We agreed. So we took a close look at our production to see if there were some loans we could profitably add to the portfolio," he said. As a result, IndyMac added some $1.4 billion of loans to its held-for-investment portfolio during the third quarter.

IndyMac's Hybrid Thrift/Mortgage Banking Earnings Summary

Mortgage Production $69 Million

Mortgage Servicing $30 Million

Thrift Portfolio $35 Million

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