Hedging Challenges Lie Ahead at WaMu

A flat yield curve is doing more than just creating headaches for portfolio lenders. It is also posing challenges to companies that hedge their mortgage servicing rights.

Chief among those companies is Washington Mutual, one of the nation's largest mortgage lenders. Washington Mutual reported that net income from its home loans group fell to $47 million in the fourth quarter, down from $164 million in the year-earlier fourth quarter. And WaMu cited "the increased cost of MSR risk management" due to a flat yield curve as the primary driver of the drop in home loans income. Moreover, chairman and CEO Kerry Killinger told investors and analysts on the company's quarterly conference call that WaMu expects the MSR hedging environment to remain challenging this year.

Chief financial officer Tom Casey shed more light on the problem, saying that a flat yield curve has increased the cost of WaMu's MSR hedging strategy.

WaMu values its MSR asset at $8 billion. And that's an $8 billion asset that, left to its own devices, could fluctuate wildly depending on interest rate conditions and wreak havoc on the company's quarterly earnings reports. But hedging out the interest rate exposure hasn't proved easy.

"The impact of the environment on our results is demonstrated by the spread between the two-year and 10-year swaps. That spread has dropped by more than a full percentage point over the past year," Mr. Casey said on the call.

The reduction in that spread reduces the interest WaMu receives on its swap and TBA hedges and thereby increases the overall cost of hedging the MSR asset, Mr. Casey explained.

WaMu also released financial information that illustrates the conundrum. In the fourth quarter of 2005, WaMu enjoyed revenue from the sale and servicing of home loans totaling $421 million, but it also reported a $157 million loss from certain trading securities used for MSR risk management purposes. While the loss on hedging instruments was actually smaller than in the third quarter, WaMu's upward adjustment to its MSR valuation was much smaller than in the third quarter, so the hedging losses were not fully offset by servicing gains.

But despite the challenges affecting management of risk in the MSR environment, Mr. Killinger expressed optimism about WaMu's prospects, noting that the Federal Reserve Board may be nearing an end to its cycle of interest rate increases.

"And as we have said many times, once short-term interest rates stabilize, our net interest margin will expand with the repricing of our indexed loans. With this comes positive financial leverage," he said, adding that the increased net interest income will drive further asset growth, fund dividend increases and enable additional share repurchases. That will lead to a higher return on equity and an improved efficiency ratio for WaMu, he said.

Mr. Killinger also noted that WaMu has moved its Long Beach Mortgage and Mortgage Banker Finance units into the home loans group, a move he said will allow WaMu to leverage distribution channels between its prime credit and nonprime lending operations. In the future, Long Beach's results will be reported as part of WaMu's home loans group.

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