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First Quarter a Challenge for Hedge Managers

With major financial institutions starting to report first-quarter earnings, the management of mortgage servicing portfolios looks like a tricky business for many lenders.

On the surface, it should seem like the best of times. Rates ended the quarter higher than at the beginning of the quarter, which should boost the value of mortgage servicing rights.

But at some shops, hedging of MSRs was not all peaches and cream during the first quarter. Already there have been warnings that hedging of MSRs proved more troublesome than expected during the quarter, in part because of a tightening in the mortgage swap basis.

National City Corp., for one, has advised lenders that its MSR hedging activity was negative in the first couple of months of the year. National City said hedging will likely show a loss for the first quarter. With that in mind, analysts at CreditSights said mortgage results could be "lumpy" for the first quarter.

And the flattening of the yield curve also poses challenges to servicers. First Horizon Home Loans saw stronger mortgage servicing income in 2005 because of rising rates and portfolio growth, but at the same time the company reported a $41.1 million decline in hedge gains last year. The flattening of the yield curve reduced income from swaps and rising interest rates led to increased option expense for the company. Still, the company reported a 26% increase in the value of its capitalized mortgage servicing rights as the portfolio grew by 10% to $95.3 billion.

But even as the economic environment for hedging MSRs becomes more challenging, at least the accounting environment is becoming more friendly.

At least that's what supporters of FAS 156 say. That rule, which allows servicers to account for servicing rights at fair market value, eliminates the challenges of achieving hedge accounting treatment for the derivatives used to offset fluctuations in MSR values. Under current rules, MSRs can only be adjusted downward because they are subject to lower of cost or market accounting. Only if lenders can demonstrate hedge effectiveness through testing can they offset a decline in the value of derivatives with servicing gains. That, unfortunately, has been a factor behind some hedging decisions. The new rule should make it easier for servicers that choose fair value accounting to make hedging decisions based purely on economic factors.

But like everything, there is a potential downside. LOCOM protected lenders from a certain amount of volatility in MSR valuations. Since they couldn't raise MSR values in a rising rate environment above the original cost, MSR values didn't have as far to fall when falling rates pushed down valuations. With that in mind, some lenders may choose to stick with LOCOM accounting and either not hedge or face the hedge effectiveness testing that has vexed some lenders. The nice thing about FAS 156 is it gives lenders a choice in the matter.

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