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Flat Yield Curve Is Challenge for MSR Managers

The first quarter of 2006 should have been the best of times for loan servicing managers. Rising long-term interest rates finally put the lid on sky-high prepayment rates, helping to boost loan servicing values.

But that was only half the story. A flat yield curve made hedging of interest rate risk more expensive, and more difficult, for some of the industry's largest players.

Interest rate risk management on mortgage servicing rights became more expensive for companies such as Washington Mutual, which reported $151 million in risk management costs associated with its mortgage servicing rights during the quarter, up from $14 million in the fourth quarter. Last year during the first quarter, WaMu actually posted net revenue of $213 million from MSR risk management. That's a year-over-year increase of $364 million in MSR risk management costs.

Tom Casey, executive vice president and chief financial officer at Washington Mutual, explained the hedging challenges during WaMu's quarterly earnings conference call.

He said the growing cost of hedging WaMu's MSR asset offset a portion of the company's gains in loan production revenue, a problem WaMu has warned about in previous discussions about how the flat yield curve between long-term and short-term interest rates is affecting the company.

Mr. Casey attributed the MSR risk management challenge to the yield flattening. "As an illustration, over the past year, the two-year to 10-year swap spread has compressed from 81 basis points to only 8 basis points," he said.

Nonetheless, he said WaMu continues to be satisfied with the cost and performance of its hedging program. "But clearly the cost of hedging the MSR asset in this interest rate environment is very expensive, and we are taking steps to reduce our hedging costs while maintaining our risk management discipline," Mr. Casey said.

What are some of those options that would reduce hedging costs?

Because the value of the MSR asset is so volatile as rates change, Washington Mutual might consider ways to reduce the capitalization of MSRs on its balance sheet. That could involve producing loans with lower servicing fees or selling off excess servicing fees. WaMu has long argued that current servicing fee requirements are too high, and some other big lenders agree. But there is hardly a universal consensus about this issue. Fannie Mae, Freddie Mac and other investors want to make sure deals contain a large enough servicing strip of income so that the servicing function can be sold off to another party in the event that a servicer fails.

But with lenders shifting to market accounting on MSRs, and with a flat yield curve raising the cost of managing interest rate risk exposure through the use of hedge instruments, WaMu is not the only lender trying to figure out a way to contain the cost of hedging. In fact, it's an industrywide challenge now for large mortgage servicers.

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