If You Can't Beat Them, Sell MSRs to Them

Few companies detail their experience hedging mortgage servicing rights in as much detail as Washington Mutual. And the companies reward for this generosity of disclosure? People like me in the media and industry analysts get to dissect and criticize them to an extent not possible with many companies.

So let's take a look at WaMu's second-quarter hedging performance, as detailed in the company's earnings release. The big news, of course, was WaMu's decision to sell the servicing rights on its government-backed loans and out-of-footprint home loans to rival Wells Fargo. That move in itself reflected the difficulty and cost of hedging a multibillion-dollar mortgage servicing asset.

WaMu took a $101 million after-tax hit on the sale of $2.6 billion in mortgage servicing rights (which accounted for $140 billion of home loans), but the company's leaders say that offloading a big chunk of the MSR asset improves WaMu's risk profile.

"When the MSR sale closes at the end of July, our MSR to stockholders' equity ratio will fall from 35% at June 30 to approximately 25%," chairman and CEO Kerry Killinger told investors.

WaMu had indicated an intention to reduce the MSR asset as a ratio to equity, but few in the industry expected the transition to be made with one huge servicing sale.

Chief financial officer Tom Casey said the sale reflects WaMu's decision to focus its loan origination effort on "higher-margin, higher-yielding products." In addition, he said the sale provides a better balance between credit risk and interest rate risk for the company.

WaMu executives say that credit risk can be managed, one is tempted to say massaged, effectively with loan loss reserves. Interest rate risk exposure on the MSR asset is a trickier risk to manage, because hedging is imperfect and interest rate movements can result in big changes in the value of MSRs.

Setting the sale aside for a moment, WaMu said its second-quarter MSR risk management cost declined to $45 million, down from $151 million in the first quarter. But that compared to pro-forma net income of $108 million in the second quarter of 2005 related to MSR risk management. Those wide swings in performance, despite a relatively benign interest rate environment, must have factored into WaMu's decision.

So what does Wells Fargo get in addition to the headache of servicing what is now, at $1.25 trillion, the nation's largest home loan portfolio?

In a news release announcing the deal, Mark Oman, senior executive vice president for the home loan and consumer finance group at Wells Fargo, said his company looks forward to bringing 1.3 million new customers on board its mortgage servicing platform.

"This acquisition will further leverage the operating scale of our servicing business. Consistent with our vision to satisfy all our customers' financial needs, we look forward to building relationships with these customers so we can be there when they need their next financial product."

Translation: Wells looks forward to aggressively cross-selling the portfolio.

After the deal, Wells Fargo said it would service 7.5 million mortgage customers. That gives Wells a wealth of cross-selling potential, but it also saddles the company with a very large MSR asset to hedge. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com