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A Pretty Quiet Quarter, by Some Standards

Garrison Keillor likes to begin his "news from Lake Woebegone" segment by telling people that it's been a quiet week in the fictional Midwestern small town. Then he gets into the entertaining details.

After reviewing fourth-quarter and year-end earnings statements from the mortgage industry, much the same can be said about the most recent mortgage servicing hedge results.

It's been a quiet quarter, for the most part. Not that there was no reason to worry. The average prime 30-year mortgage rate was 6.30% at the start of October, according to Freddie Mac's weekly rate survey. By the end of December, the average 30-year rate had slipped to 6.18%.

For the most part, that modest rate rally didn't trip up too many lenders, but there were more than a few that reported modest impairment to their mortgage servicing rights asset for the fourth quarter.

Let's start with the big kids.

Countrywide Financial Corp. saw its total loan servicing pretax earnings decline to just $9 million in the fourth quarter of 2006, down from $306 million in the fourth quarter of 2005, largely as a result of negative changes in MSR values and hedging losses. The company said quarterly earnings were constrained by a $215 million negative swing in the value of the MSR asset and retained interests coupled with a $132 million increase in interest expense related to the asset. While servicing cash flow remained strong (servicing fees net of guarantee fees totaled just over $1 billion for Countrywide in the fourth quarter), higher interest rates and increased leverage in the servicing sector stemming from the issuance of $1.5 billion high-equity-content debt securities drove up interest expense.

Wells Fargo, the nation's largest servicer with a $1.3 trillion portfolio as of Sept. 30, 2006, saw reasonably placid results despite its huge portfolio. Like Countrywide, Wells reported gross servicing fee revenue in excess of $1 billion, boosted in part because of its acquisition of MSRs from Washington Mutual.

Wells' chief financial officer, Howard Atkins, told investors that the impact of interest rate movements on the servicing portfolio net of hedging value changes during the fourth quarter "was negligible."

Not everyone was so lucky. IndyMac, after posting stellar servicing results earlier in the year, saw its return on equity from servicing and interest-only securities decline in the fourth quarter. That contributed to IndyMac falling short of earnings expectations for the quarter.

IndyMac doesn't treat its mortgage servicing portfolio as just a "macro-hedge" against its loan origination business. Instead, IndyMac wants its MSR business to contribute to earnings across rate cycles, and it actively hedges the asset to make sure the MSR results aren't impaired when rates drop. But in the fourth quarter, hedging results weren't sufficient to offset a $3 million writedown in the MSR asset. And with a servicing asset now valued at about $1.8 billion (and totaling more than $140 billion of home loans), IndyMac may have gotten off easy. The writedown could have been larger given the weak hedging results.

IndyMac is hardly alone. The flat yield curve has made hedging more challenging and more expensive for many lenders. With economists predicting that the flat curve is likely to persist through much of this year, those challenges aren't going away anytime soon.

Snapshot: Industry's Largest MSR Portfolios

Wells Fargo $1.31 trillion

Countrywide $1.24 trillion

Washington Mutual $757 billion

Source: MSN/Quarterly Data Report. Data as of Sept. 30, 2006. (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com