Don't Let Hedging Fall Off Your Radar Screen

For about the fifth year in a row, 2007 began with predictions that long-term rates would stabilize and probably edge upward, taking some of the sting out of quarterly revaluations of the mortgage servicing asset.

Not so fast. As the first quarter of this year came to a close, once again it looks like the 30-year mortgage rate would end the quarter a shade lower than where it began. And the yield curve between short- and long-term rates remains a lot less steep than some people would like. In short, hedging remains expensive and risky. And servicing rights remain subject to lower valuations.

For the week of March 29, Freddie Mac reported that the average rate on new 30-year, fixed-rate mortgages was 6.16%, down from the average 6.27% for the month of December 2006. The March 29 average was the lowest rate level so far this year.

Meanwhile, while credit risk premiums have been rising in the marketplace, that has had little impact on the spreads between long- and short-term rates that influence hedging costs. While the rate on 30-year Treasuries was almost 200 basis points higher than on 10-year Treasuries near the end of April, the rate on one- to six-month T-Bills remained higher than the longer-term rates.

So what does the rest of the year hold? Probably more challenges for companies that hedge mortgage servicing rights. While accounting changes have made it easier for lenders to focus on the economics of hedging rather than the accounting rules, it hasn't made protecting the asset from economic volatility any easier.

We've already seen how challenging hedging of MSRs was last year. As this edition of MSN goes to press, we'll soon get an idea of how tough this year is going to be for servicers, at least in the early going. Right now, the economic winds key to rate movements seem to be shifting, making it even more difficult than usual to forecast long-term rate movements.

As economists at Fannie Mae pointed out in a recent economic forecast, turmoil in international equity markets drove long-term rates down in March. At the same time, data showing economic growth were stronger in the fourth quarter of last year than anticipated seemed to spark renewed concern about inflation. Federal Reserve Board chairman, Ben Bernanke, seemed to pour cold water on hopes for an interest rate cut anytime soon, when he reiterated concerns about inflationary pressure during congressional hearings.

Meanwhile, economists at Freddie Mac lowered their forecast for the average 30-year mortgage rate through the first half of 2007, saying that flat inflation pressure expectations and the Fed's promised vigilance against inflation bode well for long-term bond yields. Freddie Mac's economic team believes that mortgage rates "should not change significantly over the year."

Freddie Mac believes that lower home sales and declining refinancing will still lead to lower mortgage production volume this year, predicting that origination volume will be down about 5% from the 2006 level. The refinancing share is expected to account for about 40% of the home loan production market, down from 43% last year. That means mortgage debt outstanding will likely increase by less than 8% this year, the lowest rate of MDO growth in more than a decade, according to Freddie Mac.

Most economists do not see the current woes in the subprime market leading to any "liquidity crisis" for the prime credit quality sector of the business. What does that mean for servicers? It means that portfolio runoff may be picking up, and the value of the MSR asset may once again be declining as lenders put the finishing touches on their first-quarter financial reports.

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