Was Hedging a Bright Spot in '07?

Not surprisingly, most of the data from the annual cost study and other analyses by the Mortgage Bankers Association paint a pretty bleak picture of the state of the industry. By 2007, declining loan production volume and emerging industry turmoil left lenders unable to cut costs fast enough to offset falling volume and lower secondary market income.

But servicing, ironically, fared OK, even showing a modest gain in profitability per loan. Marina Walsh, the MBA's associate vice president of research and economics, said that the improved servicing picture probably reflects a slowdown in portfolio churning. Servicers in the study also reported lower hedging losses last year.

Servicers, on average, earned a profit of $109 per loan in 2007, up from $58 in 2006 (see related story, page 1).

"That was one bit of good news, but they are all struggling to manage the volatility of the MSR asset," Ms. Walsh said.

This year, the industry's largest players not only scored best on measures of direct servicing costs, they also outplayed smaller players when it comes to hedging their portfolios, according to the MBA cost study.

Reduced losses related to amortization and valuation of MSRs net of hedging allowed large servicers to report better financial performance as well as better operational results from servicing activities, according to the MBA report.

In a possibly ominous sign, servicers have reported steadily rising "interest expense" during the three years up to and including 2007.

In 2004, interest expense totaled just $15 per loan. By 2007, interest expense had risen to $68 per loan. However, servicing interest income rose during that period as well.

In addition to the cost study, the MBA also produces an annual servicing operations study and forum. In September, Ms. Walsh outlined the findings of that report in an article published in the MBA's Mortgage Banking magazine.

Unlike the cost study, the operations study does include substantial data about subprime servicing, and the collapse of that market has become apparent.

In the article, Ms. Walsh noted that while the slowing of portfolio churn may have been positive for financial performance, the absence of new loans coming on board portfolios was operationally problematic for servicers of subprime loans.

"While less churn may be music to the ears of some prime servicers, the inertia of loan movement in and out of portfolios spelled disaster for many subprime servicers. Loans were staying put - and defaulting."

While prime servicers saw their financial performance - essentially MSR valuations net of hedging in addition to operational income - improve in 2007, the financial performance of subprime servicers was dramatically different.

Subprime servicers saw net financial income per loan drop to just $28 in 2007, from $151 per loan in 2006. Because of the dramatic increase in subprime defaults, MSR valuation models were revised to take into account higher credit risk, Ms. Walsh noted.

Loss mitigation staffing doubled at subprime servicers last year, the MBA reported. And while it may not have shown up in the data for 2007, servicers expect increased costs related to the management, preservation and sale of real estate-owned to be a factor in servicing costs going forward as well.

While prime servicers saw only modest increases in default rates, the default rate reported by subprime servicers skyrocketed to 24% in 2007, up from 15% in 2006, according to the MBA data.

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