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Outperformance Rules the Day Again

With servicing costs rising along with delinquency and default rates, people in the industry may be looking for a silver lining. For some big lenders, it's been hedging "outperformance."

Outperformance is really just another way of saying that a lender's hedging strategy missed the mark because of changing economic conditions. The good news is that this time dislocation in the capital markets hasn't hurt servicers, it has indirectly helped them on the hedging front.

Countrywide has suffered through many more bad news headlines than good ones lately, so let's highlight its hedging performance for the first quarter of this year. Lower interest rates forced Countrywide to reduce the fair value of its mortgage servicing rights by a stunning $1.56 billion as of March 31. But the company simultaneously posted hedging gains of $1.66 billion. That $109 million in hedging outperformance was a welcome bright spot on the company's first-quarter earnings report, a quarter in which Countrywide suffered a net loss of $883 million. It's the second time in a row that hedging outperformance has helped Countrywide stanch some of its losses. In the fourth quarter of 2007, Countrywide posted a $451 million gain from valuation changes in the net value of MSRs, net of hedging. Then, as now, the MSR values declined but not as much as the value of hedging instruments rose.

At Washington Mutual, the situation was similar, with the net gain in MSR values and related hedging dropping from the fourth quarter but still creating a benefit for the company.

Despite seeing the value of WaMu's MSR asset decline from $6.3 billion at year-end to $5.7 billion at the end of the first quarter, the company said that net of risk management activities, it was able to post a $289 million net gain from loan servicing. Still, WaMu warned that the cost of MSR hedging increased during the quarter.

Wells Fargo, which owns the industry's largest MSR portfolio covering $1.53 trillion of home loans, also reported that hedging costs rose in the first quarter of this year.

Howard Atkins, Wells Fargo's chief financial officer, hinted in a recorded call for investors that the company's MSR interest rate management could have been worse. He said the first quarter "turned out to be one of the more challenging quarters for hedging the accounting risk in MSRs, with significantly more pronounced and more frequent changes in interest rates and mortgage credit spreads throughout the quarter."

Still, he said Wells Fargo's MSR hedging process "continued to operate effectively." The company reduced its MSR value by $1.8 billion, but that was offset by a $1.9 billion gain in the value of the company's economic hedge for the MSR asset. (c) 2008 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/