Hedging Costs To Grow EvenIf Rates Don't

As the Federal Reserve officially leaves the mortgage-backed securities market, mortgage servicers will likely step up their hedging efforts to shield portfolios from any major rise in interest rate volatility.

Interest rates have fallen to historic lows and have been unusually steady since the Fed began buying large quantities of MBS in late 2008, prompting many servicers to pare back their hedging. But servicers fear that, without the Fed's stabilizing influence (it left the market as of April 1), rates will go up, boosting the value of their portfolios but also increasing their need to hedge against unexpected gyrations in mortgage rates.

"Now that the Fed is out of the picture, there is a perception that mortgage rates could be going higher along with other rates and widening in relation to other rates," said an executive at a top servicing company. Servicers "might be increasing their hedge [activities]."

Like his rivals, the mortgage-servicing executive said the key consideration in determining his company's hedging strategy is the expected prepayment rate on a portfolio, which is largely dictated by what a borrower pays in interest. "You have to be very careful to calibrate your models to what the borrower's rate is," he said. The servicer requested anonymity because of the sensitive nature of sharing his hedging strategies.

An increase in hedging activity means higher costs for servicers. "What you can start to see is more volatility in the market, which generally makes the cost of hedging more expensive," the executive said. The servicer has been reevaluating its hedging strategy since the Fed announced in September its plans to wind down its purchases of MBS.

To be sure, it is not axiomatic that the Fed's pullback will lead to higher interest rates.

Fed chairman Ben Bernanke said during a congressional hearing that the central bank had been concerned mortgage rates could pop once it stopped its MBS purchases. "But so far there seems to be very little negative reaction, which is encouraging," he said.

Most analysts though are expecting at least a slight increase.

"I think the prevailing expectation is, the interest rate is going to go up when the Fed backs out," said Rob Kessel, managing director and co-founder of Compass Analytics LLC, a San Rafael, Calif., company that develops mortgage analytics and provides risk management advisory services.

Even the perception that rates could edge upward is enough to lead servicers to increase hedging.

"While the Fed was buying, they stabilized the prices of those securities. Servicers and other participants didn't have to hedge price volatility...too much," said Greg Reiter, senior agency MBS strategist at Royal Bank of Scotland's RBS Securities Inc. "It would have been wasteful to hedge with the Fed buying."

Servicers can hedge interest rate and prepayment speed volatility in a handful of ways, usually by buying derivatives, Treasurys or other securities or by entering into swap transactions.

The idea is to protect the servicing portfolio, if mortgage rates drop, by pulling in income from investments. If rates rise, income from the servicing portfolio should offset any investment losses.

When rates fall, the value of a servicing portfolio declines because borrowers are more likely to refinance their mortgages, which reduces the duration of the loan in the portfolio. When rates rise, the servicing portfolio becomes more valuable as borrowers become less likely to refinance, preserving the loans within a portfolio.

Since the Fed began buying MBS in late 2008, mortgage rates have fallen to historic lows.

Sara Lepro is a reporter for American Banker.

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