Are FAS 133 and Falling Rates a Toxic Mix for Portfolio Managers?

For some lenders, the implementation of tough new accounting rules for treatment of hedging activities followed by a prolonged period of falling interest rates has proven to be a disastrous combination.

Take, for instance, Matrix Bancorp. of Denver. Matrix reported an after-tax net loss for the third quarter of this year totaling $5.2 million, reflecting several writedowns related to the company's mortgage servicing portfolio.

Specifically, the company took an aggregate charge of $9.6 million against the value of its mortgage servicing rights and $8 million of that was in the form of a non-cash impairment reserve against the company's investment in MSRs, increasing the total impairment reserve to $9.4 million. The company also increased its amortization of mortgage servicing rights by $900,000 from the second-quarter level.

In a statement issued by the company, co-CEO and chairman Richard Schmitz acknowledged that the third quarter was a difficult one for the company, and he placed the blame squarely on the company's investment in MSRs.

"Due to the high level of amortization, which is in response to increased prepayments, our investment in mortgage servicing has been very unprofitable this year," he said.

Matrix's timing wasn't very good it turns out. In the spring of 2001, perhaps believing that the era of constant refinancing had come to a close, the company decided not to hedge its servicing portfolio "due to the difficulty of achieving hedge accounting and the overall cost of maintaining a hedging program," Mr. Schmitz said.

In the third quarter of this year, having been already smitten pretty badly by prepayments, Matrix revisited the issue. But the accounting treatment under Financial Accounting Standard 133, the historically low rate environment, and the cost of instituting a hedging program once again forced the company to look at other options.

Beginning in August, the company started selling the majority of its newly originated mortgage servicing rights "with the intent of significantly decreasing our investment in mortgage servicing rights over the next several quarters," Mr. Schmitz said.

As market conditions allow, the company said it might make strategic sales of MSRs to further reduce its risk exposure.

"We anticipate that once interest rates begin to rise, we will recover a portion, if not all, of our impairment reserve," Mr. Schmitz said.

Mark Spencer, the company's other co-CEO, said it is unfortunate that the servicing rights impairment "may tend to overshadow some very positive trends" experienced by Matrix in the quarter, including growth in the company's real estate disposition services business.

Matrix's predicament is instructive not because it is unique, but because it is common among midsize mortgage servicers. The cost and complexity of hedging can discourage lenders from doing it - leaving them vulnerable to shocks to their earnings stability when rates fall and refinancing picks up.

That leaves lenders facing a choice, either live with the balance sheet instability that choosing not to hedge entails, or sell off servicing rights and minimize your exposure.

My guess is that when the dust settles from the rolling refinancing boom of 2001 and 2002, an awful lot of midsize lenders will choose to re-evaluate their commitment to the mortgage servicing business.

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