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Reserves Will Offset Hedge Losses When Rates Rise

In what seems like an eternal refinancing wave, it may be premature to worry about what happens when interest rates start to rise. After all, in the first week of this year, the average rate on fixed-rate, 30-year mortgage loans fell to 5.85%, a low not seen since the early 1960s.

But we all know that rates will one day rise again. And according to analysts at Merrill Lynch, accounting changes for the treatment of mortgage servicing rights may actually help lenders when that happens.

Of course, while rising rates will depress loan origination, lenders stand to benefit from rising MSR values when rates go up. Even more so now than during previous refinancing booms, according to Merrill Lynch's San Francisco- based mortgage finance analysts William Roy and Michael Hughes.

In a recent report, the analysts note that most of the industry's largest mortgage servicers have aggressively written down the value of their MSR assets by creating impairment reserves against those assets to reflect the impact of lower interest rates.

"These impairment reserves did not exist in the previous down cycle and will serve to offset hedge losses as interest rates rise during the next downturn," their report says.

Consolidation, leading to fewer competitors in the marketplace and fewer vicious price wars to compete for dwindling loan origination volume, and the new impairment reserves are among the most significant changes in the mortgage industry that have taken shape during the past few years. Both changes stand to benefit the industry, according to Merrill Lynch.

Moreover, they expect the nation's mega-servicers to lobby the secondary market agencies for lower capitalization requirements for holding MSRs. Historically, servicers have had to hold a 25 basis point servicing fee on loans sold to Fannie Mae and Freddie Mac, but there are some indications that the agencies may be willing to consider a lower servicing fee.

"We believe that the year 2003 will mark the beginning of a crusade amongst certain large mortgage banks to permanently reduce the capitalization requirements on mortgage servicing rights," the Merrill Lynch report on investment themes in the mortgage finance sector said.

"Such changes would serve to increase the level of cash a mortgage bank is able to take out of the deal during the securitization process and still retain loan servicer status."

Those changes, if enacted, would bolster the stock prices for these mortgage banks, according to Merrill Lynch, by allowing the industry to operate more profitably on higher cash flows and less volatility.

Overall, Merrill Lynch is bullish on the mortgage sector, rejecting the notion that investors should avoid buying mortgage stocks at the peak of the lending cycle.

While they believe the stock prices could fall by 5% to 10% if rates rise and lending volume contracts, they believe the values will bounce back up once investors regain confidence in the ability of mortgage companies to continue growing earnings in a rising rate environment.

"I think the psychology in the group will also roll over and there will be some pressure on the stocks in the short term," Mr. Roy told MSN. "That's the kind of negative sentiment that I think will enter the group and push the stocks a little bit lower."

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