Hidden Elements of Rate Risk Vex Hedge Strategists

If it's not one thing, it's another. That's the problem with hedging.

Just ask Andrew Hickman of ERisk, baed in New York. Mr. Hickman spoke at a U.S. Bancorp Piper Jaffray investor conference in New York, where he advised that lenders face hidden interest rate risk that can be as important as the rate risk that is disclosed.

For instance, banks benefit from rising home loan volume in a falling interest rate environment. But they also face a likely increase in bad loans, since a weak economy is typically what spurs the Federal Reserve Board to lower interest rates.

"Charge-offs are actually quite sensitive to interest rate risk," Mr. Hickman said during the conference.

On the bright side, low rates in the most recent economic cycle have helped to boost commercial real estate values and keep real estate credit problems at bay, he said. With the lowest interest rates in nearly half a century, property owners were able to restructure their debt burdens in the face of rising vacancy rates.

"This past cycle, we've kind of dodged the bullet on property values," Mr. Hickman said.

But that begs the question, if rates rise, how much might property values fall? And if loan-to-value ratios rise, will that lead to higher charge-offs on commercial real estate loans. Mr. Hickman said these are some of the questions bankers should be asking themselves.

And in the mortgage banking arena, the decision about whether or not to hedge mortgage servicing rights is not always an easy one.

"The accounting is kind of stacked against you," Mr. Hickman noted.

If a lender does not hedge, they have to recognize impairment immediately when rates fall. But when rates rise, servicing income over time will beat out amortization costs.

On the other hand, if they do hedge, they will not realize the full benefit of rising interest rates on the value of the mortgage servicing portfolio. As a result, Mr. Hickman says, they may find that as loan production revenues dry up, they won't have anything to offset the expenses associated with their servicing business.

Talk about damned if you do and damned if you don't.

But Mr. Hickman sees something of a solution in disclosure. By disclosing more information about rate risk to investors, lenders may be able to persuade investors to be more tolerant of the income volatility associated with interest rate risk.

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