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MSR Risk Attracting Attention of Regulators, Rating Agencies

Fitch Ratings recently placed Countrywide Financial Corp. on notice that it could see a downgrade on its debt rating because of concern about the valuation and durability of its mortgage servicing rights. And Fitch isn't the only organization paying more attention to MSRs these days. Other lending giants may come under scrutiny from federal banking regulators, which recently announced plans to devote increased scrutiny to MSRs held by subsidiaries of large depository institutions.

Fitch cited the "increasing risk of impairment" to Countrywide's servicing portfolio as the primary reason for its action, noting that all mortgage lenders face a potential hit to their mortgage servicing rights if rates fall.

But Fitch said the impairment risk is particularly high for those companies, such as Countrywide, with high levels of capitalized mortgage servicing rights as a percentage of equity and a heavy concentration in the mortgage business.

In addition, the Fitch statement said that Countrywide's MSR portfolio includes an increasing level of subprime loans, home equity lines of credit, jumbo mortgages and adjustable-rate mortgages "which we believe are far more difficult to model and hedge" than conventional mortgage products.

Fitch alleges that Countrywide's MSR values are generated using "aggressive" valuation assumptions, including cross-sell income and late-fee income. Countrywide vigorously denies that its assumptions are aggressive compared to other lenders.

"Given the changing dynamics of the mortgage banking industry, Fitch believes that the difficulty in hedging the volatility of MSRs will likely increase in the future," the rating agency said.

That's certainly a plausible statement, but it might have made more sense before the start of the current refinancing boom in 2001. Another plausible scenario is that the opposite may be true - that, given the low coupon rate on loans originated over the last two years, MSR volatility going forward may actually decline.

While refinancing has become easier than ever, it will only take a modest rise in rates to put a lid on the heavy portfolio churning that characterized 2001, 2002 and early 2003. The refi boom may not be out of fuel yet, but the gas tank isn't full, either. If rates do rise, Countrywide and other large lenders will see the value of their MSR portfolios rise.

Thomas Abruzzo, a Fitch analyst, said the rating agency does not currently have plans to place other mortgage- related companies on the watch list.

"There really are not a lot of companies out there that meet the profile of a Countrywide," he told MSN.

As a standalone company that funds its mortgage operations through the capital markets, he said Countrywide is less broad-based than other mortgage firms that are subsidiaries of larger banking corporations.

Responding to the Fitch action, Countrywide released a statement saying that it has produced record earnings despite the impact of falling rates on its MSR portfolio. Countrywide also said it has been successful in hedging its portfolio, noting that the company produced a gain of $1.8 billion from its servicing hedge in 2002.

Countrywide said it has historically leveraged its MSRs with associated debt at roughly three times equity, a ratio it says is "substantially more conservative" than other mortgage bankers.

"Countrywide management believes that the company is in the strongest position in its history and is well positioned for the future," chairman, president and CEO Angelo Mozilo said.

He said Countrywide's servicing portfolio on $469 billion of home loans "is positioned to generate significant earnings when interest rates ultimately rise."

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