Analyst Praises SunTrust’s MSRs

SunTrust Banks, the 10th largest bank in the U.S., is poised to reap greater benefits from an improving economy than some of its rivals, according to a recent report from Sandler O'Neill.

And mortgage servicing is one of the business lines that should help SunTrust outpace its competitors in an improving economy, Sandler O'Neill vice president Kevin Fitzsimmons said in his report.

Other strengths for SunTrust include its wealth management, investment banking and large corporate lending business units.

SunTrust's exposure to areas hardest hit by the economic environment in recent years, including mortgage servicing, contributed to its sluggishness, according to Sandler O'Neill.

SunTrust, which services $64 billion of home loans, is a top-20 mortgage servicer, Sandler O'Neill noted. This business should benefit from slower prepayments as rates rise, helping to offset lower loan origination volume.

"We expect the likely increase in mortgage servicing income to be viewed as higher quality vs. that of most peers, mainly stemming from SunTrust's more conservative approach to adjusting the values of MSR assets," Mr. Fitzsimmons said.

By contrast, most competitors use a pooled approach to valuing MSRs, while SunTrust uses a loan-by-loan approach, actually attaching an MSR asset to each related loan. That way, if a loan prepays, the MSR asset is gone as well.

That means SunTrust absorbs the full impact of changing values of its MSRs entirely through amortization expenses. Since it does not use an allowance, it does not incur impairments or recaptures.

As a result, as prepayments slow, SunTrust will incur falling MSR amortization expenses, which "should unmask positive mortgage servicing revenues."

Competitors, meanwhile, will write up the value of their MSRs by taking large recaptures from their MSR allowance, which investors may view as "less core" in terms of operating earnings, the Sandler O'Neill report said.

In addition, since SunTrust doesn't hedge its mortgage servicing business beyond the natural hedge of its loan production business, the potential upside to its servicing will not likely be diluted from offsetting losses on hedges as rates rise, Sandler O'Neill said.

Sandler O'Neill initiated coverage of SunTrust Banks with a "buy" rating and established a price target of $68 per share. Last week, SunTrust shares were trading at just over $60, or about 12 times Sandler O'Neill's 2004 EPS estimate for the firm.

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