Countrywide Benefits from 'Multidimensional' Hedge

Saying that Countrywide Financial Corp. has "among the most flexible hedging regime" in the industry, a stock analyst here says the company has positioned itself well to withstand interest rate gyrations such as the ones experienced this summer.

And its hedging strategy may be less of a drag on increasing MSR values in a rising rate environment than many peer companies will experience, according to David Hendler of Credit Sights, New York.

While other lenders may be hurt by "negative whiplash" from mortgage-related hedges that were designed for a falling rate environment, Countrywide has put in place options-based hedges that will expire without an effect on fair values or earnings as interest rates rise, according to Mr. Hendler.

But there is a cost for this "insurance-like policy" - the premiums Countrywide must pay on the options.

Countrywide has said it is vigilant with regard to "fat-tail" risk, Mr. Hendler said. That condition exists when interest rates react sharply and unfavorably, thwarting the effectiveness of hedging programs that are designed to mitigate gradual rate shifts.

But Countrywide, by using more option-based hedges that fade away when the mortgage durations extend and servicing accretes in value, avoids the Catch-22 of losing value on its hedges when rates rise.

"In effect it is hedging its hedges, safeguarding the overall franchise from the hazards of convexity risk," Mr. Hendler said in his report.

Countrywide's hedging strategy allows it to benefit from "asymmetrical benefits" that would be lost under a more conventional hedging strategy. That way, most of Countrywide's servicing appreciation runs through earnings and is not offset by hedging losses.

Some servicers that rely on derivative positions and other cash hedges designed to enhance results when interest rates decline find these hedges are difficult to offload when rates rise, the analyst said.

Mr. Hendler says that Countrywide "presents much better details" than many mortgage bankers, with a breakdown of the estimated change in fair values for MSRs and other retained interests, the committed pipeline and mortgage loan inventory, and other balance sheet items.

"The interesting pattern that emerges is that for MSR and other retained interest is that the impact of hedges when rates rise is less in magnitude than the impact of hedges during falling rates," he said.

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