Calling All Hedge Managers: Don't Let Your Guard Down

This could be the year. 2004 may mark the end of the refinancing boom. Economists predict that economic growth will accelerate and mortgage rates will edge upward over the course of the year. That means mortgage servicing portfolios will rise in value. Portfolio runoff will ease. And impairment and amortization-related writedowns will become yesterday's news.


You see, the problem is that the outlook for this year is similar to the outlook for last year at this time. Instead, the industry saw rates edge downward to new record lows last year, sparking a continuation of the three-year-old refinancing boom that has left lenders scrambling to manage portfolio runoff and explain amortization and impairment charges to senior management.

The outlook suggests that is going to change this year. And once again, mortgage servicing should become a source that adds profitability to the bottom line rather than a business segment that slows down the huge gains associated with strong loan production. But if there's one lesson to be learned from the mortgage environment in recent years it is that even when it seems inevitable that the refinancing boom has finally come to a close, the fun may not be over.

Sure, the economy grew at an 8.2% annual rate in the third quarter of last year - the fastest rate of growth recorded in several decades. But that was boosted by tax refunds to consumers, continued improvement in consumer balance sheets due to refinancing, and a continuation of the robust housing market.

To be sure, as MBA chief economist Douglas Duncan has pointed out, the economic growth seen late last year appears to be more widespread and robust than it was earlier in the recovery. Capital spending, inventories and employment are starting to show improvement, factors that should add to confidence about the durability of the recovery, Mr. Duncan said in a recent MBA economic commentary.

"The more balanced recovery" now underway reduces markedly the chances that the expansion will falter by reason of its earlier lopsided character, he said.

Even though the housing stimulus may be largely behind us, the MBA economist believes that his forecast for 4.2% growth in gross domestic product this year may be too conservative.

But there are indications that interest rates will stay low. As Mr. Duncan points out, slack labor markets are limiting wage increases. And a combination of excess manufacturing capacity and stiff competition from other countries has limited businesses' pricing power. Productivity gains, by pushing down labor unit costs, are also helping to keep inflation in check, which should help keep interest rates down.

But those same factors putting downward pressure on rates could come back to haunt servicers if the economic expansion proves to be more ephemeral than it looks now. The factors keeping inflation and interest rates on the low side look pretty reliable this year. As we've learned during the last couple of years, economic expansions can be fragile, and any additional weakness in the labor markets could have the mortgage industry looking at record low interest rates again this year.

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