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Rate Dip in March Puts Squeeze on 'Natural Hedge' Strategy

With 30-year mortgage rates dipping to their lowest level since last July, the mortgage industry is likely to have another blockbuster year. But you might not know it from reading first quarter earnings reports.

That's because a recent boom in lending also means that impairment is rearing its ugly head again, threatening to blemish the balance sheets of mortgage servicers at the end of the first quarter. And the timing of the recent rate dip could obscure any offsetting benefit lenders receive from a surge of loan origination activity.

During the week of March 26, the average 30-year mortgage rate had risen slightly from 5.38% to 5.40%, but still was within roughly 20 basis points of the record lows seen last June. The 10-year Treasury rate, to which mortgage rates are closely tied, was about 50 basis points lower than at the end of last year.

Not surprisingly, refinancing has once again surged as a result, notes analyst Mike McMahon of Sandler O'Neill. Higher prepayment expectations will force lenders to reduce servicing valuations, he said in a recent report.

"Clearly, any entity with mortgage servicing rights on their books is going to be vulnerable at quarter-end to an impairment charge," Mr. McMahon told MSN.

The timing of the Treasury rally that has brought rates down means the mortgage industry will probably see more negative surprises than positive ones when companies start reporting first-quarter results, he said in late March. And those companies that "go naked," meaning they don't hedge their mortgage servicing rights, may leave investors feeling over-exposed to interest rate movements.

Companies that utilize a financial hedge will probably enjoy hedging gains that will likely offset much of the impairment. But companies that rely primarily upon loan origination capacity to hedge prepayments face an unpleasant timing issue because very few of the loan applications will actually fund prior to the end of the month, Mr. McMahon said in his report.

Loan applications taken in March are not likely to fund until April or May, which will defer loan sale gains until the second quarter, he noted. That creates a timing difference between impairment charges and loan sale gains.

Additionally, companies that have "impairment recoveries embedded in their 2004 earnings guidance could have issues," Mr. McMahon said.

And that renewed volatility in the mortgage sector may cause some banks to become disillusioned with the mortgage business line, Mr. McMahon said. "I firmly believe that you either have to be in the business in the big way or you have to get out," he said.

The stock prices of companies that have significant mortgage banking volatility are trading at a lower multiple than firms with steadier earnings, he said. Washington Mutual's stock, for instance, has been trading at just over 10 times earnings, while Golden West has been trading at over 14 times earnings recently. Golden West, which derives much of its earnings from net interest income on loans held in portfolio, has had steady earnings growth and doesn't have to manage gain-on-sale or hedge accounting.

"Companies that have high valuations generally don't have to explain timing issues in their earnings," Mr. McMahon said.

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