Servicing Hedge Part of WaMu's Challenge

Everyone knows that loan origination volume is declining as rates rise, but when the nation's largest mortgage servicer warned that mortgage income is likely to fall short of expectations this year, it cited servicing rights as part of the problem.

Washington Mutual chairman and CEO Kerry Killinger, acknowledging that 2004 is shaping up to be a "transition year" as rates rise and refinancing slows, said at a recent investors conference sponsored by Sanford C. Bernstein & Co. that mortgage banking will be a less powerful component of WaMu's performance this year than it has been in the past.

In a research note on WaMu, Bernstein analyst Jonathan Gray reduced his rating on the company to "market perform" from buy, in part because of management's disclosure that the servicing hedge is not performing as planned.

He reduced his 2005 earnings-per-share estimate by 3% "to reflect our more conservative 'guesstimate' of the future behavior of the servicing hedge."

Mr. Gray said in a recent research note that "poor visibility" makes it difficult to anticipate WaMu's performance.

"Disclosure of information that better explains MSR hedging, and the EPS impact of the aggressive branch expansion, would improve visibility, reduce investment risk, and warrant better valuation," Mr. Gray wrote.

While hedging should offset servicing declines when rates fall and servicing gains when rates rise, Mr. Gray wrote that hedging usually mutes but does not eliminate this trend. In WaMu's case, he suggested the servicing hedge may be "too powerful," offsetting all of the upside for rising rates on the mortgage servicing portfolio.

For their part, WaMu executives remain largely upbeat about the company's prospects this year, despite acknowledging that mortgage banking earnings will likely decline.

While not providing new earnings guidance, Mr. Killinger said during an investors conference last week that WaMu's outlook for mortgage banking earnings is "more cautious" than it was as recently as early April.

But he said growth in other areas and planned cost cutting should reinforce the company's long-term earnings growth strategy.

"We are anticipating some pressure in our mortgage banking business because of the shifting economic and interest rate environment," he said during the Sanford C. Bernstein & Co. conference.

But at the same time, he reiterated WaMu's commitment to seeking growth in its core businesses, saying that the company's retail and commercial banking businesses "will likely continue their growth trajectory" this year.

Mr. Killinger said WaMu's strategy is to expand its business providing retail banking services for the broad middle market of "average, everyday people" in the United States.

WaMu today is America's seventh-largest financial services organization as measured by assets.

He said home loans and checking accounts provide a key anchor for consumer relationships that facilitate cross-sales of other products and services.

In the first quarter, WaMu's retail checking account business had grown by a net of 800,000 accounts from 12 months earlier.

Home equity lending has also been growing at a fast rate, he said. WaMu's home equity business has grown by 81% since 2001, growing to over $31 billion held in portfolio.

Mr. Killinger said that WaMu has only in the past year or two started focusing on marketing home equity loans to its mortgage customers, increasing the home equity product penetration rate from about 3% of mortgage customers to 5% in about the last year.

In addition, cost reductions will continue to be an important strategy for growing earnings, particularly in the third and fourth quarters as technology initiatives in the mortgage area are completed.

He advised investors and analysts that because of WaMu's strategy of hedging the value of its mortgage servicing rights, much of the benefit of rising rates on the value of the MSR asset will not be realized, just as much of the cost of falling rates has been hedged out as a result of the strategy of reducing volatility to the MSR portfolio.

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