WaMu Revision Puts Focus on Basis Risk

A number of factors contributed to Washin-gton Mutual's recent announcement that it was reducing earnings guidance for this year, with an expected decline in mortgage origination volume playing a big role in the company's anticipation that mortgage banking revenue will decline.

But WaMu also said that its hedging of mortgage servicing rights also is a factor in the weaker outlook for mortgage banking, as MSN reported in our July edition.

The company's revision to earnings guidance sheds a little more light on the specific problem with hedging, and it's an issue that could affect other large lenders as well.

However, some stock analysts, including Jonathan Gray of Sanford C. Bernstein & Co., have said that WaMu's problem appears to be company specific rather than industrywide. In a research note following WaMu's reduced guidance, he argued that WaMu's servicing hedge is too large for its own good, swamping any benefit higher rates would provide the MSR value.

WaMu cited two concerns related to hedging in its June 28 announcement. First, the cost of hedging its mortgage servicing portfolio in a rising rate environment is going to rise, the company said.

Also, "significantly tightening basis spreads" mean that while the company's huge portfolio of MSRs rose in value during the second quarter, the company expected the losses it would take on hedging instruments to exceed the gains reported on the MSRs. In an ideal world, any lender would like to have the opposite happen.

The tighter basis spread between the mortgage and interest rate swap indices are behind the problem, WaMu said.

"Our risk management approach does not attempt to fully hedge the effects of changes in basis spreads," executive vice president and chief financial officer Tom Casey said in the company's announcement. "While basis spreads vary over time around a historical mean, a significant widening or tightening of basis spreads in any one quarter can affect net income. Our hedging results benefit when spreads are wider, as they were in the fourth quarter of 2003 and the first quarter of 2004, and will be negatively affected as spreads tighten, as they have the second quarter of this year."

As this edition of MSN went to press, WaMu had yet to release its second-quarter earnings. The second-quarter results should shed light on just how much of a bite the servicing hedge takes out of earnings.

WaMu also cited lower loan production volume and incomplete cost cutting moves as factors in the decision to lower guidance.

The company now estimates that 2004 earnings per share will be in the range of $3 to $3.60. Last year, WaMu reported earning $1.44 per share from its mortgage banking business. In the first quarter of this year, WaMu earned $0.25 per share from mortgage banking, and the company now estimates that it could lose money from its mortgage banking operations for the full year. WaMu projects that mortgage banking income will contribute between a loss of 15 cents per share and a gain of 35 cents per share to its earnings this year.

That would be quite a reversal from last year, when mortgage banking accounted for more than a third of WaMu's earnings per share.

WaMu said that its new earnings guidance assumes that the fed funds rate will gradually increase by 75 to 125 basis points during the second half of the year and that the 10-year Treasury yield will end the year between 4.5% and 5.0%.

The company's loan pipeline hedging has not been adversely affected, WaMu said.

In addition to reducing total mortgage originations, WaMu said the rising rate conditions will mean that more adjustable-rate loans will be originated for its portfolio, reducing gains related to mortgage loan sales.

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