'Easing Up' on Hedging Can Backfire
The second quarter wasn't an easy time to hedge servicing rights, it turns out. Just ask Washington Mutual. But WaMu wasn't alone in taking a hit related to the change in basis spread that caused some lenders to lose more on their hedge instruments than they gained on their servicing rights as interest rates rose.
Fifth Third Bancorp., Cincinnati, for instance, disclosed in its second quarter results that $43 million in losses on derivatives apparently used to hedge the servicing portfolio outweighed the $34 million in valuation and amortization gains posted for the servicing rights. Because mortgage banking accounts for a smaller share of income at Fifth Third and other banks that found themselves hamstrung by volatile rate conditions in the second quarter, the hit they took related to servicing hedges didn't garner as much publicity as WaMu's situation.
In short, the second quarter left little doubt that hedging strategies can add volatility to profit margins for companies that own mortgage servicing rights.
But even lenders that took a hit on servicing in the second quarter say they are poised to see better results in the second half of this year, especially if rates continue to trend upward.
In a conference call to discuss second quarter results, IndyMac Bancorp's chairman and CEO, Michael Perry, said the company had "a terrible quarter on the servicing asset" despite achieving record pro-forma earnings.
He said the company "eased up" on hedging to heed a bias toward rising interest rates, only to see that strategy backfire when rates dipped again toward the end of the second quarter.
But the second quarter misfortune on servicing results may have a silver lining in the third quarter and beyond, Mr. Perry suggested.
IndyMac, which valued its servicing asset at 142 basis points in the third quarter, has $200 million of capital tied up in the asset, Mr. Perry said. But he indicated that servicing remains a key element of IndyMac's business.
"Given the fact that we have a very small direct-to-consumer business, we wouldn't have obtained the loans from refinancing except from the servicing portfolio," he noted during the call.
Charlotte Chamberlain, an analyst at Jefferies & Co., suggested during the call that IndyMac's valuation "looks to be fairly aggressive."
But Mr. Perry defended the company's MSR valuation, saying it represents a smaller percentage increase in valuation than most other large lenders.
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