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Servicing Profits Return as Rates Rise

Last year, gravity pulled the industry's profitability back toward earth after a stratospherically successful 2003, but servicing rights helped many lenders weather the fall to some extent.

While servicing profits fell 50% last year, according to a recent cost study from the Mortgage Bankers Association, servicing reversed its course and turned profitable after being hampered by heavy refinancing in 2003.

In fact, secondary marketing income - which includes capitalized loan servicing rights - averaged $1,661 per loan in 2004. That made secondary marketing income, fueled in part by improved servicing values, the biggest contributor to the bottom line of the mortgage industry last year.

Lower amortization and impairment expense was, not surprisingly, the key to improved servicing performance. Per loan financial profits from servicing, net of hedging gains and losses, averaged $21 last year. While that doesn't sound like much, it's a dramatic improvement from a net loss of $166 per loan on average in 2003, when record-breaking refinancing fueled portfolio runoff.

The largest servicers reported stronger operational results than smaller servicers, but they also took larger impairment and amortization hits than smaller servicers, the MBA noted.

Marina Walsh, an MBA economist, told MSN that the cost survey raises questions about the ability of servicing to act as a natural hedge against declines in loan origination profitability. That's because servicing profits, relative to loan funding profits, are a small component of the industry's total earnings. In short, it's easier for top funders to offset loan servicing losses in a low rate environment than it is for servicers to offset lost loan origination income in a rising rate environment. In addition, because large servicers hedge the interest rate risk inherent in their portfolios, some of the gains that could be accrued in a rising rate environment are wiped out by hedging.

Moreover, servicing values fall faster in a declining rate environment than they rise when interest rates go up. "A lot of companies got burned in the last few years because they had to take huge impairment to their mortgage servicing rights," Ms. Walsh noted.

Last year, mortgage production profits fell to an average of $657 per loan, down from $1,272 per loan in 2003, according to the MBA. Even so, loan origination profits as a per-loan average far outpaced the $21 per loan profit from servicing.

Narrowing interest spreads on warehouse lines, increased pricing pressure, and higher sales and fulfillment costs on a per-loan basis were the culprits behind the sharp decline in loan production profitability, according to the MBA. However, the MBA believes that 2003 was by far the most profitable year in history for the mortgage industry.

The MBA's cost study in its current form only goes back a few years. But Ms. Walsh said based on historical lending volume numbers, 2004 probably doesn't look that bad except in comparison to the record breaking year before. "We are kind of looking at 2001 and 2002 figures. 2001 was sort of the beginning of the refi boom and that was considered a good year," she said.

Ms. Walsh noted that despite the challenges of managing the financial asset of servicing rights, lenders have registered steady improvement in operational results.

Servicers reported net servicing operational income of $395 per loan in 2004, up from $363 in 2003. That number has grown steadily if unspectacularly in recent years, according to the MBA's cost of servicing study, a separate initiative from the overall annual cost study.

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