Happy Days Are Here Again for Hedge Managers

As Charles Dickens once wrote: "It was the best of times; it was the worst of times." The first quarter may have seen a falloff in loan origination volume, but most big lenders posted solid gains from their mortgage servicing portfolios as rates edged upward.

The average 30-year mortgage rate ended the first quarter about a quarter percentage point higher than at the beginning of the quarter, which provided modest support for servicing values and facilitated the recovery of "impairment reserves" on the books of many lenders.

Countrywide Home Loans was among the lenders benefiting from servicing gains in the first quarter.

Countrywide reported a relatively modest $17 million in earnings from loan servicing during the first quarter, but that modest gain was a whopping $295 million improvement from the $278 million MSR loss suffered a year earlier.

But because of LOCOM (lower of cost or market) accounting, Countrywide's servicing earnings do not take into account a $160 million increase in the value of the company's MSR portfolio. In the future, Countrywide may not be so encumbered by its accounting practices.

Countrywide said that for the second quarter of this year, it has implemented hedge accounting for certain strata of its MSRs, "which may remove the LOCOM constraint for those strata."

And Countrywide continues to grow its servicing portfolio at a fast clip. As of March 31, the company serviced $893 billion of home loans, up $55 billion from one year earlier. The weighted average coupon on the portfolio was 5.9%, down 10 basis points from one year earlier. The capitalization rate on the MSR portfolio is 122 basis points, up from 103 basis points one year earlier.

Countrywide touts its large servicing portfolio as a "natural hedge" against declining loan origination income as interest rates rise.

Wells Fargo, the nation's second-largest mortgage servicer, also benefited from rising servicing values, according to the head of the company's home and consumer finance unit.

"The rise in interest rates during the quarter and the growth in the servicing portfolio resulted in an increase in the mortgage servicing rights asset to $9 billion, or 1.24% of loans serviced for others, up from $7.9 billion, or 1.15%, at year-end," he said in the company's earnings release.

Wells Fargo was able to recapture $271 million of impairment reserve related to the MSR asset during the first quarter.

Wells Fargo said it has grown its MSR portfolio every year since re-entering the business in 1990, even as repeated refinancing booms sapped the strength of some servicing rivals. Mr. Oman said the company now serves more than five million mortgage customers, and the average duration of the MSR asset increased to 5.1 years from 4.5 years at the end of last year. An increased life span for the MSR asset means Wells Fargo expects to collect revenue over a longer period of time, reducing amortization costs.

And in something of a twist, Wells Fargo also reaped net derivative gains from hedging activities totaling $85 million in the quarter. Combined, the hedging gains and the release of impairment reserve contributed $356 million to MSR revenue in the first quarter. Wells Fargo still has $1.3 billion in valuation allowance on its books that could be recaptured if rates continue to drift upward.

Washington Mutual, the nation's third-largest servicer of home loans, also reported a higher MSR valuation at March 31. WaMu's portfolio was valued at $6.8 billion at the end of the quarter, a capitalization rate of 125 basis points.

The turnaround for servicing was stark at WaMu. In the first quarter of 2005, WaMu's servicing income totaled $407 million, compared to a loss of $920 million a year earlier.

And more improvement may be coming. WaMu still has $1.5 billion in "roll forward" valuation allowance assigned to the MSR asset that could be recaptured.

WaMu serviced $778 billion of home loans from its own portfolio and for others as of March 31, up from $769 billion a year earlier. The average coupon on the portfolio was 5.83% at the end of the first quarter.

That servicing income helped WaMu post $243 million in earnings from its mortgage unit in the first quarter, up from $142 million in the fourth quarter and $228 million in the first quarter of 2004.

In addition to favorable MSR performance, WaMu said that higher gain from mortgage loan sales and lower non-interest expense also contributed to the increase in earnings.

But CFO Tom Casey reminded investors on the company's conference call to discuss first-quarter results that the MSR asset is very sensitive to changes in interest rates.

"We manage it for the long term as one component of the mortgage business and would not necessarily expect this level of performance going forward," he said. "While we've had a good quarter, it is important to remember that the MSR is a complex asset that is highly sensitive to changes in market conditions."

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