Interest Spreads, MSRs a Concern for Portfolio Lenders

Analysts at Merrill Lynch have downgraded the stocks of several prominent financial companies, in most cases citing margin pressure from a flattening yield curve as the culprit behind the lower expectations. But firms with large MSR portfolios could see additional problems if long-term interest rates continue to slide.

That flatter yield curve will have consequences for firms that hold adjustable-rate, hybrid and other home loans in portfolio. In addition, some analysts have expressed concern that June's dip in long-term interest rates could force lenders to report impairment to the value of their mortgage servicing rights in the second quarter.

Among the firms downgraded by Merrill Lynch were North Fork Bancorp, which was downgraded from a "buy" rating to "neutral." Merrill Lynch noted that North Fork generates more of its revenue and earnings, at 16% and 26%, respectively, from "carry trade" than other large regional banks. A flatter yield curve will put interest margin pressure on the bank, the report said.

In addition, Merrill Lynch said that North Fork's mortgage origination volume, which has accounted for 16% of revenue, is likely to remain relatively flat in the second quarter. Merrill Lynch's earnings estimates for the firm are 1.7% below the consensus estimate for this year and 4.2% lower for next year.

"Our valuation framework now indicates a 12-month theoretical fair value of $30," the Merrill Lynch report said.

Other lenders that were downgraded include Regions Financial, which was downgraded from "neutral" to "sell," Bank of New York, downgraded from "buy" to "neutral" and Trizec Properties, downgraded from "buy" to "neutral."

In the case of Regions Financial, Merrill Lynch noted that the stock already is trading at an 11% premium to the median for other large regional banks based on Merrill Lynch's model.

Merrill Lynch's valuation work indicates that fair value for Regions Financial was about 15% lower than the stock's trading price in early June.

In the case of Bank of New York, Merrill Lynch indicated that it expects trade volumes, particularly in retail equities, to become weaker in the second quarter and into the summer, providing a "weaker growth backdrop" than the company has had in the past.

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