Want unlimited access to top ideas and insights?
Third quarter earnings are in for the residential mortgage industry and the results show both challenges and opportunities in a volatile interest rate market. The rally in the Treasury market has made selling loans into the secondary market more attractive and also boosted lending volumes, but the cost of hedging and other expenses can hurt overall profitability.
For example,
The ebb and flow of interest rates
Market leader United Wholesale Mortgage, for example,
"We do not hedge our MSRs," Ishiba told the analysts who follow the UWM stock in a discussion hosted by BTIG Managing Director Eric Hagen. "Obviously, the ten-year [Treasury note] goes up and down. The MBS, the rates go up and down. How it finishes, depending on how it started, it ties to an MSR loss. Anyone… anyone that fucking focuses on the MSRs and the fair value just does not understand mortgages."
When it comes to hedging MSRs, Ishbia is entirely right. The "fair value" of the MSR is a matter of indifference to sophisticated lenders such as JPMorgan, UWM, PennyMac and Rocket, which all have large MSR portfolios. Instead, the yield on the MSR and the optionality it represents are the key assets.
In this writer's biography of Freedom Mortgage founder Stan Middleman, we noted that negative duration MSRs are a natural hedge for loans. Mortgage lenders must hedge loan pipelines because of interest rate volatility, but in a well run bank or mortgage firm, new lending is a hedge for the MSR.
"Loans and fixed income securities, such as bonds, generally have positive duration," we wrote in "
Duration is a fancy term for how long it takes for you as an investor to receive your money back. Because of the negative duration of servicing assets, however, MSRs are actually a great financial and economic hedge for a residential loan portfolio.
Nonbank financial companies do not have large portfolios of loans like a depository, thus the hedge example is less precise than for a bank. Before the Basel III bank capital regime demonized MSRs based upon European antagonism toward intangible assets, mortgage servicing was an important capital asset for banks large and small, and often helped small depositories weather periods of economic stress.
Yet large nonbank firms such as Freedom and UWM have flourished by eschewing the expense of hedging the MSR and instead using those financial resources to make new loans. For some nonbank lenders, creating new MSRs by generating higher loan volumes has been a very effective strategy to hedge the servicing asset against swings in interest rates.
Other lenders, however, have been penalized by investors for over-hedging the servicing book and hurting GAAP earnings. PennyMac, for example, has often been castigated by institutional investors for big swings in hedge results, which have hurt GAAP earnings but do not reflect the true economic reality.
So why do most public and some private mortgage firms hedge the MSR? The short answer is to protect the fragile sensibilities of institutional investors and regulators, people who do not fully understand mortgage lending and the related GAAP accounting. Hedging MSRs, as opposed to loan pipelines, is really an unnecessary cash expense for a well-managed, well-financed lender.
For example, when interest rates rise, people are less likely to move or seek new loans, either to purchase a home or refinance. The length of time people will stay in their homes — and the duration of the MSR — extends in time, so the net present value of the servicing income from the MSR is greater.
When interest rates fall, conversely, the value of the MSR falls, but the astute lender creates new assets to replace loans that prepay. This is why the ability recapture loans that prepay is a core skillset for lenders. And the cost to originate a new loan is a key benchmark for a well-managed lender.
Regulators and Wall Street bankers argue that an unhedged MSR portfolio can expose an institution to significant capital losses, particularly during interest rate shifts. But firms such as Freedom and UWM have grown significantly by taking the opposite strategy, each with very different business models.
UWM is focused primarily on the conventional loan market and dominates the broker channel in part by often selling MSRs to offset the high cost of loan origination. Lenders frequently are down on a cash basis when they sell a mortgage note into the secondary market, but high prices for MSRs can help the seller generate an overall profit.
Freedom, on the other hand, is primarily focused on the government market and tends to retain the servicing asset, both because of the MSR cash flow and the option value represented by the customer relationship. The largest private mortgage lender in the US, Freedom finances the MSR portfolio in the bond market, enabling it to focus all of its capital on new loan originations.
As Stan Middleman told me: "We hedge the MSR with our new origination and recapture capabilities. If we can originate and acquire MSR below fair market value, and recapture our share of refinancings, we can take advantage of swings in interest rates and the lending market very effectively."
Ishbia, for his part, argues that analysts ought to ignore swings in the value of the MSR and instead focuses on creating new loans and servicing assets. He argues that the GAAP results that all public companies must publish do not convey the substance of the business. If the company has a write-up of the value of the MSR under GAAP due to interest rate movements, it means nothing.
"Don't give me credit for that," Ishbia said on his earnings call. "I didn't do anything for that… Watch my core business. Watch what I do with my production, my gain on sale, my expenses. Watch our adjusted EBITDA of $200 million plus [in Q3 2025], that's how you run a business. That's what we focus on."
