The mortgage-servicing writedowns

By Felix Salmon
October 22, 2009
Michael Moore has lots of detail today on the treatment of mortgage servicing rights in banks' earnings reports. No, wait, it's actually interesting! Especially when you look at the numbers involved.

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Bloomberg’s Michael Moore has lots of detail today on the treatment of mortgage servicing rights in banks’ earnings reports. No, wait, it’s actually interesting! Especially when you look at the numbers involved.

Wells Fargo is the poster child here: it wrote down its mortgage servicing rights by a whopping $2.1 billion last quarter, but it actually made a profit of $1.5 billion on them, since the value of its hedges on those rights soared by $3.6 billion. At the end of the quarter, it valued its rights at $14.5 billion.

Moore tries to explain what’s going on here, but something smells fishy:

The value of the rights depends largely on the expected life of the mortgage, which ends when a borrower pays off the loan, refinances or defaults. When rates drop and more borrowers refinance, MSR values decline. Banks typically hedge the movements using interest-rate swaps and other derivatives…

Because there’s no active trading in the contracts, there are no reliable prices to gauge whether banks are valuing the rights accurately, analysts said.

Here’s the first thing which puzzles me: in the third quarter, mortgage rates fell by 0.26 percentage points. How could such a relatively modest decline in rates result in a plunge of $2.1 billion — more than 12.5% — in the value of a $16.6 billion portfolio? And what kind of hedges result in a $3.6 billion profit when rates decline by 26bp?

Over at JP Morgan, the numbers are a little more modest, although Jamie Dimon’s shop, too, contrived to make a profit on its hedges: the portfolio declined in value by $1.1 billion, or 7.5%, while the bank’s hedges went up in value by $1.5 billion.

I’m especially puzzled by the big writedowns because anecdotally there doesn’t seem to be a huge amount of mortgage refinancing going on, and I don’t think that expected default rates rose in the third quarter either. (If anything, judging by the prices of mortgage bonds, they fell.)

There also seems to be a strong correlation between the size of the writedown that a bank took, on the one hand, and the degree to which its hedges made money, on the other. Is there any good reason why this should be the case? Or are banks just taking writedowns as and when they manage to pay for them out of hedging profits?

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Comments
3 comments so far

Felix,
Is this really your question:
“There also seems to be a strong correlation between the size of the writedown that a bank took, on the one hand, and the degree to which its hedges made money, on the other. Is there any good reason why this should be the case?”

Isn’t this strong correlation exactly what one would expect if the banks are effectively hedging the MSRs?

Perhaps there’s more to it than that, but it seems that you’re ignoring the very reason the hedges exist in the first place. If your question is, rather, “Why do the banks appear to be over-hedging?”, I don’t have an answer for that.

Posted by Andy | Report as abusive

Wells Fargo’s investor release for Q3 earnings includes the summary copied at bottom. Further into the PDF, a main comment about changes in MSR value is that interest rates & prepayments influence that value the most (above all else). The decrease (or increase) in prepay assumptions impacts greatly the valuation (much like it would for an agency 30yr MBS-backed strip IO).

I would like to hear what the hedge-carry income entails, all the same.

“$1.5 billion combined market-related valuation changes to mortgage servicing rights (MSRs) and economic hedges (consisting of a $2.1 billion decrease in the fair value of the MSRs more than offset by a $3.6 billion economic hedge gain in the quarter), largely due to hedge-carry income reflecting the current low short-term interest rate environment, which is expected to continue into the fourth quarter; MSRs as a percentage of loans serviced for others reduced to 0.83 percent; average servicing portfolio note rate was only 5.72 percent. “

Posted by Griff | Report as abusive

26 bps over a 30 year or even a 20 year period is a lot!
I have not looked into any of the details, but just as a general comment, duration is the key word here.

Posted by M | Report as abusive
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