Mortgage Servicer Role May Weigh on Banks

All four banks declined to comment, citing a quiet period before earnings, or did not respond to requests for comment.

Rettinger is not concerned about a decline in MSR assets affecting bank earnings or stress tests. In fact, he expects MSR results to have improved last quarter. Conder agrees, saying that "with all the other problems that they have, it's kind of the gnat on the butt of an elephant."

Indeed, while $5 billion to $10 billion seems like a significant sum, it represents a minute portion of balance sheets that are over $1 trillion in size. Furthermore, hedging strategies that fail to offset risk entirely will still mitigate a decline in value.

However, Munson says the uncertainty about MSR results has led him to exit any long positions he held in BofA, JPMorgan and Wells Fargo, which hold a significant portion of mortgage-servicing rights in the U.S. He says some firms used servicing rights to artificially boost the popular metric of tangible common equity and questions what may happen to balance sheets if hedging strategies fail and customers go elsewhere to replace an old mortgage with a new, cheaper one.

"Wells Fargo had huge mortgage service rights on their TCE and if you took it out, it really started to take out their equity," Munson says, in explaining his decision to exit positions. "BofA has a huge mortgage servicing business. It's part of their bread and butter."

His concerns seemed to take on some significance when looking at the top 50 U.S. banks' tangible common equity ratios. The top four banks in terms of total assets ranked near the bottom -- or below -- in terms of TCE divided by tangible assets, excluding MSRs, according to SNL Financial.

JPMorgan ranks No. 1 in assets, but No. 41 in the TCE metric, with a ratio of 3.91%; Citi ranks No. 2 in assets, but No. 51 in TCE, with a ratio of 1.77%; BofA ranks No. 3 in assets, but No. 46 in TCE, with a ratio of 3.07%; and Wells Fargo ranks No. 4 in assets, but No. 50 in TCE, with a ratio of 2.38%.

There has been extensive debate about the wisdom of using such ratios to determine a bank's health, since there is no regulatory standard for TCE, and it seems as though every analyst calculates the ratio in different way. Rochdale Research analyst Richard Bove noted that some believe 3% is a "safe" TCE ratio -- "based on no one knows what," he says -- while others prefer 6%.

Perhaps the real significance of the MSR debate is just how opaque even the smallest portion of a balance sheet has become -- especially when a renegade tranche of credit default swaps that were once largely ignored could bring a giant international insurance firm like American International Group (AIG) to its knees.

"With organizations of that size and complexity, I pick up one of those 10-Ks or 10-Qs and start reading through the fine print," says Conder. "I look at this kind of financial information all day long, but I don't always understand it. I don't think there are many people on the earth who completely understand what is going on. For the average investor, it's nearly impossible."

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