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Wells Fargo's Rate Strategy Pays Off

NEW YORK ( TheStreet) -- As the mortgage market eased from a breakneck pace, and the fixed income market began pricing in the likelihood of higher interest rates, banks have had a harder time managing exposure to rate-sensitive devices called mortgage-servicing rights.

When mortgage money is lent, and the loan is securitized, the rights to collect fee income are separated out into MSRs. Banks may retain the MSRs from loans they make, or purchase them from other banks. Banks receive fee income from processing related mortgages' loan payments, and can either earn or lose money in hedging against two key MSR risks.

One risk is that of loan repayment, since the bank would stop receiving the MSR fees, and the other is that of interest-rate swings, which would affect the stated value of an MSR portfolio. Banks hedge against those changes by purchasing interest-rate derivatives and mortgage securities from Fannie Mae (FNM) and Freddie Mac (FRE).

But the outlook for all of those products has changed as the Federal Reserve has gotten closer to boosting its interest-rate target. Futures markets have been pricing that in to a greater extent, which affects derivatives products. The Fed is also close to the end of a $1.5 trillion program to buy agency securities, and the value of those assets is likely to drop, and rates to rise, once it is complete.

In an advisory to banks on Jan. 6, the Fed and five other regulators told banks to prepare for an upward rate shift. Being imprudent with hedging could have consequences, "placing downward pressure on capital and earnings," they noted.

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