H&R Block

(HRB) - Get Report

is best known for preparing tax returns, but it's the firm's ailing mortgage business that's giving investors headaches.

Shares of the Kansas City, Mo.-based consumer services firm fell Wednesday after the company reported a $44.1 million loss in its first quarter ended July 31, due primarily to the poor performance of its mortgage division. At midday, the stock had dropped $4, or 7.8%, to $47.25.

July-quarter losses are common for H&R Block, which gets most of it tax preparation revenue in the period prior to the April 15 tax filing deadline. But the magnitude of this year's deficit surprised Wall Street, which had been banking on H&R Block's mortgage business to perform better than it did.

Wall Street analysts, according to Thomson First Call, had been expecting a loss of 5 cents a share in the quarter, not the 26-cents-a-share bloodletting H&R Block reported.

The company blamed the trouble in the mortgage business on rising interest rates, which it said reduced the profitability of its lending operation. Pretax income from the mortgage division fell 43% from a year ago to $93.5 million, which was not nearly enough to offset the $113 million pretax loss in the firm's tax business.

Rising rates created a problem for H&R Block as the spread between its own borrowing costs and the rate it charges borrowers got squeezed. Smaller margins reduce the profit H&R Block makes when it resells those loans in the secondary market. That's why revenue from the sale of mortgages declined 25% from a year ago to $137 million.

The company said it had expected some margin compression because there's a normal lag time in its ability to pass on higher rates to borrowers. But H&R Block executives confidently predicted that the mortgage business would improve in the second half of the fiscal year as it adjusts to a rising rate environment, and it stuck with its full-year earnings forecast of $4 to $4.25 a share.

"Our mortgage business is on track to meet our expectations for the year," said H&R Block Chairman and Chief Executive Mark Ernst.

Some on Wall Street aren't buying H&R Block's rosy scenario. Morgan Stanley analyst Chris Gutek said in a research note that H&R Block should get out of lending.

"The mortgage business is likely to add considerable volatility to Block's operating results and may be a cause of disappointment, given management's optimistic expectations," said Gutek, who promptly reduced his full-year earnings estimate by 10 cents to $3.86 a share.

An H&R Block spokesman could not be reached for comment on Gutek's report.

Volatility in mortgage earnings is one reason

Cendant

(CD)

, the consumer-services conglomerate, had been trying to find a buyer for its mortgage business. Cendant, which owns Avis, the Century 21 real estate business and Ramada Inn, among other properties, said it didn't consider mortgages one of its core businesses.

Selling the unit hasn't been easy. Earlier this month, Cendant announced that it was ending talks with the only potential buyer that had expressed an interest.

Fluctuations in interest rates also have caused havoc for

Washington Mutual

(WM) - Get Report

, one of the nation's biggest thrifts and top mortgage banks. Earlier this summer, WaMu reported disappointing second-quarter earnings and announced it was eliminating thousands of jobs because of the impact of rising rates on its mortgage division, which includes a large mortgage servicing operation. Critics have blamed much of WaMu's trouble on its failure to properly hedge its servicing portfolio against sharp spikes in interest rates.

Mortgage servicing, a business that involves the collection and processing of interest payments for another lender, tends to perform better in a rising rate environment because higher rates extend the life of the portfolio. Low interest rates prompt homeowners to either refinance their mortgages or pay them off early, and that decreases the portfolio's value.

At H&R Block, mortgage servicing is not as important as the revenue it generates from selling mortgages it issues, so it doesn't have the same hedging problems WaMu faces.

But in order for H&R Block to meet its optimistic full-year forecasts, it needs to be able to write mortgages bearing a higher interest rate without losing any market share to its bigger competitors in the industry. That's a formula some think H&R Block will have difficulty pulling off.

"We believe it will be challenging for Block to push price increases in the face of increasing competition in the nonprime segment of the mortgage industry," said Gutek.