A day before Alan Greenspan and the

Federal Reserve

are expected to formally reverse three years of easy money policy, it is perhaps unsurprising that mortgage stocks are getting slammed.

The reason for the selloff, however, might be a surprise: the second earnings warning in six months from

Washington Mutual

(WM) - Get Report

, the Seattle-based home lender.

To a large extent, the thrift's most recent warning confirmed many bank analysts' long-held suspicion: that WaMu does a poor job hedging itself against the impact of interest rate fluctuations on its big mortgage lending operation. And several think the warning is a poor reason to bail from an entire sector.

Late Monday, the Seattle-based thrift said rising interest rates were pummeling its lending arm and would lead to sharply reduced 2004 profits. In early trading, shares of Washington Mutual plummeted $3.25, or 7.9%, to $38.06.

"The mortgage boom has turned to a mortgage bust for some players such as WM. This raises issues about potential problems at other bank players,'' said Prudential Equity Group bank analyst Michael Mayo, in a research note. "This risk, however, might play out unevenly among mortgage players.''

To show that not all mortgage lenders are alike,

Countrywide Financial

(CFC)

said early Tuesday that its mortgage business is doing just fine and is well adjusted for a rising rate environment. The California-based lender said its hedging strategy is designed to quickly respond to up or down shifts in interest rate.

But in lemming-like fashion, investors appear to be ignoring that advice and are selling shares of any financial-services firm with a significant mortgage presence. Some of the hardest-hit stocks in early Tuesday trading include Countrywide, down $1.82, or 2.6%, to $69.68;

Doral Financial

(DRL)

, off 73 cents, or 2%, to $34.10;

E*Trade

(ET) - Get Report

, down 15 cents, or 1.3%, to $11.05, and

New Century Financial

(NCEN)

, off 64 cents, or 1.3%, to $47.40.

There's no disputing that mortgage originations and home refinancings will be down this year, compared with last year's torrid pace. By year's end, some estimate, the volume of new mortgages could fall 40% from the record levels reach in 2003.

But the cooling-off in the mortgage market has been happening ever since long-term Treasury bond yields began moving sharply higher this spring. This should come as no surprise to any investor.

In fact, Wednesday's expected one-quarter-point hike in the fed funds rate has been discussed, debated and dissected for so long, it's unlikely to have any immediate impact on 30-year mortgage rates, which are more closely tied to 10-year Treasury yields. The average rate on a 30-year mortgage is 5.89%, up from 5.1% in March.

And there's much more to the mortgage business than writing home loans. A big business for many mortgage lenders and banks is mortgage servicing, in which a company handles the collection of interest payments for a mortgage owner.

The mortgage servicing business tends to perform better in a rising rate environment, because higher rates extend the life of the portfolio. Low interest rates prompt homeowners either to refinance their mortgages or pay them off early, and that decreases the portfolios value.

Mayo says "higher servicing revenues'' due to rising rates, will "partly offset lower origination-related revenues." He expects an upswing in servicing revenue to benefit

Wells Fargo

(WFC) - Get Report

, which maintains of the largest servicing operations.

In looking at the impact of the slowing mortgage market on several big banks, Mayo expects mortgage earnings at Wells Fargo and

Citigroup

(C) - Get Report

to be relatively flat compared with a year ago. But the analyst foresees mortgage earnings declining 10% at

J.P. Morgan Chase

(JPM) - Get Report

and 20% at

Bank of America

(BAC) - Get Report

, meaning those lender will have to look to other division to pick-up the slack.

The good news is that Mayo expects a rebound in mortgage earnings in 2005.

"The potential good news is that next year, in 2005, we expect bank mortgage earnings to be roughly 4% higher,'' he says.