Just as banks are beginning to work the massive amount of bad debt through their systems, a less obvious creature related to the once-booming housing market may pose a threat as mortgage rates decline and homeowners refinance.

Mortgage-servicing rights, or MSRs, comprise a relatively small portion of the more than $1 trillion balance sheets of the major banks. Most of these banks also hedge against the risk of sharp movements in interest rates and against refinancing booms -- like the one going on right now. But smaller firms whose MSR portfolios comprise a bigger portion of assets are far more exposed to losses, especially those who consider hedging too costly.

For instance, National City, a mid-cap bank that was based in Cleveland, posted hundreds of millions of dollars in hedging losses on its MSR portfolio before regulators pushed it into the arms of PNC Financial Services ( PNC) at the end of 2008. First Horizon's ( FHN) First Tennessee Bank has sold off tens of billions of dollars' worth of MSRs to reduce its exposure to such assets.

"A lot of them look at the cost to hedge that exposure, and that cost is pretty big," says Dale Conder, COO and chief risk officer at A10 Capital, which advises banks on commercial-real estate deals. "So what happens is this kind of domino effect where they say, 'No, we believe in our model and we're not going to hedge.' Then a big refinance boom takes hold and that model starts going out the door."

MSRs are the fees banks can collect from investors for collecting monthly payments made by home loan borrowers, putting money into escrow for taxes and insurance premiums and paying principal and interest to lenders. Banks acquire MSRs by either purchasing them or retaining the right to service loans that are securitized and sold off to investors.

"Mortgage companies love to retain the servicing because it's free money," says Lee Munson, who has a background in mortgage servicing and is chief investment officer of Portfolio LLC. "And it's a really stable business in better times."

Typically, the two risks to that "free money" are prepayment and lower mortgage rates. If borrowers prepay, the servicer loses out future revenue streams. Lower mortgage rates impact the formula by which the servicer's fees are determined. These risks could be hedged through interest-rate derivatives or purchasing plain-vanilla mortgage assets from Fannie Mae ( FNM) and Freddie Mac ( FRE).

However, interest rates have declined sharply over the past six months, with the average 30-year fixed mortgage rate plunging from over 6% to 4.78%, according to Freddie Mac. The rate trend, combined with unprecedented government intervention into the housing market, has spurred a refinancing boom as homeowners across the country flocked to get better deals.

These trends have made hedging ever more difficult, says Tom Rettinger, a former managing director at Countrywide before it was acquired by Bank of America ( BAC).

"The biggest risk that you can talk about is that the risks are no longer interest-rate driven risks," asserts Rettinger, who is now a managing director at BRG Inc., which advises banks and hedge funds on risk management. "The government-intervention risk is much higher, given the lack of hedgeability of mortgage programs that may or may not be approved in Congress."

Rettinger uses the example of a program that Freddie and Fannie have agreed to participate in, which will allow subprime borrowers to refinance loans they were otherwise not qualified to alter. Many mortgage investors and servicers had been discounting prepayment fees, based on the unlikelihood that troubled borrowers would qualify for a refi. The only way to shift such a position into profitability would be to purchase hard mortgages at a discount.

"But nothing is trading at a discount these days," Rettinger says.

Each bank also faces competitive risk. The financial-supermarket model championed by Citigroup ( C) and other full-service firms like BofA, JPMorgan Chase ( JPM) and Wells Fargo ( WFC) operates under the assumption that consumers prefer to have their checking, savings, investments and loans all under the same roof.

But in the tightened credit environment of the financial crisis, says Rettinger, consumers have been applying at more institutions to ensure loan approval. As a result, customer loyalty has taken a back seat to refinancing opportunities with better rates and better terms.

Inconsistent Reporting

It's unclear how any of this -- lower interest rates, government initiatives, competition for creditworthy consumers and the ensuing refinancing boom -- will affect banks' balance sheets and stress tests, at least in terms of MSRs.

Banks have leeway in valuing MSRs, disclosing information about them and characterizing them as intangible or tangible assets, according to regulatory standards set by the Financial Accounting Standards Board. MSR fair value is mostly based on modeling today, rather than actual trading, since there is not much buying and selling going on. Nonetheless, a sharp decline in the value of major banks' MSR portfolios was evident during the fourth quarter, as was a lack of cohesion in the way MSR results are reported.

The MSR portfolios of BofA, Wells Fargo and JPMorgan Chase grew immensely due to their acquisitions of Countrywide, Merrill Lynch, Wachovia, Washington Mutual and Bear Stearns. However, BofA's portfolio lost $6.8 billion in value during the fourth quarter, as JPMorgan's lost $8.9 billion and Wells Fargo's lost $674 million. Net results remained in the black at BofA and Wells, due to hedging gains of $8.6 billion and $681 million, respectively. JPMorgan still lost $535 million even with hedging, but also factored in new production gains and other fees to report a net result of $2.7 billion.

Citi, which didn't have new acquisitions to affect results, posted a decline of $3.9 billion on interest rate drops and prepayments. Its MSR portfolio lost 34% over the duration of 2008, to close the year at $5.6 billion vs. $8.4 billion at the end of 2007.

The company didn't disclose its hedging results, except to say that "the change in the value of these hedging instruments does not perfectly match the change in the value of the MSRs ."

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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