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.
"Current financial market and economic conditions present significant risk management challenges to institutions of all sizes," warned the feds. Fourth-quarter MSR results at the country's four giant banks showed signs of those challenges already. Net results were still positive, but showed a mix in fee income and hedging performance, as the refinancing wave that kicked off in the spring abated, and some banks did better than others in adjusting derivatives exposure along with the rate outlook. Wells Fargo ( WFC) appears to have been the most bullish on the potential for an interest-rate hike in the near-term. The bank reduced what is known as its "carry trade" -- a strategy of funding long-term assets with short-term liabilities that have a higher rate of return -- by $34 billion, while JPMorgan Chase ( JPM), Bank of America ( BAC) and Citigroup ( C) all took the opposite tack, increasing theirs on average by roughly the same amount. But whereas Bank of America and JPMorgan lost money on their MSR derivatives, Wells Fargo earned a pretty penny, showing that its early adoption is paying off. Wells held $16 billion worth of MSRs at the end of 2009, a $1.5 billion increase from the previous quarter. It earned $2.1 billion in servicing income, and $1.9 billion in market-related valuation changes, largely from effective hedging. Fair value adjustments accounted for roughly $830 million, while changes in valuation models accounted for a $1 billon gain. CFO Howard Atkins cited "solid results" and "strong" hedging activity. He also predicted that MSR income could remain "relatively high" in the near-term if its strategy continues to pay off.
By contrast, Bank of America's MSR results were ho-hum. Its overall MSR portfolio grew $1.9 billion over the final quarter to become $19.5 billion at year-end. The bank lost $213 million in fair-value adjustments while fees were essentially flat. Though derivatives changes aren't broken out, former CFO Joe Price told conference-call listeners that positive hedging activity offset slightly lower production levels. JPMorgan Chase didn't fare quite as well. Its MSR portfolio grew 14% over the quarter to $15.5 billion, but the bank lost $657 million in fair-value adjustments. Derivatives alone declined by $1.65 billion, compared with a $1.5 billion gain the previous quarter. Overall servicing revenue was essentially flat at $1.2 billion. CFO Michael Cavanaugh acknowledged the lackluster results, but said while MSR risk management "had been a big positive in some of the prior quarters," it "normally is more like what it is this quarter." Citigroup didn't provide much commentary or detail for its mortgage-servicing results. The bank simply said its MSR balance grew 5% over the quarter to $6.5 billion. If fourth-quarter results and interest-rate expectations are any indication, it appears competitors may need to start mimicking Wells Fargo's tactics more closely. The Fed's golden era of free money and purchasing assistance has existed for over a year, and may be around for another quarter or two, but it won't last forever. The market reaction is always one step ahead -- as are the most adept risk managers. Atkins indicated that Wells Fargo management has its sights set ahead on where the next earnings boom will be. He said that at times "less conducive to strong mortgage earnings" -- as the economy begins to expand, and interest rates rise -- Wells will rely on other businesses to drive results.
"We manage the mortgage business very holistically ... within a reasonable range of interest rates," said Atkins. "Our goal isn't to try to maximize profits each quarter, nor do we try to eliminate all interest rate risk." -- Written by Lauren Tara LaCapra in New York