Rights and wrongs of hedging mortgage risk

Mortgage banks


These days, when US mortgage banks release their quarterly results, it's assumed that at least some firms will report problems with their risk management. And with second-quarter results out this month, some analysts reckon the only question is over the failures' identities, not their existence.

One persistent problem for mortgage banks arises from the risk management of mortgage servicing rights (MSR) portfolios. MSRs are generated when a firm sells its home loans and retains servicing of the mortgages, or enters into a contract to service the loans of a third party. "We have come to the conclusion that the MSR is just a very tricky asset class to risk manage," says David Hendler, an analyst at CreditSights, a capital structure research firm based in New York.

Firms typically earn a fee of around 20–30 basis points a year for servicing a mortgage, and in turn are exposed to complex interest rate and prepayment risks. "MSR risk presents one of the toughest challenges in financial risk management," says Michael Koegler, a managing director in fixed-income sales at Bear Stearns in New York. "As a risk manager, you can't rely solely on the numbers that come out of your model to make decisions. The variety of risks inherent in the MSR portfolio requires the portfolio manager to use intuition along with good analytics."

But MSR hedging can all too often leave balance sheets in the red as hedges go awry. For instance, in April, Will Miller, chairman of Indiana-based Irwin Financial, pointed to a combination of interest rate volatility and accounting asymmetry as the reason behind a first-quarter MSR impairment of nearly $15 million, net of hedging. "The economic value of our servicing rights continued to rise and would have offset the hedge losses had we been allowed to book the value in increase under US generally accepted accounting principles (Gaap)," he said.

Under US Gaap, derivatives are accounted for on a mark-to-market basis, while MSRs are accounted for on a lower-of-cost-or-market basis. So while, economically, the losses on hedges can be offset by appreciation in the value of the MSRs, accounting rules put a cap on the MSR appreciation, preventing the offset from being fully realised.

Irwin Financial is by no means atypical. "Even the big players haven't had a good experience hedging their MSR risk," says CreditSights' Hendler. A prime example is Washington Mutual (WaMu), which had an MSR portfolio worth nearly $728 billion at the start of 2005, making it the third largest residential mortgage servicer in the country. During its second-quarter earnings conference call last year, chief executive Kerry Killinger laid much of the blame for a huge year-on-year drop in second-quarter net income – from $489 million in 2003 to a net loss of $63 million in 2004 – on its MSR hedging programme.

And this was not the first time WaMu's interest rate swaps-based hedging strategy has led to wild swings in the value of its hedge book. In the second and third quarters of 2003, for example, it posted an MSR hedge gain of $745 million, followed by a hedge loss of $317 million. So it's unsurprising that the bank's board ultimately decided that enough was enough, and set out to reduce WaMu's reliance on interest rate swaps from the third quarter of 2004.

Certainly, dynamic hedging of mortgage risk with swaps is a highly controversial strategy (Risk December 2003, page 22). Nonetheless, many banks have adopted this strategy because they don't want to pay the upfront cost of an option premium. Normally, delta hedging with swaps is cheaper than buying convexity upfront via interest rate options, says Srinivas Modukuri, a mortgage strategist at Lehman Brothers in New York. Typically, the implied volatility of options used in mortgage hedging – such as one-month options on 10-year swaps, for example – has on average been around one-fifth greater than subsequent realised volatility, according to Modukuri's research. This excess measures the implicit premium paid for implied volatility – that is, for buying options.

Although dynamic replication is cheaper, the strategy is not without problems. "The disadvantage of the delta hedging lies in the term on average," says Modukuri. "The actual ratio every month can vary significantly. Returns through delta hedging will be more volatile than through buying options."

Countrywide Financial Corporation is the largest servicer of residential mortgages in the US (see table A), and a long-time proponent of options-based hedging over replication – that is, using swaps-based dynamic hedging to synthetically mimic an option. "We prefer to hold options positions outright, rather than attempt dynamic replication with swaps, which is a technique we feel is susceptible to periodic failure," says Jeff Speakes, chief economist at Countrywide Home Loans, the California-based firm's mortgage banking subsidiary.

Countrywide's MSR portfolio totalled $937 billion at the end of May 2005 – one third larger than it was just a year earlier. "Option hedges help us fare better in extreme market environments, so we are comfortable with paying an option premium, even when the markets appear calm," Speakes says. That comfort level was sorely tested in the final quarter of 2004, when Countrywide's servicing hedge losses, combined with net impairment of its MSRs, totalled nearly $361 million.

Sharon Haas, a managing director at Fitch Ratings in New York, believes some hedgers' reluctance to use options has eased of late. "Choice of hedges is sensitive to market environment," she says. "There is an expectation that prepayments will slow and MSR values will appreciate – but without knowledge of how much and when. Consequently, we have definitely witnessed greater willingness to use options."

Part of this growing attraction to options might be due to plummeting swaption volatility, which has made premiums much cheaper. Daily volatility on a one-year/10-year swaption – that is, a one-year option on a 10-year swap – is currently around 6bp. At the start of 2004, the volatility was greater than 9bp.

Although granularity of disclosure is often lacking among US mortgage banks and application of hedge accounting is not uniform, it is clear that in the past few quarters WaMu has moved away from a predominantly swaps-based MSR hedge mix. But it is also fairly clear that it hasn't made significantly greater use of interest rate options or swaptions. Instead, the firm has turned to mortgage securities, which, theoretically at least, have less basis risk to MSRs than swaps-based hedges.

Figure 1 illustrates how, so far, WaMu's modified hedging strategy has reduced the volatility associated with its MSR business. In the past 12 months, WaMu has increased its use of mortgage to-be-announced (TBA) securities and principal-only (PO) securities. TBA securities are pass-through mortgage-backed securities (MBS), to be issued at a specified price on a specified future date; their value increases with mortgage rates. PO securities are also MBS, with the holder receiving only principal cashflows on an underlying mortgage pool. PO securities are purchased at a discount to par and their value typically increases as interest rates decrease. By definition, the value of MBS-type hedges are more highly correlated with changes in the value of MSR than Libor-based instruments, and so should require less drastic rebalancing than swaps-based hedges.

In his first-quarter conference call, WaMu's Killinger claimed the firm had worked hard on its MSR risk management and had made good progress. "They are very volatile assets that require careful hedging," said Killinger. "We did make a significant shift, both in terms of our strategy and in bringing in some people. So far the results have been quite encouraging."

For much of the past year, WaMu has engaged the services of the risk advisory arm of New York-based BlackRock, an asset manager with around $391 billion worth of assets under management. This external help complements WaMu's recent internal efforts. In November 2004, it hired Taj Bindra as its executive vice-president of finance and servicing operations of mortgage banking. Bindra was previously the chief financial officer of Chase Home Finance, a position he had held since 1999.

However, some analysts are not convinced about the robustness of the kind of MSR hedging strategy that WaMu is following. "Use of mortgage security-based hedges may reduce MSR volatility in low-volatility environments," says CreditSights' Hendler. "But options are the best protection against more volatile, fat-tail situations." WaMu declined to speak to Risk for this article.

But beyond questions about the robustness of different strategies, some take an even more radical stance and question the very necessity of financial instrument hedges. "It's not that we don't hedge our MSR risk, but rather that we employ a balanced business model and manage our overall business to attempt to limit income statement volatility," says Robert Reynolds, chief administration officer at SunTrust Mortgage, who is responsible for mortgage risk management at the Atlanta-based bank's mortgage arm.

Reynolds believes explicit hedging of MSR risk with derivatives creates a more volatile total business. "Taking this approach may insulate the MSR aspect of our business from volatility, but it would leave the volatility associated with the production side of our business without a natural offset." He argues that hedging through a business cycle can create more earnings volatility and is essentially a net reduction in the return of a servicing portfolio.

According to Bear Stearns' Koegler, viewing an MBS pipeline as a business hedge for MSRs can be a reasonable way to look at things on a macro basis much of the time. There are, however, scenarios where this approach can come unstuck. Take, for instance, a scenario where a housing bubble bursts. "In such a situation, interest rates might fall, but the housing market might fail to pick up. This would lead to [concurrent] slow originations and a servicing portfolio that loses value on a mark-to-market basis," he says.

Nevertheless, a number of mortgage banks are thinking along the same lines as SunTrust. The US Financial Accounting Standards Board (FASB) announced at the end of April that it plans to issue an exposure draft that would overhaul the accounting of servicing rights. The final rule – due in the first quarter of next year – will take into account these banks' points of view on how best to limit balance-sheet volatility. "Rather than requiring all companies to account for the servicing rights at fair value, FASB will allow the option to account for servicing rights under the amortisation method, which is existing Gaap," says Paul Laurenzano, a practice fellow at FASB.

The compromise solution was decided upon after banks that don't use derivatives hedges claimed that moving away from the amortisation, or lower-of-cost-or-market, approach to a fair-value approach would inject volatility into their profit and loss. Despite the freedom, companies will be required to apply their elected accounting method to their entire portfolio of mortgage servicing rights.

So, from next year, MSR hedgers should find accounting asymmetry less of a bind in their financial reporting. There may even be less hedging activity to report. US homeowners' shift away from traditional 30-year fixed-rate mortgages into non-traditional adjustable-rate mortgages has significantly reduced the negative convexity profile of the mortgage market as a whole. "With less convexity risk, vega risk and a shorter duration, hedgers of adjustable-rate mortgage MSR may not need to buy as much volatility for their hedge books," says Bear Stearns' Koegler.

"The negative convexity in non-traditional mortgages is smaller, so in one sense hedging MSR risk is a little easier," says Countrywide's Speakes. But the problem is that there is relatively little performance data on adjustable-rate mortgage products. Those hedgers with greater datasets and superior modelling capabilities have a natural advantage over their peers, he claims.

"No-one is really sure about the new mortgage products' performance, so it is difficult to assess how to hedge," says Marc Yaklofsky, a director in the financial institutions group at Fitch Ratings, in New York.

But there is a different take on the reduced MSR hedging activity of late, and it has prompted many market observers to question some risk managers' motivations. "Before the yield curve began to flatten [in 2004], hedgers profited from a positive carry that has now largely disappeared," says SunTrust's Reynolds. "This raises the question of whether hedging activity was actually being used as a way of taking on interest rate risk."

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