Hedging Challenges Lie Ahead at WaMu.(Washington Mutual)

A flat yield curve is doing more than just creating headaches for portfolio lenders. It is also posing challenges to companies that hedge their mortgage servicing rights.

Chief among those companies is Washington Mutual, one of the nation's largest mortgage lenders. Washington Mutual reported that net income from its home loans group fell to $47 million in the fourth quarter, down from $164 million in the year-earlier fourth quarter. And WaMu cited "the increased cost of MSR risk management" due to a flat yield curve as the primary driver of the drop in home loans income. Moreover, chairman and CEO Kerry Killinger told investors and analysts on the company's quarterly conference call that WaMu expects the MSR hedging environment to remain challenging this year.

Chief financial officer Tom Casey shed more light on the problem, saying that a flat yield curve has increased the cost of WaMu's MSR hedging strategy.

WaMu values its MSR asset at $8 billion. And that's an $8 billion asset that, left to its own devices, could fluctuate wildly depending on interest rate conditions and wreak havoc on the company's quarterly earnings reports. But hedging out the interest rate exposure hasn't proved easy.

"The impact of the environment on our results is demonstrated by the spread between the two-year and 10-year swaps. That spread has dropped by more than a full percentage point over the past year," Mr. Casey said on the call.

The reduction in that spread reduces the interest WaMu receives on its swap and TBA hedges and thereby increases the overall cost of hedging the MSR asset, Mr. Casey explained.

WaMu also released financial information that illustrates the ...