Cost of Hedging Rate Risk Can Eat Into Your Income.(Brief Article)

Recent writedowns in the value of mortgage servicing portfolios, most notably the $450 million hit that HomeSide took, remind lenders how crucial it is to hedge against interest rate risk. For the most part, the mega-servicers have done pretty well so far in this year's refi boom, but there is still a strong possibility that some will have to report writedowns in the third and fourth quarter, since the refi boom shows few signs of abating.

But there is a dark side to successful hedging against interest rate risk: it ain't cheap.

Just ask Washington Mutual, the nation's largest mortgage lender. By any measure, Washington Mutual is a premier mortgage lender that has set the pace in terms of hedging success. Through the first two quarters of this year, the Seattle banking giant had little bad news to report in terms of servicing writedowns. In fact, record origination volume more than offset the negative impact of any adjustments that had to be made on servicing values.

But that success didn't come free, as a recent analyst report from Morgan Stanley Dean Witter points out.

Morgan Stanley's Kenneth Posner and his colleagues recently spent a day with top WaMu brass as part of their "mostly mortgage" tour of West Coast financial firms.

Morgan Stanley raised its stock price target for WaMu (to $52 from an earlier target of $43) based on the benefits of low interest rates and a strong franchise value for the firm, but the analysts also took note of some risk management challenges that WaMu faces.

In a its report on Washington Mutual, Morgan Stanley analysts note that WaMu management has announced plans to reduce interest rate risk inherent in its portfolio. But the report also raises questions about the ability of any lender to profitably invest in on-balance sheet mortgage loans.