Point of View: A Capital Markets View of MSRs.(Brief Article)

Messrs. Aldrich, Greenberg and Payner are executives with CDC Mortgage Capital, a unit of Caisse Des Depots Group, based in France. This Viewpoint is an excerpt from a recent article they wrote about the valuation and hedging of mortgage servicing rights for a financial journal. They believe that continuing consolidation suggests the need for a more detailed understanding of valuation methods. For a copy of the full paper, please e-mail Mr. Greenberg at Greenber cdcna.com.

Another development in the mortgage servicing market in recent years is the recognition of the substantial market risks inherent in owning MSRs. Many market participants still employ a static analysis of risk, which significantly understates the true exposure. The use of dynamic interest rate and prepayment models gives a more realistic picture of the risks involved in owning MSRs, although these models are still deficient in practice as significant differences between theoretical and market valuations can persist over long periods of time.

Furthermore, the imminent adoption of FAS 133 has focused much attention on the issues of valuing and hedging MSRs. Prior to the adoption of FAS 133, the accounting rules for MSRs are that they are marked at lower of cost or market (LOCOM) and associated hedges are marked to market.

To the extent that rates rise, it is only possible to mark the MSRs up to the cost paid for those rights and no higher. Thus, there is an accounting distortion relative to the economics. The amount by which the market value of the servicing exceeds the cost is sometimes called "cushion."

If certain requirements are satisfied, "hedge accounting" can be used. Under hedge accounting rules, the value of the servicing can be marked up above its cost to the extent, and only to the extent, that it offsets losses on derivative hedge instruments which are marked to market.

Thus, in a rising rate environment, MSRs can be written up to offset the losses on the hedges, resulting in very little p&l volatility. Under FAS 133, hedge accounting is still attainable but under different and more stringent requirements. Even assuming that these requirements can be met, the new rule states that MSRs are essentially marked to market, as are the derivative hedges.

The result is that any p&l volatility between the ...