Servicing Hedge Part of WaMu's Challenge.(Washington Mutual)

Everyone knows that loan origination volume is declining as rates rise, but when the nation's largest mortgage servicer warned that mortgage income is likely to fall short of expectations this year, it cited servicing rights as part of the problem.

Washington Mutual chairman and CEO Kerry Killinger, acknowledging that 2004 is shaping up to be a "transition year" as rates rise and refinancing slows, said at a recent investors conference sponsored by Sanford C. Bernstein & Co. that mortgage banking will be a less powerful component of WaMu's performance this year than it has been in the past.

In a research note on WaMu, Bernstein analyst Jonathan Gray reduced his rating on the company to "market perform" from buy, in part because of management's disclosure that the servicing hedge is not performing as planned.

He reduced his 2005 earnings-per-share estimate by 3% "to reflect our more conservative 'guesstimate' of the future behavior of the servicing hedge."

Mr. Gray said in a recent research note that "poor visibility" makes it difficult to anticipate WaMu's performance.

"Disclosure of information that better explains MSR hedging, and the EPS impact of the aggressive branch expansion, would improve visibility, reduce investment risk, and warrant better valuation," Mr. Gray wrote.

While hedging should offset servicing declines when rates fall and servicing gains when rates rise, Mr. Gray wrote that hedging usually mutes but does not eliminate this trend. In WaMu's case, he suggested the servicing hedge may be "too powerful," offsetting all of the upside for rising rates on the mortgage servicing portfolio.