Hedging's trial by turmoil.
The school of hard knocks teaches some hard lessons. For mortgage bankers, the classroom has been meeting overtime for more than a year. The refinance boom of 1998 has been a trial by turmoil for the hedging strategies mortgage bankers use to preserve the value of their mortgage servicing assets.
No test was more vigorous than the crisis that overwhelmed global financial markets from late August to early October. That's when interest rates plunged and there was a flight to quality - U.S. Treasuries - that created a liquidity crisis for all other bonds.
Interest rate spreads between Treasuries and mortgage-backed securities (MBS) widened to levels not seen in decades. Mortgage prepayments rose while the value of servicing assets plunged.
A major hedge fund run by some of the smartest players on Wall Street - Long-Term Capital Management - required a $2.7 billion rescue. Such firms thrive on risk by investing in derivatives and other hedges. Mortgage servicing hedges, by contrast, are used to reduce risk and are not purchased as investments.
The good news is that the servicing hedges at most mortgage banking firms did extremely well when the big test came. Some major servicers had windfall gains in the third quarter of 1998 because they had loaded up with Treasuries or Treasury-based hedging instruments.
The bad news is that a few servicers that were unhedged - or that chose inadequate or inappropriate hedges - suffered significant losses. Mortgage Banking has identified mortgage servicing write-downs totaling $504 million at five companies, including $250 million at a leading commercial bank.
In addition, there was a $225 million write-down on a $2.3 billion portfolio of interest-only strips (IOs) and mortgage-backed securities held by a real estate investment trust (REIT) based in Dallas. The write-down came because the hedges for the portfolio did not perform as expected.
"Good, quite positive"
Despite the turmoil, the number of good hedge performers far outweighed the few calamities. "By and large, the performance of those seriously committed to hedging has been good, quite positive," says Robert Husted, president of MIAC Risk Management LLC, New York City.
Hedging success, ironically, was sweetest at the height of all the financial turmoil - the third quarter of 1998. "Two huge tidal waves collided and canceled each other out," says Husted, referring to a sharp drop in the value of mortgage servicing rights that was offset by a huge spike in the value of Treasury-based hedges.
Mortgage bankers were ecstatic. "We were doing cartwheels. It couldn't have performed any better. Life was good during the third quarter," recalls Bill Naryka, chief financial officer of Fleet Mortgage Group in Columbia, South Carolina. The gain in the company's hedge outpaced the decline in the value of its mortgage servicing rights, he says.
"Our hedges worked extremely well - almost better than expected," says Luke Hayden, executive vice president of Chase Manhattan Mortgage Corporation in New York City.
"Our hedge gained $300 million, outpacing our asset value loss by 10 percent," says Kevin Race, chief financial officer for HomeSide Lending Inc., of Jacksonville, Florida.
Were mortgage bankers blessed with wisdom and foresight? Or were they just lucky?
One Wall Street adviser, who declined to go on the record, said that the good results in the third quarter of 1998 were, to some extent, "accidental." According to the source, mortgage bankers had failed to diversify their risks as risk-management theory dictates you should. They were overconcentrated in Constant Maturity Treasury (CMT) floors to hedge their portfolios. Other derivatives, such as swaps, looked like bargains compared with CMT floors, the source says.
"Whether due to stubbornness or foresight, mortgage bankers were sitting in a pile of CMT floors" when the Treasury market rallied, the source says. This ensured their hedges would outperform expectations, the source noted.
Some mortgage bankers concede the point about accidental gains. Good luck definitely played a role, says Larry Washington, senior executive vice president at First Nationwide Mortgage Corporation in Frederick, Maryland, whose parent company is California Federal Bank - which last year acquired Glendale Federal Bank, creating the second-largest thrift in the nation. First Nationwide had a $89 billion servicing portfolio as of February 1999.
"I'd like to say our hedges outperformed because we're so smart and we knew what was going to happen. But it was because prepayment speeds accelerated more than we predicted, and Treasury rates fell more than mortgage rates," Washington says. "As a result, Treasury hedges paid more than others."
Lessons from turmoil
The long and short of it is that mortgage servicers either did very, very well or did very, very poorly.
For companies without a hedge, last year made it painfully clear that a policy of no hedging is a mistake. Some have been forced to leave the business as a result or put large chunks of servicing up for sale. For others, however, the mistake was in choosing the wrong hedging strategy, Husted says.
"The message there is that the mortgage servicing asset is so risky that you need to accurately quantify the risk and take steps to mitigate it," says Husted.
Another lesson learned is that hedging portfolios should be diversified, according to Tom Pascale, a director at Credit Suisse First Boston in New York City. "Mortgage bankers now routinely ask about spreads in their market discussions, and they adopt a mix of hedges between Treasuries and swaps," says Pascale.
Hedge portfolios now are more likely to include more types of hedges, including general interest rate swaps and their derivatives. This suggests, Pascale says, that mortgage bankers now better understand the relationship of the swap market to events around the world as a result of last year's turmoil.
Besides CMT floors, mortgage servicing hedge portfolios also now include Treasury futures and options. They sometimes also include interest rate swaps, options and derivatives, including Constant Maturity Swap (CMS) floors. These are tied to the LIBOR (the London Interbank Offered Rate). Hedges also include instruments tied to mortgages, including principal-only strips (POs), super or leveraged POs, mortgage-backed securities and other, more exotic, derivatives.
Finally, the hardest lesson of all seems to be that owning servicing is too costly or too risky for many, so it's better to get out of the business, according to Husted. He predicts that "a reasonable handful" of the top 50 servicers will do just that - get out of the business - or consolidate with other mortgage bankers during the next six months.
First Nationwide Mortgage
First Nationwide Mortgage's experience with hedging over the last year illustrates the kind of approach that successful mortgage bankers have been taking to protect their servicing asset.
First Nationwide does not hedge the entire servicing portfolio of CalFed Bank, even though it manages that portfolio, according to Washington. CalFed retains the mortgage servicing rights to the $22 billion servicing portfolio it originates and holds on its books. The parent company is responsible for hedging those mortgages - where both the loan itself and the servicing is held in portfolio, Washington says.
First Nationwide Mortgage hedges what it calls its $67 billion "third-party" servicing portfolio, made up of mortgages sold to Fannie Mae, Freddie Mac, Ginnie Mae and private investors.
First Nationwide not only monitors the risk of changing interest rates but also monitors closely the risks associated with changes in the spread between 10-year Treasuries and 30-year mortgage-backed securities, Washington says. "This has become the key issue for mortgage servicers," explains Joel Shaiman, managing director at BlackRock, Inc., in New York, an investment management firm and risk adviser that has advised First Nationwide.
"Going back several years, the issue was to get the first-order interest rate risk hedged. People did such a good job of that, [that] all of a sudden interest rate risk was no longer the biggest risk. The bigger risk was the spread between Treasuries and mortgage rates," says Shaiman.
Spreads between Treasuries and mortgages narrowed in October 1997 to only 90 basis points - far below the normal range, according to Naryka. Naryka cites Bloomberg historical yield data showing that since 1988 the spread between Treasuries and mortgages has been between 145 and 165 basis points 80 percent of the time.
Early last year many risk managers at mortgage servicers, noting how narrow the spread had become, began to adjust their hedge positions to prepare for the inevitable widening of the spread.
To hedge the spread risk, First Nationwide, like other mortgage bankers, bought CMT floors. They provide the positive duration and positive convexity needed to offset the negative duration and negative convexity of mortgage servicing, says Shaiman.
A security that has positive duration rises in value when interest rates fall, while a security that has negative duration falls in value when interest rates fall. Treasuries have positive duration, while servicing has negative duration.
A security that has positive convexity rises at a greater pace than the corresponding change in interest rates. It also declines in value at a lesser pace than the corresponding change in interest rates. Treasuries have positive convexity.
A security that has negative convexity rises at a lesser pace than the corresponding change in interest rates. It also declines at a greater pace than the corresponding change in interest rates. Servicing has negative convexity.
Treasuries, POs, interest rate swaps and a host of other hedging instruments have the positive duration and positive convexity that can offset the changes in value of servicing, Shaiman notes. No instrument, however, has gains or losses that correspond exactly to the change in the value of servicing rights.
By the time the third-quarter crisis hit, First Nationwide was loaded up with CMT floors big time and was covering 100 percent of its "third-party" servicing portfolio, according to Washington. First Nationwide was, thus, well positioned to benefit from the windfall that came in September and October, when spreads widened to the high end of the range.
On October 5, 1998, spreads reached their peak for the year at 213 basis points - the gap between 10-year Treasuries at 4.16 percent and 30-year Fannie Mae mortgages at 6.29 percent, according to Washington.
The peaking of spreads created a new hedging issue. It shifted the focus to the dangers posed by the inevitable narrowing of the spread.
As Washington saw it, narrowing could occur in either of two ways. Treasury yields could go up while mortgage rates remained the same. Or mortgage rates could go down while Treasury yields remained the same. If Treasury yields rose, a hedge based on Treasuries would decline in value. Since mortgage rates remain unchanged, the servicing asset would not go up in value. So, in this scenario, the mortgage servicer would lose, Washington says.
Washington also saw risks if the spread should narrow because mortgage rates fell while Treasuries stayed the same. In this case, the servicing asset loses money, but the value of the hedge would not rise to offset it.
The lesson? When spreads are very wide, no matter how the spread narrows, "if you're in a Treasury-based instrument, you lose," Washington says.
Another issue also had to be resolved. What portion of the servicing portfolio should be hedged - 100 percent? 90 percent? 80 percent? That decision, too, could affect the performance of the hedging strategy.
Washington explains how. When mortgage interest rates are rising, "it's a good thing" to be less than 100 percent hedged, he says. Thus, the expected decline in the value of the hedge will be offset by a greater gain in the value of the servicing rights, he explains.
When rates are falling, however, a servicer will suffer a greater loss if he or she is not 100 percent hedged. The gain in the hedge will not match the decline in the servicing asset.
As the result of this kind of step-by-step analysis, one thing became very clear to Washington early in the fourth quarter of 1998: "If spreads were to tighten and if we remained in Treasury-based derivatives, we were going to get killed." The solution? First Nationwide Mortgage closed out many of its Treasury-based hedges and bought up some CMS floors and swaptions, which are options on interest rate swaps. At the same time, it moved to cover less than 100 percent of its portfolio.
How has First Nationwide's hedging program performed since the third quarter of 19987 "We've had mixed result so far," Washington says."The hedges lost more value than we thought they would." At the same time, the value of the servicing asset has not risen as much as mortgage servicers expected, he says.
"The problem is that you're trying to hedge prepayments, but you're using instruments that react to general interest rates," says Washington. It would be better to buy a hedge that was more directly correlated to mortgage interest rates. "If I could, I'd have PO swaps, but you can't find any at reasonable prices," he says.
Despite the mixed performance of its hedging strategy in recent months, First Nationwide does not have to take a write-down because it has imbedded gains in its servicing - which gives it a cushion against write-downs, according to Washington.
First Nationwide is not alone in its spotty performance recently. Shaiman claims that most mortgage bankers have not done that well in the extended period of narrowing spreads since last October.
"Unless people moved 100 percent into mortgage-based hedges, they gave up a portion of what they gained" in the third quarter of 1998, says Shaiman. Swaps, the instrument of choice for most mortgage servicers, did not do as well. "They are less correlated" when rates tighten, Shaiman says, meaning they lose more in value than the corresponding gain in mortgage servicing rights.
While they were few in number, there were some fairly sizeable write-downs in mortgage servicing at several mortgage banking operations last year. Wall Street hedge advisers find the experiences in these write-downs to be helpful in demonstrating some of the pitfalls associated with hedging strategies. Some mortgage servicers that took a write-down, soon thereafter initiated a hedging effort or beefed up existing hedging. For example, Montgomery, Alabama-based Colonial Bancgroup Inc. in the fourth quarter took a $30 million hit due to faster-than-expected prepayments on its servicing portfolio, according to National Mortgage News. Colonial began a hedging program in October, according to company press releases.
Bank of America Mortgage
One of the larger write-downs of mortgage servicing rights - $250 million - occurred during the third quarter at what is now known as Bank of America Mortgage.
The write-down came during the same quarter that saw the merger of the former Charlotte, North Carolina-based NationsBank with San Francisco-based BankAmerica Corporation. Prior to the merger, the old BankAmerica Mortgage, San Francisco, had a $97.7 billion servicing portfolio, according to the new Bank of America Mortgage. The old NationsBanc Mortgage, Charlotte, had a $126 billion servicing portfolio.
The combination created Bank of America Mortgage, with the nation's largest servicing portfolio, valued at $223.7 billion. At year-end 1998, Bank of America still edged out no. 2 Norwest with a servicing portfolio of $249.7 billion, while Norwest stood at $245.2 billion, according to Inside Mortgage Finance.
BankAmerica Mortgage has not precisely identified where in its combined servicing portfolio the write-down has occurred. The company's release that announced the third-quarter results attributed it to a "write-down in the value of a previously unhedged mortgage servicing portfolio in the West, primarily reflecting the impact of declining interest rates." Wall Street sources report that the write-down was entirely attributable to a loss in the value of mortgage servicing rights in the portfolio of the old BankAmerica Mortgage.
MIAC's Husted says the old Bank of America was relying on the so-called macro-hedging approach. This approach looks at all the risks across the entire bank. Then, if there is an offsetting asset or security in the bank that would compensate for a loss in the mortgage servicing right, it is considered to be hedged internally.
By contrast, the old NationsBank Mortgage was "very vigorous" in its targeted approach to hedging its servicing asset, Husted says. It bought hedges specifically targeted at servicing, and he expects it would have been properly hedged going into the merger.
Dallas-based Capstead Mortgage Corporation is "a good example of how someone can diligently apply themselves and still come up short," says Husted. "They had the right philosophy and strategy, but the wrong tactics."
Capstead, a REIT, had two write-downs of its mortgage servicing rights last year - $45 million in the second quarter, and $144 million in the third quarter, according to the company's quarterly report.
There was, however, a countervailing gain in the third quarter from Treasury hedges that more than offset the $144 million write-down. The write-down had to be reported, along with the gain in the Treasury hedges, because the company did not attempt to gain hedge accounting for the Treasuries, according to Andrew Jacobs, executive vice president for finance. Late last year, Capstead sold its mortgage servicing business to Horsham, Pennsylvania-based GMAC Mortgage Corporation.
Capstead's mortgage servicing asset woes were overshadowed by a $255 million loss in the second quarter, which came in the wake of the failure of its hedges to protect other mortgage-related assets, according to Phil Reinsch, senior vice president and controller.
Capstead's loss came on the sale of $977 million in IOs and $1.3 billion in adjustable-rate mortgages, which were sold "to preserve shareholder value," Reinsch says, as they were expected to decline in value in the future. These losses, combined with the servicing write-down, plunged the company into the red by $268 million in the second quarter, according to the company's quarterly report.
Capstead hedged its portfolio of IOs and adjustable-rate mortgages with CMT floors that had a strike price far out of the money - meaning it would not pay until rates rose somewhat higher than the standard strikes. Such strikes might pay off at 150 basis points, for example, instead of at 25 basis points. Thus, they depend less on the cash transfer that would come once rates moved "into the money" and rely almost entirely on appreciation of the underlying asset.
During the second quarter, "the deep out-of-the-money Treasury floors didn't work," says Jacobs. That is, they did not rise in value sufficiently to offset the decline in the IOs and adjustable-rate mortgage securities.
"They still moved more in value than some that were in the money," explains Jacobs. The problem, he says, is that during the second quarter, Treasuries just did not rise as much in value as models would have predicted.
Capstead, however, kept its Treasury floors and applied them as a hedge for its mortgage servicing portfolio. In the third quarter, these same hedges worked beautifully, more than offsetting the decline in the value of the servicing asset, Jacobs says.
If Capstead had not kept those Treasury-based hedges, it would not have been able to offset the $144 million write-down in the fourth quarter, Jacobs notes. Thanks to the hedges that were included in the deal, Capstead was able to sell its mortgage servicing portfolio to GMAC for a small gain at the end of last year, according to Jacobs.
Capstead's hedging success in the fourth quarter gave the company some comfort. Says Jacobs, "It was one of the most volatile years on record. In this, the harshest of environments, we were still able to dispose of the entire business and make a little money on it."
Husted surmised that Capstead may have paid too much for the servicing rights and then hedged with an inappropriate hedge - CMT floors with strikes that were "too far out of the money."
But Jacobs defends the price paid for the servicing, noting it was low-rate servicing and therefore worth more. "We had one of the lowest coupon weighted averages in the country, 7.40 percent," he says. Jacobs also points out that the hedges did fully offset the decline in mortgage servicing rights in the third quarter.
But Husted suggests that Capstead may have incorrectly calculated that mortgage rates would not fall below 7 percent. Capstead also may not have realized how expensive it might be to protect the servicing rights, he adds.
"They thought it was prepay-protected, but it wasn't necessarily value-protected," Husted says.
Husted also says that when a strike price for a hedge is further out of the money, it relies less on the intrinsic value of the hedge and more on the level of volatility in the market. If volatility does not rise, the hedge may not gain much in value. "When you're way out of the money, if you miss, you miss by a lot," he explains.
Volatility actually fell in the first half of 1998, even as the Treasury and mortgage markets rallied, breaking the normal relationship, according to a Wall Street options research analyst at a top investment banking house. "If you were using CMT floors to hedge a position in the first half of 1998, you didn't get the full benefit of the hedges because volatility fell," says the analyst. At the same time, mortgage prepay speeds were higher than models would have predicted, the source says. This combination dealt a double blow to servicers holding Treasury hedges.
Falling volatility and rising prepays - defying the theory of how an option should perform - upended Capstead in the second quarter, the analyst says. Those same hedges, however, performed differently in the third quarter, when volatility was rising and prepay speeds were lower because mortgage rates did not fall as far as Treasury rates fell, the analyst explains.
The irony is that if Capstead "had held its assets another six months, they would have been golden," says the analyst. "That's because what hurt in the first half of 1998 helped in the second half; what God giveth, God taketh away."
Wilshire Financial Services Group
Wilshire Financial Services Group, Portland, Oregon, parent of the First Bank of Beverly Hills, reported a $13.7 million write-down in mortgage servicing rights for the third quarter of 1998. Wilshire manages but does not own Wilshire Real Estate Investment Trust.
The servicing write-down is the least of Wilshire's troubles. The company's large holding of lower-credit B and C loans and its holdings in mortgage-backed securities put it in a vulnerable position in the third quarter. When the value of these loans and securities fell, lenders issued collateral calls, which reduced the company's cash position. This forced Wilshire to unload major assets at discounted prices to meet these calls and provide liquidity, according to company press releases.
Wilshire's $2.9 billion servicing portfolio was not hedged, according to Zan Hamilton, senior vice president at Wilshire. "We don't hedge servicing per se," Hamilton says. "We buy at a discount," which is considered "an internal portfolio hedge." Wilshire's portfolio is made up of mostly nonconforming and Alternate-A loans, Hamilton says.
A massive restructuring announced in November - which included converting the company's $184.2 million in traded debt to equity - failed to calm the fears of investors. The company's share price, as high as $30 in June, fell to below a dollar in November. NASDAQ halted trading February 3 as the share price approached zero.
After obtaining approval by 96 percent of the votes of holders of outstanding notes, Wilshire Financial Services announced in early March that it was ready to file a voluntary petition for reorganization under Chapter 11 with the U.S. Bankruptcy Court for the District of Delaware, according to a company press release.
Company officials did not return phone calls to discuss the company's hedging strategies.
It is probably impossible to determine the full extent of economic losses (tied to servicing) not reflected on the income statements and balance sheets of mortgage banking firms, which may be greater than what has been reported, according to Stephen Harris, vice president at Goldman Sachs & Co., New York.
Many firms do not reveal details of their hedging operations. "This is the entire crux of the reason that the Financial Accounting Standards Board (FASB) is so adamant in defending their support for mark to market," Harris says.
FASB has, in fact, written a new Financial Accounting Standard 133, which is titled "Accounting for Derivative Instruments and Hedging Activities" - effective for fiscal years beginning after June 15, 1999, which in practice will cover years beginning January l, 2000, for the overwhelming number of firms.
According to FASB's guidance, "The effect [of the new standard] is that changes in fair value on both the hedge item and hedging instrument are recognized in the same period, and any ineffectiveness of the hedge strategy is reflected in net income."
Currently, mortgage servicers use a variety of methods to calculate the prepayment speed, a basic factor in determining the basis for making a write-down. This, in turn, gives them considerable leeway in the extent to which a write-down is claimed or revealed, according to Husted. "There's a valuation latitude there that makes it possible to delay recognition of losses," he says.
The arrival of FAS 133 is, however, expected to alter completely the landscape for hedging of mortgage servicing and to lead to more volatile earnings reports, according to mortgage bankers.
"It will cause marginal players to exit the business," according to Luke Hayden, at Chase Manhattan Mortgage Corporation. This, in turn, will "further the consolidation phase of the servicing business," he says.
Most mortgage bankers say it is too early to comment, although many have already drawn up a plan to comply with FAS 133. It will "greatly complicate" hedging and "greatly constrain" the ability to use many of the popular option-based instruments now widely used by mortgage bankers, according to Hayden.
It is now possible that the next wave of hedging turmoil may be driven more by accounting issues than by market gyrations.
The Basics of Hedging
Servicing hedges are financial instruments, including derivatives, that are purchased to protect holders of mortgage servicing portfolios from declines in either economic or accounting value of their mortgage servicing rights.
Such rights entitle mortgage servicers to a stream of income that comes as a tiny percentage of each and every mortgage payment. This income, called the servicing fee, usually ranges from 25 basis points to 44 basis points.
Hedges for servicing are expected to rise when interest rates fall, offsetting the decline in the value of the mortgage servicing portfolio that occurs because of an increase in prepayments and the inability of the production of new loans to keep pace with the runoff of mortgages closed out of the servicing portfolio.
Hedges have a downside, too. Those used to hedge servicing usually decline in value when interest rates rise, Risk managers try to make sure the decline in hedge value is no greater than the rise in the value of the servicing asset.
SERVICERS ON THEIR HEDGING STRATEGIES
In the third quarter of 1998, HomeSide Lending, Inc., Jacksonville, Florida, made some changes in the hedges covering its $120 billion servicing portfolio that positioned it well for the liquidity crisis in the third quarter, according to Kevin Race, chief financial officer.
"We moved some of our position out of options and into more futures," Race says. Why? "We wanted a higher delta," he explains. Derivatives with a higher delta will go up more in value in response to a given change in interest rates than a derivative with a lower delta, he explains.
HomeSide, like other servicers that hedge, found its hedges outperformed expectations, while asset values for the mortgage servicing rights did not go down as fast because mortgage rates did not fall as far and fast as Treasuries. In fact, Race says, HomeSide's hedge outpaced the decline in servicing rights by 10 percent.
Race has found that the fourth quarter of 1998 and early 1999 have presented HomeSide and other mortgage bankers with "a challenging environment" for hedging."A lot of people are struggling. As asset values [of mortgage servicing rights] are going up, hedges are going down faster."
HomeSide has also seen "a slight underperformance" of its hedge program, as the mortgage-Treasury spread has tightened, Race says. "We believed that mortgage spreads were wide and would tighten. We didn't anticipate how they would bounce around, particularly [in January]," he says.
Most servicers now are balancing the need to protect the servicing asset with the need to keep down the cost of managing the hedge, Race says. The big
question now, he says, is: "How do I create a sufficient level of protection at the lowest implied cost?"
Fleet Mortgage Group, Columbia, South Carolina - like most other mortgage bankers - has paid close attention to the changing spreads between 10-year Treasuries and 30-year mortgages as a tool for evaluating its hedge program on its $118 billion servicing portfolio, according to Bill Naryka, chief financial officer. This approach, as with others, helped Fleet reap a bonanza in the third quarter of last year.
When spreads are narrow and expected to widen, Fleet adds more Treasury-based instruments. When the reverse is true, it relies more on interest rate swaps and related instruments, Naryka says.
Fleet does not attempt to predict interest rates. Instead, it diversifies its portfolio to be prepared for a number of contingencies. "We have different hedges that behave differently in different interest rate moves. This way, we don't get whipsawed when interest rates move," says Naryka.
"We look at how much money we can gain or lose with a plus or minus move of 50 basis points in interest rates. We managed the hedge book within that constraint," says Naryka."Virtually the entire portfolio is hedged."
Fleet also does daily rebalancing of its portfolio. "It's the biggest asset we have and the riskiest," says Naryka. Fleet has five people on staff who work under Naryka to manage the hedge portfolio.
Norwest Mortgage, Des Moines, Iowa, relies partly on its considerable production network presence to serve as a natural hedge for 20 to 25 percent of the servicing asset in its huge $245.2 billion servicing portfolio, according to Geoff Dreyer, managing director for risk management.
Last year, for example, Norwest originated $109 billion, half of which was from its retail network. This set an industry record for annual originations by a single company, Dreyer says.
Norwest diversifies its hedges for the rest of the portfolio "across a broad spectrum," says Mohan Chellaswami, vice president in capital markets at Norwest's office in St. Louis. The hedge portfolio includes Constant Maturity Treasury (CMT) floors, Constant Maturity Swap (CMS) floors, Treasury futures, swaptions (options on swaps), principal-only strips (POs) from mortgage-backed securities, options on Treasury futures and others.
Norwest's hedge portfolio is managed to cover any decline in the mortgage servicing right that might occur within a 200 basis point plus or minus change in interest rates.
During the third quarter of 1998, the company's hedge offset losses in the mortgage servicing rights, when the natural hedge of production is included, Dreyer says. Since then, Norwest has moved more of its hedge portfolio into CMS floors and out of CMT floors, he says.
Chase Manhattan Mortgage
Chase Manhattan Mortgage Corporation, New York City, began to move out of swaps and into Treasury derivatives in February 1998, according to Luke Hayden. This positioned Chase, which has a $212 billion servicing portfolio, to reap a big gain in its hedge during the liquidity crisis that began in August.
Chase, which adjusts its position daily, began to migrate back into swaps from Treasuries after spreads reached their widest point last October.
"We're pretty simple folks," explains Hayden. "We like to stick with the most liquid instruments."
PNC Mortgage, Vernon Hills, Illinois, operates its hedging strategy within policies set up by the parent bank company's Asset Liability Committee, according to Mel Steele, senior vice president, secondary marketing. That committee requires that PNC Mortgage offset 100 percent of any impairment of its mortgage servicing rights.
PNC, which has a servicing portfolio of $60 billion, has met the goals set for it by the Asset Liability Committee, according to Steele. "At all times over the past year, we have had an offsetting value created by hedge instruments that has kept us from suffering any impairment," he says.
When the liquidity crisis hit in the third quarter of 1998, says Steele, PNC was well protected because "most of our instruments were Treasuries."
PNC, like other mortgage bankers, has moved into more swaps since last year and is monitoring the markets daily to adjust its hedge, Steele says.
First Union Mortgage Corporation
First Union Mortgage Corporation, Charlotte, North Carolina, began hedging three years ago and has developed "what we believe is a well-thought-out policy" that protects the value of the mortgage servicing asset, according to Tim Schuck, asset portfolio manager in the mortgage company.
Policy is set by a hedging committee, whose members come from the mortgage company and the capital markets area of the parent company, First Union Corporation."Our policy is to assure we are fully hedged for any 200 basis point movement in rates," says Schuck.
First Union, which has a $70 billion servicing portfolio, has relied heavily on 30-year Treasuries to hedge its impairment risk. "Occasionally we'll take an option position that is essentially short term, securing our position in long bonds," says Schuck.
During the third quarter of 1998, the hedge "more than offset" the decline in the asset value of the servicing rights, Schuck says. At the time, First Union sold some of the Treasuries to take the gains, he adds.
Despite the market turmoil, First Union's hedging policy "has performed well" over the last year and preserved the value of its servicing rights, Schuck says. The hedge is reviewed monthly, and First Union continues to remain concentrated in long Treasury bonds, according to Schuck.
Robert Stowe England is a freelance writer based in Arlington, Virginia.
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|Title Annotation:||includes related articles on hedging and hedging strategies|
|Author:||England, Robert Stowe|
|Article Type:||Cover Story|
|Date:||Apr 1, 1999|
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