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Not Everybody Loves a Refi Boom


Falling interest rates have been a boon for homeowners, who have happily fueled one of the largest refinancing booms in history. In the first six months of 2001, 2.5 million borrowers traded their mortgages in for lower-rate loans, and things aren't slowing down. After dropping in July, refinancings are expected to jump again for August.

But the flurry of activity is putting increasing pressure on companies and investors that rely on a steady stream of mortgage payments for income. Topping the list are mortgage servicers, which get fees for collecting and processing payments on loans. When a homeowner refinances his or her loan, the principal is paid back to the loan's owner but the servicer loses out on expected fees. In July, the sixth-largest servicer, HomeSide Lending, Inc., based in Jacksonville, Fla., took a $450 million charge because its servicing portfolio shrank. Although refinancings have rocketed industrywide, the company has been unable to pull in enough new loans to balance the losses.

Also at risk are investors in some of the $3.8 trillion in outstanding mortgage-backed bonds. Home loans are bundled into securities on Wall Street, and some are carved into investments known as IOs, or "interest only" securities, and POs, or "principal only" securities. When rates go down and homeowners refinance in droves, principal payments on the loans are made sooner, driving the value of POs up. IOs, on the other hand, fall in value as refinancings increase because interest on the loans will be paid over a shorter time than expected. When rates fall rapidly, holders of IOs get clobbered. About $40 billion in IO-related securities is traded on Wall Street.

Now, some analysts and investors say the recent drop in 30-year mortgage rates to below 7% could trigger a new round of refinancings, and perhaps a new crop of losses. "Someone with a huge exposure could get a nasty surprise" predicts Michael McMahon, a Sandler O'Neill & Partners financial analyst. Huge exposure is the name of the game for the top 10 mortgage servicers, which now handle nearly 50% of the country's home loans, up from 25% in 1995.

To mitigate their risk when rates go down, these outfits rely on hedging. They purchase POs and other financial instruments that generally gain in value when rates fall. Demand for POs, for example, shot up late last year, as companies anticipated rate cuts. To gauge how effectively proper hedging can help a company, just look to Countrywide Credit Industries Inc., based in Calabasas, Calif. In the fourth quarter of 2000, the company took a $740 million charge to revalue its mortgage-servicing portfolio, but investors didn't blink--because the charge was offset by a PO and derivative hedge that brought in $698 million.

DEBACLES. Deciphering a company's exact hedging strategy is tough. After all, many consider the nuts and bolts of their hedging operations proprietary information. To date, there have been some spectacular debacles when investors have misstepped. In 1994, for example, a $600 million fund invested in mortgage securities lost most of its value when the hedges it relied on failed. Using POs to hedge for falling IO values isn't a perfect trade: Values of POs are undermined when delinquencies rise. If the economy starts to crumble, the hedge doesn't work. Already, some securities backed by low-quality mortgage loans, called subprime, are showing record-high delinquency rates.

Most mortgage servicers, though, insist there's no threat of large charges ahead. "It won't happen with us," says William A. Longbrake, chief financial officer at Washington Mutual Inc. The thrift has increased its mortgage-servicing portfolio 50% since the first quarter, to become the largest in the business. "As the business consolidates, you've got more people who know what they're doing" under one roof, Longbrake explains. Perhaps, but under that same roof is more risk than ever before. By Heather Timmons in New York


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