How Mortgage Servicers Hedge Risk

Rate volatility is the reason that mortgage servicers hedge their portfolio. This hedging activity is not seen or noticed directly by mortgage holders, or even by individual mortgage originators, but it allows consumers to take quicker advantage of falling interest rates, and generally makes it possible for mortgage lenders and servicers to keep costs down.

People often assume that mortgage servicers make their money strictly off the interest borrowers pay each month on their mortgage. A higher-rate mortgage would seem to be a more valuable asset for the loan servicer. But if current market rates are low, then a higher-rate loan in the bank’s servicing portfolio would actually be a less valuable asset than a lower-rate loan. This is because the higher-rate loan would likely be paid off through a refinance.

Mortgage servicers try to smooth out the profitability of their portfolio through hedging. They do this primarily by buying derivatives or entering into swap transactions. If rates decline, the mortgage servicer can predict that a percentage of their higher-rate loans will pay off through a refinance in the coming months. So the lender can take immediate action through forward purchase commitments of rate-driven securities. Use of the derivative market will provide profit even as the value of the servicing portfolio declines.

Another misconception about mortgage servicing is that banks finance mortgages with their own money. If this were the case, a mortgage payoff would put a significant amount in their own coffers for future investment. But mortgages are sold on the secondary market to investors. So a payoff actually represents a loss in income to the mortgage servicer.

Most mortgage servicers are also in the business of originating new mortgage loans. When rates fall, profit from origination activity increases, but the value of the servicing portfolio declines. When rates increase and origination volume slows down, the servicing income increases. Thus banks that do both origination and servicing are better positioned for the cyclical mortgage market than banks that only do one or the other.

Mortgage markets operate in a way that allows both loan originators and servicers to predict their near-term profit or loss with a high degree of accuracy. Because refinance transactions take 30 to 60 days to close, the originators must wait for their profit, while the servicers have a chance to engage in hedging activity before their losses are realized. This helps the mortgage servicing company show more consistent earnings from month to month and quarter to quarter.