Writedowns on Mortgage Servicing Make Even JPMorgan Vulnerable

By Michael J. Moore Oct. 12 (Bloomberg) -- The four biggest U.S. banks by assets may have to take writedowns on $55 billion of mortgage- collection contracts after marking them up by $11 billion in the second quarter, casting a shadow over earnings. Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. wrote up the value of the contracts, known as mortgage-servicing rights or MSRs, by 26 percent in the quarter as mortgage rates climbed by about 0.35 percentage point. Net gains on the contracts added more than $1 billion to Wells Fargo’s record earnings in the quarter and $1 billion to JPMorgan’s first-quarter profit. Mortgage rates fell about 0.26 percentage point in the third quarter, according to Freddie Mac, and servicing costs are rising, meaning the four banks, which handle collections on more than $5.9 trillion of U.S. mortgages, may face writedowns. “We’re very bearish on MSR valuations,” said Paul Miller, a banking analyst at FBR Capital Markets in Arlington, Virginia. “They are overvalued. There are higher costs associated with the servicing, and we’re very concerned about it.” The four banks control 56 percent of the market for the contracts, according to Inside Mortgage Finance, a Bethesda, Maryland-based newsletter that has covered the industry since 1984. Servicers collect payments from borrowers and pass them on to mortgage lenders or investors, less fees. They also keep records, manage escrow accounts and contact delinquent debtors. ‘Accounting Game’ The value of the rights depends largely on the expected life of the mortgage, which ends when a borrower pays off the loan, refinances or defaults. When rates drop and more borrowers refinance, MSR values decline. Banks typically hedge those movements using interest-rate swaps and other derivatives. Under U.S. accounting rules in place since 1995, banks are supposed to report the value of their mortgage-servicing rights on a fair-market basis, or roughly what they would fetch in a sale. A bank must record a loss whenever it sells MSRs for a price below where they’re marked on the books. Because there’s no active trading in the contracts, there are no reliable prices to gauge whether banks are valuing the rights accurately, analysts said. “It’s an accounting game,” said Richard Bove, an analyst at Rochdale Securities Inc. in Lutz, Florida. “The deeper you get into the subject, the more items you find that are impossible to determine, and therefore it becomes a give up. Whatever they want to show, they show.” Hedging MSRs JPMorgan reports its third-quarter earnings on Oct. 14. Seven analysts surveyed by Bloomberg expect the bank to post a profit of $2 billion, down 27 percent from the second quarter. Citigroup, which reports the next day, is estimated by eight analysts to post a loss of $2.5 billion after recording a $4.3 billion profit in the second quarter when it sold a controlling stake in its Smith Barney brokerage. Bank of America’s earnings are expected to drop 95 percent from the second quarter to about $165 million when the lender announces results on Oct. 16, according to the mean estimate of 10 analysts. Eight analysts estimate Wells Fargo will post net income of $2.1 billion on Oct. 21, down 34 percent from its record earnings the previous quarter. Whether the banks will take losses as a result of any MSR writedowns in the third and fourth quarters depends on the level of their hedging. Bank of America, which lowered the value of its rights last year by $6.7 billion, still added $2 billion to its earnings as hedges outperformed the declines. JPMorgan’s hedges earned $1.5 billion more than the $6.8 billion it took in writedowns on its collection contracts in 2008. ‘Inherently Unpredictable’ Bank of America holds the largest amount of MSRs, with $18.5 billion as of June 30. JPMorgan had $14.6 billion, while Wells Fargo owned $15.7 billion and Citigroup $6.8 billion. The four banks don’t own most of the mortgages they service. Wells Fargo handles $270 billion of its own residential mortgages and $1.39 trillion of loans for others, according to company filings. Bank of America services $2.11 trillion of mortgages, $1.70 trillion of them for investors. Citigroup services $770 billion, including $579 billion of loans it doesn’t own. JPMorgan, which handles $1.4 trillion of mortgages, said it services $1.1 trillion of loans for other investors. Spokesmen for the four banks declined to comment about how the rights are valued. The companies say in regulatory filings that the assets are volatile and marking them requires making assumptions about future conditions. “The valuation of MSRs can be highly subjective and involve complex judgments by management about matters that are inherently unpredictable,” San Francisco-based Wells Fargo said in its second-quarter regulatory filing. Wells Fargo, JPMorgan Wells Fargo wrote up the value of its MSRs by $2.3 billion in the quarter, the result, it said, of model inputs and assumptions. The hedges it used to offset the movement of the servicing rights fell $1.3 billion, resulting in a net gain of $1 billion to its $3.2 billion second-quarter profit. New York-based JPMorgan, which wrote up its MSRs by $3.83 billion in the quarter, reported a $3.75 billion loss on its hedges, leaving it with an $81 million profit. Bank of America based in Charlotte, North Carolina, gained $3.5 billion on the increase in value of its collection contracts. The bank didn’t disclose the performance of its hedges. Citigroup, which marked up the value of its rights by $1.3 billion, also didn’t disclose its hedges. “Nobody wants to point out that the emperor has no clothes,” said FBR’s Miller. “They all took massive hedging losses over the last quarter, mainly coming out of May, when rates shot up 150 basis points, and mysteriously MSRs were written up to match those losses.” A basis point is 0.01 percentage point. No Market Banks say there is no liquid market for the securities, as the volatility of the rights has pushed some smaller firms out of the market and record delinquencies have led others to shun mortgage assets. The banks list the rights as Level 3 assets, an accounting term for securities whose value is unclear, and they rely on internal models to determine their value. “About 75 percent of residential MSR assets are owned by 10 firms, so when you’ve got that supply-demand dynamic that changes, there’s not going to be a whole lot of trading,” said Daniel Thomas, a managing director in asset sales at Mortgage Industry Advisory Corp. in New York. “When the market is dry like it is as far as trading volume, these guys have a lot of latitude for a Level 3 input valuation.” Servicing rights provide a steady stream of income. The four banks collected about $4.1 billion from fees in the second quarter. Much of that revenue, about $3.2 billion, was already accounted for in the valuations of the rights. Servicing Costs Servicers face higher costs as delinquencies rose almost 80 percent in the last year and large banks move to implement President Barack Obama’s mortgage-modification program. Home loans 60 days or more past due climbed to 5.3 percent of loans through June 30, up from 4.8 percent on March 31 and 3 percent a year earlier, the Office of the Comptroller of the Currency and the Office of Thrift Supervision said in a Sept. 30 report. Contacting and working with borrowers who fall behind on their mortgages is time consuming and costly. Loan-servicing employees can handle as few as one-tenth the number of delinquent loans as performing loans, said Steven Horne, the former director of servicing-risk strategy at Fannie Mae who now heads Wingspan Portfolio Advisors LLC, a specialist in distressed-loan collections in Carrollton, Texas. First Tennessee Bank National Association, a subsidiary of First Horizon National Corp., saw its servicing costs rise to about $80 a year per loan from $60 a loan a year earlier as delinquencies and defaults rose, said David Miller, head of investor relations at the bank. Unable to Refinance While higher servicing costs and falling mortgage rates lower the value of the rights, the weak economy can push them higher. Borrowers who owe more than their home is worth or who have lost their jobs are often unable to refinance, tempering the impact of lower rates on prepayments. Banks’ hedges also often benefit from lower rates. In the U.S., 26 percent of borrowers owe more than their home is worth, said Karen Weaver, global head of securitization research for Deutsche Bank Securities in New York. In parts of California, Florida and Nevada, it’s as high as 75 percent. The U.S. economy has lost about 6.9 million jobs since the recession started in December 2007. Average Life Difficulties in refinancing mortgages during the worst recession since World War II are reflected in banks’ expectations of the life of the servicing rights. The assumed weighted average life of a servicing right tied to a fixed-rate mortgage jumped to 5.11 years as of June 30, Bank of America said in a regulatory filing. That’s up from 3.26 years at the end of 2008, following a 0.28 percentage point rise in mortgage rates. The assumed weighted average life had fallen from 5.38 years on Sept. 30, 2008, after mortgage rates dropped 0.95 percentage point in the fourth quarter. A change in prepayment rates that would cause a 0.48 year drop in the weighted-average life of the portfolio would result in an estimated $1.43 billion decline in the value of its servicing rights, the bank said. “Either because people are underwater, which means it’s unlikely they are going to jump out of that mortgage, or they just aren’t moving around as much, those mortgages are going to last a lot longer, and that would help the valuations,” said Ray Pfeiffer, chairman of the accounting department at Texas Christian University’s Neeley School of Business. Volatility The volatility of the rights and the cost of hedging them have led First Tennessee Bank to cut more than half of its MSR holdings, which included contracts to service about $100 billion of mortgages at its peak in 2008. “The underlying cash flow of the servicing business is pretty good, the fees relative to the servicing costs are actually fairly attractive,” Miller said. “It’s a very difficult asset to hedge, and that’s one of the things that makes that business, in our mind, less attractive.” To contact the reporter on this story: Michael J. Moore in New York at mmoore55@bloomberg.net.