Lenders Chafe at Service Fee

By Matthew Goldstein
Senior Writer
TheStreet.com
2/10/2005 7:07 AM EST

Such is the power of Fannie Mae (FNM:NYSE) and Freddie Mac (FRE:NYSE) in the mortgage market that the two government-formed titans are able to impose a pair of esoteric fees on lenders that end up being paid by nearly everyone who buys a house.

Neither fee is well-known. One covers the cost of having Freddie or Fannie guarantee a loan from default, something they do for the vast majority of mortgages written in the U.S. The other goes to the bank "servicing" one of those mortgages, a process that entails collecting monthly interest payments, assessing late fees and paying taxes and insurance premiums.

Now, a group led by Countrywide Financial (CFC:NYSE) is pushing Fannie and Freddie to cut the current servicing fee in half, a step that could reduce costs for homebuyers. The campaign has opened a deep rift among mortgage lenders and spooked small ones, who fear they will become vulnerable to takeover if their larger brethren are freed from the servicing-fee burden.

The servicing fee currently adds 0.25 of a percentage point to a loan's interest rate, a standard that has held steady for more than a decade.

For mortgage banks that specialize in servicing, the levy can generate a lot of income. So it might seem odd that some mortgage lenders are behind the push.

Nevertheless, the drive to reduce the fee does make sense to a company like Countrywide in light of various intricacies of mortgage servicing, a capital-intensive business that entails a good deal of risk. While loan servicing is a potentially lucrative enterprise, it can be particularly difficult to manage since it is affected by both the direction of interest rates and the behavior of homeowners.

Using a complicated formula, a mortgage bank must predict how much income can be generated from each mortgage over the life of the loan, while estimating prepayment rates and various fees. In the mortgage business, the asset is referred to as a loan's mortgage-servicing right, and lenders must hedge against a fluctuation in its value. To support the necessary interest-rate hedges, a mortgage firm must set aside capital.

Lenders backing the fee reduction are willing to sacrifice a little income if it means setting aside less capital to support their hedging activity. These firms contend the fee reduction will permit them to better spend that capital on developing other areas of business.

That's a big reason Countrywide, which has one of the nation's biggest mortgage-servicing businesses, is lobbying hard for the fee reduction.

"The amount mandated today makes no sense at all based on the cost of servicing,'' said Countrywide Chairman and CEO Angelo Mozilo, during a conference call earlier this week. "We're working very hard on it with both Fannie and Freddie.''

Indeed, Countrywide has good reason to lobby for the fee reduction, after announcing disappointing fourth-quarter earnings on Feb. 2. Profits at the Calabasas, Calif.-company slid 39% from a year ago because its hedging strategy for its $838 billion servicing portfolio failed to predict the sharp convergence of short-term and long-term interest rates.

The hedging snafu at Countrywide, coupled with a $92 million impairment charge on the value of the portfolio, led to a $278 million pretax loss in the servicing business, compared with $83 million in pretax earnings in the fourth quarter of 2003.

A reduction in the servicing fee might have mitigated some of the losses in the firm's servicing business.

"The main issue you hear from the proponents is the cost of capital,'' says Doug Duncan, chief economist for the Mortgage Bankers Association. "Any institution that holds servicing rights will have to hold capital to support those assets.''

Paul Miller, a mortgage finance analyst with Friedman Billings Ramsey, says the industry is putting a lot of pressure on Fannie and Freddie to trim the servicing fee. He says it's become an important issue for mortgage banks, which traditionally have been averse to keeping a lot of capital tied up.

"Countrywide views this as being capital intensive,'' said Miller. "They want to free it up and use it elsewhere.''

So far, Fannie and Freddie, which both have been saddled with major accounting scandals in the past two years, aren't saying much on the topic. The mortgage giants say they are reviewing the issue and have had several meetings with the Mortgage Bankers Association on the matter. It's believed if one of the mortgage finance firms moves to cut the servicing fee, the other would follow.

But not all the big players in the mortgage business are lining up with Countrywide. Indeed, except for Countrywide, few are publicly commenting on the issue. Officials at Washington Mutual (WM:NYSE), Wells Fargo (WFC:NYSE), Bank of America (BAC:NYSE) and PHH (PHH:NYSE), the recently spun-off mortgage arm of Cendant (CD:NYSE), all declined to comment.

While sources said Seattle-based WaMu is siding with Countrywide in the dispute, Wells Fargo is quietly leading the opposition. People familiar with the issue say Wells doesn't believe the cost savings for homeowners will be significant and is fearful about the impact on profits.

Reducing capital allocations is not as big a concern to Wells because big commercial banks are required by bank regulators to maintain far higher capital ratios than mortgage banks.

Mike McMahon, a Sandler O'Neill mortgage banking analyst, says some smaller lenders also oppose trimming the servicing fee because it could lead to consolidation in the industry. For many smaller servicing firms, the lost revenue outweighs any gains they'll get from maintaining less capital in support of their hedging strategy.

"It would make mortgage servicing an even lower-margin business and more competitive,'' said McMahon. "Perhaps it would increase the pace of consolidation."