Abstract
Mortgage servicing rights (MSRs) accounting rules create severe interest rate earnings risk for mortgage banks, even when the firm is cash flow-neutral to interest rate changes. Mortgage banks have been forced to adopt aggressive and at times uneconomic hedging practices or abandon mortgage servicing altogether. In this paper, simple mortgage banking model is developed to analyze earnings volatility, with and without MSR hedges. The results suggest that short-term earnings volatility induced by the asymmetric accounting treatment of the servicing and mortgage origination franchises is marked and persistent, and that hedging, while somewhat reducing earnings risk, essentially shifts it over time.
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