Lower Rates Crimp Value of Banks’ Mortgage-Servicing Rights

Lower interest rates generally help banks’ mortgage businesses. Except when they don’t.

The value of mortgage-servicing rights, which are a key part of banks’ mortgage businesses, got hit by falling rates in the second quarter at

Wells Fargo

& Co.,

JPMorgan Chase

& Co. and other lenders, weighing on what was otherwise a strong period for home-lending operations.

Mortgage servicing involves collecting payments and performing other administrative duties on home loans, but the value of the rights to service those mortgages usually drops when interest rates fall.

Wells Fargo, the largest bank holder of servicing rights, said the value of its mortgage-servicing rights dropped 9% from the end of the first quarter to $12.1 billion at the end of the second quarter. JPMorgan, the second-largest, said the value of its mortgage-servicing rights fell 15% over the quarter to $5.1 billion.

The moves show the flip side of falling rates, which generally spur borrowers to take out home loans or refinance. The average 30-year fixed mortgage ended the second quarter with a rate of 3.73%, down from 4.08% at the beginning of the period, according to Freddie Mac data. The Federal Reserve has signaled it is ready to cut rates after several years of raising them, in turn pulling down the cost of borrowing for mortgages and other debt.

But while lower rates can fuel mortgage making, they usually hurt the paper value of servicing rights. That is because lower rates make homeowners more likely to refinance their mortgages or otherwise pay them off early, which means the servicer loses that future income stream.

It might be a humdrum business, but it is important to many lenders. Lenders can service mortgages they have made or buy the rights to service mortgages made by other lenders. Some do so because they provide a steady source of income.

Citizens Financial Group

Inc., for example, doubled the amount of mortgages it services when it bought a lender last year, leading to a jump in mortgage-banking revenue.

In their second-quarter earnings reports last week, banks disclosed steep declines in the value of these assets. The banks that have reported earnings so far generally lost between 7% and 10% of fair value in their mortgage-servicing-rights portfolios, according to Mark Garland, managing director at SitusAMC, which advises on servicing transactions.

For servicing portfolios, it was the speed of the drop that caught many executives off guard.

“Mortgage companies do best when rates move steadily in a direction as opposed to rapidly in a direction,” said Stephen Lynch, a credit analyst at S&P Global Ratings, whose coverage includes mortgage firms. “We definitely saw a dislocation.”

Banks typically use derivatives to protect against volatility in the value of their servicing rights, a practice known as hedging. But that becomes more difficult when rates fall quickly. Some lenders disclosed getting wrong-footed by their hedges. “It was a tough quarter to hedge,” Mr. Garland said.

When banks service a mortgage, they can collect a small cut of the mortgage payment. Many banks take this job because it allows them to develop a relationship with the borrower and try to sell them other bank products, while also collecting income.

Banks serviced some $3.6 trillion of mortgages that have been packaged into

Fannie Mae

or Freddie Mac securities or otherwise sold on to other investors, according to data from the end of March by industry-research group Inside Mortgage Finance.

The business of buying and selling servicing rights became a hot trade last year as mortgage rates hit multiyear highs. Those trades have cooled as rates dropped this year. In the first quarter as rates were falling, $135.7 billion of Fannie, Freddie and Ginnie Mae servicing rights changed hands, down about $40 billion from the prior quarter, according to Inside Mortgage Finance.

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Write to Ben Eisen at ben.eisen@wsj.com

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