Not everyone fears the Fed these days. When last year's record-low interest rates spawned an unprecedented wave of mortgage origination and refinancing activity, one segment of the mortgage business was never invited to the party: mortgage servicing.
Mortgage servicing runs countercyclical to the rest of the industry, as increased levels of refinancing can drain loan-servicing fees. The longer a loan stays on the books, the higher the associated revenues from servicing that particular loan.
Now that rising rates have slowed refinancing dramatically and cut new loan originations in half, firms with large mortgage-servicing portfolios may finally throw a little soiree of their own. Clearly, this fact was not lost on Citigroup
The acquisition of Principal's mortgage business will increase the size of Citigroup's home loan portfolio by 50% and elevate CitiMortgage to a top-five position. With $352 billion in managed assets, the company will hold a 4.2% market share, behind rivals such as Countrywide Credit Industries
To visualize how effective the mortgage-servicing business can hedge against a rising rate environment, one need look no further than Principal Financial's first-quarter earnings. In the mortgage-banking segment, earnings derived from the origination of new loans fell precipitously from $109.6 million to $23.7 million. Meanwhile, earnings generated from loan servicing soared to a $4.9 million gain vs. a loss of $57.3 million in the first quarter of 2003.
The deal will close later this year, pending regulatory approval, and appears to be a win-win for shareholders of both companies. Though Principal Financial forecasts an initial $0.08-$0.10 reduction in operating income, the sale will remove a highly volatile earnings component and allow costs to be redirected toward its core employee benefits and retirement business. Principal is the nation's leading provider of 401(k) plans. The proceeds of $1.26 billion ($710 million after-tax) represent a premium of $290 million over net book value, and will be used to fund a stock buyback, as well as future acquisitions. The final price, though, is tied to a complex formula and likely to fluctuate with changes in the underlying book value and mortgage-servicing rights of Principal Financial.
Citigroup receives a profitable business for a great price at an opportune time. With the average 30-year fixed-rate mortgage climbing 55 basis points over the past month to 6.61%, the prospects for loan servicing continue to look attractive. The acquisition will solidify yet another unit in what is already the world's largest financial services firm, and is expected to be accretive to earnings in 2004. With earnings of nearly $18 billion last year, though, the impact of the additional income is modest.
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Fool contributor Nathan Slaughter owns none of the shares mentioned. He welcomes your comments.