PennyMac Financial Services Inc

NYSE:PFSI

Earnings Call Transcript 2019-Q2

[Christopher Oltmann, executive]

Good afternoon, and welcome to the second quarter earnings discussion for PennyMac Mortgage Investment Trust. The slides that accompany this discussion are available from PennyMac Mortgage Investment Trust's website at www.pennymac-reit.com.

Before we begin, please take a few moments to read the disclaimer on Slide 2 of the presentation. Thank you.

Now I'd like to turn the discussion over to Stan Kurland, PMT's Executive Chairman.

[Stanford Kurland, executive]

Thank you, Chris. Let's begin with Slide 3. PMT reported net income attributable to common shareholders of $38 million or $0.50 per share compared to $47.3 million or $0.68 per share in the prior quarter.

The annualized return on average common equity was 10%. Book value per common share increased to $20.79 at quarter-end from $20.72 at March 31. And PMT paid a dividend of $0.47 per share for the quarter.

PMT reports results through 4 segments: credit sensitive strategies, which contributed $33 million in pretax income; interest rate sensitive strategies with a pretax loss of $1.9 million; correspondent production, which contributed $16.2 million in pretax income; and corporate with a pretax loss of $13.9 million.

Our results this quarter were driven by continued solid results from our GSE credit risk transfer investments and strong performance in our correspondent production business. The performance of our agency mortgage-backed securities and interest rate hedges worked to substantially offset the market-driven valuation impact on our mortgage servicing rights and excess servicing spread investments as interest rates declined during the quarter.

PMT continued its strong pace of capital investment, driven by record conventional acquisition volumes totaling $12.2 billion in UPB. Approximately 76% of this quarter's mortgage production was delivered into CRT investment, which resulted in robust CRT investment growth; as well as new MSR investments on the total volume of conventional loans produced during the quarter.

Turning to Slide 4. Let's continue our discussion of second quarter highlights. During the quarter, we settled our fifth CRT transaction with a face amount of $933 million and have begun to deliver loans to Fannie Mae under a commitment for our sixth CRT transaction. In addition, we issued $638 million of 4-year term notes to finance PMT's fourth CRT investment and completed the sale of $42 million in UPB of nonperforming loans from the distressed portfolio.

PMT's strong investment opportunities and excellent performance drove successful capital-raising activities in the quarter totaling $214 million in net proceeds.

In May, through an underwritten equity offering, we raised approximately $170 million from an issuance of 8.1 million common shares. And through our at-the-market or ATM common equity program, we issued an additional 2.1 million shares, raising $44 million.

Finally, I'm pleased to note, after the quarter-end, we entered into an agreement to sell approximately $115 million in UPB of nonperforming and reperforming loans or 86% of the remaining distressed loans.

Now let's turn to Slide 5 and discuss the current market environment. Looking forward, the outlook for the direction of the U.S. economy is becoming less certain. The recent rally in treasury bonds, coupled with yesterday's decision by the Federal Reserve to lower short-term rates, supports the view of a weakening economic outlook, primarily driven by concerns over a slowdown in global growth and heightened uncertainty around the long-term impact of tariffs and ongoing trade tensions. Reflecting these uncertainties, the average 30-year fixed mortgage rate ended the quarter 33 basis points lower than at the end of the first quarter, driving greater refinance activity and a boost to the purchase market from improved affordability in the midst of the summer home buying season.

In response to lower rates, forecasts for the size of the mortgage origination market in 2019 and 2020 have been revised upward. We currently estimate that approximately 50% of the mortgage loans held in agency mortgage-backed securities are now eligible for refinance, with an even higher percentage in more recently issued vintages. Purchase originations are still expected to grow by single-digit percentages over the next 2 years, aided by low rates and moderating home price appreciation.

Credit markets remained healthy, supported by strong employment trends consistent over the last few years. One indicator is the level of mortgages 30 days or more delinquent at June 30, which is near historical lows, but rose slightly from March 31. However, serious delinquencies, those 90 days or more delinquent, fell to their lowest level in 12 years.

Spreads on more seasoned CRT securities widened slightly as a result of elevated prepayment activity, while spreads on more recently issued CRT securities tightened by a few basis points.

Now let's turn to Slide 6 and discuss the quarter's investment activities. On Slide 6, we detail investment activity for each of PMT's investment strategies during the second quarter. The primary driver behind PMT's capital-raising activity this year is its compelling outlook for investment growth. Our increased investment activity in the second quarter supported this perspective, driven by strong capital deployment to CRT and MSR investments resulting from robust growth in production volume.

Loans eligible for CRT deliveries totaled $9.3 billion in UPB, which resulted in new firm commitments to purchase CRT securities totaling $324 million. Distressed loans and REO totaled $172 million at June 30, 2019. No new investments were made this quarter, and we are actively pursuing strategies to expedite the liquidation of these investments. Of the total amount, distressed loans comprised $74 million and REO totaled $98 million.

As I mentioned in the highlights, we completed a sale of distressed loans during the quarter, and after quarter-end, we entered into an agreement to sell substantially all of the remaining distressed loans. We are also making solid progress on the liquidation of the REO portfolio, which decreased 15% from the end of the prior quarter.

New MSR investments added during the quarter totaled $153 million sourced from the securitization of $12.2 billion in UPB of conventional production. Agency MBS are held by PMT as part of a comprehensive strategy designed to mitigate the interest rate sensitivity of a growing MSR asset. As a result, we acquired $81 million in new MBS investments during the quarter.

Now let's turn to Slide 7 and review the run rate quarterly return potential of PMT's investment strategies.

Our expectation for PMT's activities is a run rate diluted EPS of $0.56 per quarter, which would result in an annualized return on common equity of approximately 11%. PMT's run rate potential reflects our expectation for returns over the next several quarters, our income potential results from continued growth of CRT and MSRs, organically driven by our correspondent production activities.

PMT's run rate equity allocation related to credit sensitive strategies is expected to increase and deliver an annualized return on equity of 19%. This assumes increased capital deployment into and continued strong underlying fundamental performance of our CRT investments.

Equity allocated to interest rate sensitive strategies is expected to average 32%, with an annualized return on equity of approximately 11%. We consider the results of this segment in aggregate as MBS and hedge positions are primarily used to moderate the impact of interest rate volatility on MSRs and ESS returns. Our expectations are primarily driven by our outlook for the earnings contributions from the growing MSR asset.

The correspondent production segment is expected to deliver an annualized return on equity of approximately 22%, which reflects our outlook for a modest improvement in the production environment, driven by an increase in the forecasted market size as a result of higher refinancing demand.

And lastly, we expect the ongoing impact of distressed loans and real estate owned to diminish significantly, given the recent sales and commitments to sell substantially all of the remaining loans in the distressed loan portfolio.

This concludes my presentation. I'd now like to turn the discussion over to David Spector, PMT's President and Chief Executive Officer, who will review our mortgage investment activities.

[David Spector, executive]

Thank you, Stan. Let's begin with Slide 9 for a look at our correspondent production highlights. Correspondent acquisitions by PMT in the second quarter totaled $21.7 billion in UPB, up 44% from the prior quarter and 45% year-over-year, split approximately evenly between government-insured and conventional loan acquisitions.

Conventional correspondent acquisitions totaled $11.1 billion in UPB, up 34% from the prior quarter and 104% year-over-year. The increase in conventional loan volumes were driven by lower mortgage rates resulting in higher volumes of refinance purpose mortgages. As part of its correspondent loan acquisitions, PMT acquired conventional loans originated by PFSI totaling $1.1 billion in UPB. These loans were originated through PFSI's Consumer and Broker Direct channels, and their growth has made PennyMac Financial PMT's largest corresponding client.

Government loan acquisitions, for which PMT earns a sourcing fee from PennyMac Financial, totaled $10.6 billion in UPB, up from $6.8 billion in the prior quarter and $9.5 billion in the second quarter of 2018. Combined, conventional lock volume totaled $12.6 billion in UPB, up 41% from the prior quarter and 110% from the second quarter of 2018.

While the correspondent market as a whole remained competitive, margins improved by 4 basis points quarter-over-quarter and helped drive improvement of the correspondent production segment's profitability. The weighted average fulfillment fee paid to PFSI to facilitate correspondent loan production was 28 basis points, down from 34 basis points in the previous quarter.

We also continue to increase the number of approved correspondent sellers, up to 752 at quarter-end, a slight increase from 743 approved sellers at the end of the prior quarter. July's production volumes continue to reflect strong performance, with total correspondent loan acquisitions and interest rate lock commitments each exceeding $10 billion in UPB.

Now let's turn to Slide 10 and discuss PMT's investments in GSE credit risk transfer. As Stan mentioned earlier, during the quarter, we settled our fifth CRT transaction with Fannie Mae, totaling $933 million in face amount. Subsequently, we commenced deliveries into our sixth CRT transaction with Fannie Mae, delivering a total of $9.3 billion in UPB, which resulted in a firm commitment to purchase $324 million in CRT securities.

On a pro forma basis at June 30, 2019, PMT's outstanding CRT investments totaled $2.6 billion, with the UPB of the loans underlying the CRT agreements totaling $60 billion. Credit performance and characteristics of the loans underlying these investments remain strong.

The 60-plus day delinquency rate was 0.27%, unchanged from the prior quarter and down from 0.29% at June 30, 2018. The FICOs of the underlying collateral remained consistent over time, while the weighted average loan-to-value of the underlying loans have increased modestly to 83% and reflect a larger population of loans with private mortgage insurance in the first loss position.

Losses recognized on CRT investments in the second quarter totaled $900,000, bringing lifetime cumulative losses on our CRT investments to $5.4 million.

Now let's turn to Slide 11 and talk about the financing arrangements associated with our CRT investments. As we noted last quarter, we introduced a groundbreaking asset-backed financing structure to finance PMT's first 3 settled CRT investments, issuing 3-year secured term notes totaling $296 million to replace short-term financing at a similar cost of funds. I am pleased to announce that this quarter, we completed the issuance of 4-year secured term notes totaling $638 million to finance our fourth CRT transaction. We now have in place over $900 million of term notes to institutional investors, strengthening PMT's liquidity, while at the same time, reducing margin call risk and the need for related cash reserves.

As I mentioned earlier, this quarter, we settled our fifth CRT agreement for a total of $933 million. This investment is currently financed with securities repurchase agreements with the intention to finance this investment with secured term notes.

Our sixth CRT transaction is currently in its aggregation phase. Settlement of this transaction is expected sometime in the first half of 2020.

Now let's turn to Slide 12 and discuss MSR and ESS investments. PMT's organic MSR investments resulting from its correspondent conventional production activity totaled $1.1 billion at quarter-end, down modestly from March 31, driven by fair value losses resulting from lower mortgage rates. PMT's MSR portfolio totaled $106.2 billion in UPB at June 30, 2019, up from $99.3 billion at March 31, 2019.

PMT's ESS investments resulting from bulk, mini-bulk and flow MSR acquisitions by PennyMac Financial from 2013 to 2015 decreased slightly from $205 million at March 31, 2019, to $194 million at the end of the second quarter. The decline resulted from pay down of the underlying loans in addition to interest rate-driven fair value losses on the investments. The UPB associated with ESS investments totaled $21.8 billion at June 30, 2019, down from $22.7 billion at March 31, 2019.

Now I'd like to turn the discussion over to Andy Chang, PMT's Chief Financial Officer, to review the second quarter's financial results.

[Andrew Chang, executive]

Thank you, David. Let's turn to Slide 14 and discuss the second quarter's income and return contributions by strategy.

PMT's activities in the second quarter generated an annualized return on common equity of 10%, net of all expenses. In total, credit sensitive strategies contributed $33 million to pretax income or a 22% annualized return on equity for the quarter. Within this segment, CRT investments contributed pretax income of $37.5 million, which I will expand upon in the next slide.

Distressed loan and REO investments contributed a $5.3 million pretax loss, primarily driven by expectations for slower home price appreciation and higher resolution costs. Interest rate sensitive strategies, which include the performance of our MSRs, ESS and agency and non-agency senior MBS positions and related interest rate hedges, together contributed a pretax loss of $1.9 million or a negative 1% annualized return on equity for the quarter.

As Stan mentioned earlier, these results were driven by fair value losses on our MSR and ESS investments, which resulted from the decrease in mortgage rates, offset by gains in the fair value of our agency MBS and other interest rate hedges. While we show the income contribution for each of these interest rate sensitive strategies separately, they are managed together as the interest rate sensitivity of MSRs and ESS is inversely correlated to that of MBS and our other interest rate hedges.

Correspondent production contributed $16.2 million to pretax income or a 17% annualized return on equity for the quarter, driven by an increase in correspondent acquisition volumes and higher margins. The corporate segment contributed a pretax loss of $13.9 million.

Lastly, we recorded a $10.9 million benefit for income tax expense, driven by the fair value losses on MSRs, which are held in PMT's taxable REIT subsidiary.

Now let's turn to Slide 15 and break down the performance of our GSE credit risk transfer investments.

Our CRT investments contributed $37.5 million of pretax income in the second quarter, consisting of $7.3 million in gains from market-driven value changes and $30.1 million of income excluding market-driven value changes. Gains on our existing CRT investments for market-driven value changes included losses of $3.6 million, driven by credit spread widening on seasoned CRT investments. The remaining market-driven value changes were $11 million included in net gains on loans acquired for sale. These gains relate to the fair value recognition upon loan delivery under firm commitments to purchase CRT securities under our newest transaction with Fannie Mae. $9.4 million of such gains were attributed to the correspondent production segment.

Income, excluding market-driven value changes, consists of net realized gains and net interest expense related to our CRT investments. For the quarter, realized gains and carry on CRT investments totaled $35.3 million, and losses recognized were $900,000. Interest income earned on cash deposits securing CRT investments was $7.8 million, while interest expense relating to the financing of these investments was $12.1 million.

And with that, I'll turn the discussion back over to Stan for some closing remarks.

[Stanford Kurland, executive]

Thank you, Andy. This week marks the 10th anniversary of PennyMac Mortgage Investment Trust, and we are proud of our track record in pursuing unique mortgage-related investment strategies and delivering attractive risk-adjusted returns while preserving shareholder value.

Our recent successful capital raises have been driven by PMT's performance and compelling investment outlook. We expect the new investments in CRT and MSRs to be accretive to PMT's overall return profile and further benefit from increased scale economies. And we remain optimistic about our ability to drive strong returns and shareholder value over the current investment horizon.

Lastly, we encourage investors with any questions to reach out to our Investor Relations team by email or phone. Thank you.

[Christopher Oltmann, executive]

This concludes PennyMac Mortgage Investment Trust's second quarter earnings discussion. For any questions, please visit our website at www.pennymac-reit.com or call our Investor Relations department at [phone]. Thank you.