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PennyMac Financial Services Inc
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Good afternoon, and welcome to the PennyMac Financial Services, Inc. Second Quarter 2023 Live Earnings Q&A Session. Additional earnings materials are available on PennyMac Financial's website at pfsi.pennymac.com.
Before we begin, let me remind you that this Q&A session may contain forward-looking statements that are subject to certain risks and identified on Slide 2 of the earnings presentation that could cause the company's actual results to differ materially, as well as non-GAAP measures that have been reconciled to their GAAP equivalent in the earnings materials.
I would like to remind everyone we will only take questions related to PennyMac Financial Services Inc. or PFSI. The live Q&A session for PennyMac Mortgage Investment Trust of PMT will begin on our webcast at 5:45 P.M. Eastern Time. For additional materials related to PMT's earnings and live Q&A session, please visit pmt.pennymac.com. We also ask that you please keep your question limit to one preliminary question, and one follow-up question as we would like to ensure that we answer as many questions as possible. [Operator Instructions]
Now, I'd like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer; and Dan Perotti, PennyMac's Chief Financial Officer.
Thank you, operator. And I'd like to welcome everybody to PennyMac Financial's first live earnings Q&A session. As you all know historically we've not done a live earnings call, but we believe strongly in the continued evolution of our strong and accessible Investor Relations team and we believe that now is the appropriate time to introduce this live call.
We believe these Q&A sessions will give stakeholders increased transparency into our business in a timely manner and although we are introducing a live call you can rest assured that we'll maintain our strong ongoing commitment to investors and analysts via conferences, non-deal roadshows phone calls and other industry events.
Now we'd like to begin taking questions. Operator?
[Operator Instructions] We’ll now take your first question. And your first question is from the line of Kevin Barker with Piper Sandler.
Great. Thank you. Thanks for doing this call. I think it's important to have that disclosure with everybody. I wanted to address Page 7 of the presentation. You make a guidance in there that PFSI's ROE is projected to trend towards the pre-COVID range during 2023. Could you just maybe add a little more color around that on what your definition is of the pre-COVID range? And then when you say trend towards does that mean attain it, or get close to that level and potentially reach it in 2024? Thank you.
Yeah. So, look – hi, Kevin. How are you doing? Look, I think that as we know pre-COVID we ran an ROE of just slightly under 20%, call it 19%. We had the two COVID years and since then we've been in single digits. We try to put an exact time on when we're going to get to a certain point is not what we're trying to address here. What we're saying is that we believe that we bottomed out sometime in the prior quarter. And last quarter we were at 4% ROE. This quarter we are at 7% ROE and we see ROEs continuing to move up.
Now a lot of that -- most of it has to do with the fact that the question is what's going to happen with mortgage rates. We spent a lot of time over the last year buying a lot of high note rate loans due correspondent to support. The consumer direct channel has when rates decline that will provide refinance opportunities. But the question's when do rates start moving down and we're in an excellent position to seize on that. But there's also I think growth opportunities that we see in our Production channels particularly in correspondent and in broker. And so I think it's a lot of positive feeling here in terms of the acceleration of the ROEs where and when I think is the unknown.
Okay. Just a follow-up on that. Do you think it's attainable to return back to pre-COVID levels if rates will remain near current levels? I say that, because there's potential where we could have a yield curve steepener if the Fed starts to drop rates and the long end stays elevated for an extended period of time. We could have mortgage rates within our range here. Now obviously, there's a lot more mortgages being produced at a higher rate, but do you feel like lower rates are required to get back to that pre-COVID range?
Hey Kevin, this is Dan. So I think that rates declining would be an accelerant to getting back up higher into pre-COVID range, but I think your point is a good one and certainly in line with our strategy here where we're adding significant amounts of higher note rate loans as we move forward in time. We've built that up to about -- in terms of loans with note rates above 5% it comprises about 15% of our Servicing portfolio as of the end of Q2. And so, as we continue to do that that puts more of those loans into play for refinance. You can say something similar about the industry generally although not everyone is adding at that same clip.
But that opportunity sort of grows just if there's regular interest rate volatility to drive some amount of refinance volume, increasing amount of refinance volume. So while rates declining is -- would be a sort of accelerant to moving our ROEs back up toward our pre-COVID levels or our pre-COVID range, which really, to remind folks, the bottom of our pre-COVID range was 11% so effectively getting back up into double-digits but it's not necessary. It would probably just take a little bit longer to the extent that rates stay higher for an extended period of time.
Okay. Thanks. Thank you, Dan. Thank you, David.
Thanks Kevin.
Your next question is from the line of Michael Kaye with Wells Fargo.
Hi. You had a very strong pickup in production margins this quarter. Could you just talk about -- I mean do you think that's sticky? Was there any sort of one-time dynamics in there? Do we continue to see the momentum into Q3?
I think that the margin story was a really good one in the second quarter. And as you know we're seeing a continuation of that in this month. I think that we're seeing -- on the broker side, we're seeing pricing holding in where it was in the second quarter. We're seeing a return to the rational pricing that we expected. Similarly, in the consumer direct channel, we're seeing good margins there and I think that that gives us a lot of strong belief that we'll continue to see it.
On the correspondent side, we've seen margins come back in the correspondent in a nice way. In the second quarter, in PFSI in the correspondent sector we saw margins go up from 25 basis points to 33 basis points, and we're continuing to see them holding nicely for correspondent as well. So, I like the margin story. So I think there's a little bit more room in correspondent, especially as you see with the banking regulations that have come out and how MSRs are being treated I suspect that we'll continue to see some good margin opportunity or margin increase opportunity in correspondent especially.
Okay. That's -- glad to hear. I know there's a lot of talk with the consumer direct segment originating these high note rate MSRs for when eventually we do get a rate dip, but in the meantime is there any initiatives in the consumer direct channel to try to gain a foothold in a purchase market as you wait for the refis to eventually rebound?
Look, we have a really I think a really good product introduction that we introduced about a year ago in closed-end seconds. We're seeing increasing amount of course, of closed-end second originations. They're running about the monthly current run rate of about $50 million, $60 million a month at profitable levels. And what that's allowing us to do is a few things.
Number one, it's allowing us to offer our current existing servicing customers the ability to take cash out of their properties. It's also keeping them from doing cash-out refinances which I just -- I can't see why anyone with a low note rate first which is a lot of our portfolio refi-ing out of their low rate first just to take out cash. And so having that fixed rate second product is really important and it's been really powerful.
The other thing about the fixed rate second program is it's allowing us to keep capacity in place. And that capacity can manage rates decline offer rate and term refinances in addition to cash out refinances in addition to closed-end second.
So, it's very much allowed us to keep capacity in place so when rates decline we can pivot over. And we had some -- earlier in the year we had a brief period when rates got low and we were able to pivot to take advantage of that opportunity. So, the closed-end second product is a good one.
And I think what I like about the closed-end second product is you can have first lien rates decline, but still have demand for closed-end seconds given the sheer number of low interest rate firsts that we have in the portfolio.
So, that's been a really great product for us. I also think that given the banking regulations it was just announced this morning and we had a brief review of them I think there's going to be an opportunity for returns of some securitization. I think that there's going to be a lot of discussion and changes that I think potentially could take place.
But suffice it to say I think given what happened with the regional banks last quarter, given these banking regulations there's going to be a need for non-bank capital to support jumbo loan originations in particular. And so I'm encouraged by that as well. We have a jumbo product out in all three channels that I think is going to I think will be very valuable to us as things settle down here.
Okay. Thank you.
Your next question is from the line of Doug Harter, Credit Suisse.
Thanks. Hoping you could talk a little bit more about our hedging strategy and some of the comments that kind of the cost in July has come down, but just how you're thinking about hedging the portfolio differently given the yield curve and kind of given how far out of the money 85% of your Servicing portfolio is.
Yes. So, look I think we have historically from the day we started this company we've hedged our servicing portfolio and I think we have a tremendous track record in doing so. I think that we have we've seen over the last year a really unique environment where we've gone from a pretty steep yield curve to an inverted yield curve and we've seen a lot of volatility in the market.
What that's meant is that the cost to hedge has gone up to levels that we have not seen. And so in the process we've had to really look at our hedging program and ask ourselves what -- how do we want to think about what it is we're hedging and what are we hedging for?
So, historically we've had a bias to rising rates. And that bias to our new rates has been primarily because as rates increase we have loans in the pipeline we have to close out we have infrastructure that we need to right-size and there's a cost to that. Given the levels we're at today and given the levels of activity that need is nowhere near what it was two years ago. And so the need to have gains in the sell-off have largely dissipated.
Similarly, when we look at our rally profile we have a lot -- to Dan's point, we have a lot of high rate loans that in a rally, we believe that we can seize on the refinance opportunity faster than anybody and that means we would have profitability in that rally. So, that allows us to open up a little bit more exposure in a rally.
And so in looking at that combined with the fact that volatility was at historic highs we said to ourselves okay we need to adjust our hedge for that. So that put down the hedge cost down tremendously from call it the beginning of April to the beginning of June.
And in June and July, we -- I'm really happy with what I'm seeing in terms of the hedge costs associated with hedging the portfolio the performance of the hedge as well as is it providing what we need it to provide for.
And so I think we're going to continue to see those levels maintain. And look volatility to buy to put on the hedges were pretty much at an all-time -- I mean were at an all-time high at one point even higher than when COVID hit at one point in the second quarter. So it speaks to the nimbleness of Will and Dan and the team to be able to adjust accordingly and react to those high hedge costs.
I guess in addition to the lower hedge costs is there any capital or liquidity that's freed up by kind of the new hedging strategy you have in place?
A - Dan Perotti
Not in particular freeing up capital or liquidity. We do have really significant amounts of liquidity at this point. We have $1.5 billion of cash on the balance sheet. We have the ability to draw down significant amounts more from our secured financing lines up to nearly $3 billion if the need came. So this doesn't really change significantly our liquidity -- or the hedging change doesn't really significantly change our liquidity profile and similarly really similarly on the capital side.
So that wasn't necessarily the primary focus of those changes. It was really more around constraining some of the costs while still keeping a prudent hedge sensitivity profile allowing for essentially as David said not as great a gain in the sell off and still keeping limitations on the exposure that we could see in a rally in terms of the net change on the MSR.
Great. Appreciate it. Thank you.
Your next question is from the line of Bose George with KBW.
Hi, guys. Good afternoon. Just wanted to ask about the bulk market. Obviously, historically you haven't done much there but it seems like returns are very attractive. So just curious if you have any possibility of dipping a toe in there?
Yes. So I'm going to -- I'll let Dan go into what we're seeing in particular in the bulk market. But generally speaking when we think about investing in Servicing Bose investing to correspondent is at the top of our list of what is our economic best execution. Number one, we can go through all the diligence of the loans. We can review the loans. We know the counterparties. We can price in correspondent to create the Servicing portfolio that we want to own.
And then similarly when we create the MSR there's a tax benefit that makes owning OMSRs much more economically attractive to us than owning bulk MSRs. Having said that, we do look at all of the bulk MSR packages that come out. Look I think there's a lot of discussion about the yields in the bulk MSR market that are being thrown around.
Our -- I think that we're not going to be the counterparty that's going to price a bulk MSR with the longest hire for longer scenario. We're not going to price bulk MSRs just on a marginal basis. As we look at the bulk MSR market we do see some attractive packages. And in PMT by the way we bought a small package last month or this month I should say. And so we do -- and it met the PMT required returns. And so I generally am of the view that there will be more bulk MSRs coming out and we'll be looking at the packages and we will opportunistically if the opportunity arises we will purchase such a package.
Yes in terms of the returns that we see on the MSR packages. I think, we don't see it I think in the exact same way as others. Really more probably on the conventional side closer to high single-digits. And as David sort of alluded to that may be related to what's the expectation for rates that are built into those assumptions because there's a lot of other assumptions that are -- that can drive what you estimate the returns to be over time.
But as David said they can be attractive in some cases. We did for PMT purchase a small bulk MSR portfolio on the conventional side. On the government side, the availability of those packages has been -- or the flow of those packages has been significantly lower and we haven't seen any opportunities that really we thought made sense to hit on. We'll continue to evaluate them but really as David said we think there are a lot more advantages to deploying our capital by investing into the correspondent into MSR via the correspondent channel at higher note rates where we have control around the specific loans that we're bringing on as opposed to via bulk packages.
Okay. Great. That's very helpful. And I just wanted to go back to the bank regulatory stuff again. I mean you noted that it could bring back the non-bank global securitization. Specifically, just on the MSR side I mean do you feel like that could trigger more activity? It looks like I guess more banks will have a restriction on or I guess hit that 10% sooner as well so like a bigger pool of banks there.
I do. I do. I think it's going to create opportunity for banks that want to sell MSRs. I think that it's going to attract on the flip side it will attract probably some more capital in this space which is not the worst thing. But I think that it's -- there's a lot of questions that really need to be answered. And look it could have its effect also in the correspondent space because remember that there are bank-owned correspondents or bank correspondent divisions that end up -- they're in that business basically to own servicing. And so that could help in correspondent and that's why I'm generally bullish. I think in the long run margins will find their way up in correspondent.
Okay. Great. Thanks a lot.
Your next question is from the line of Henry Coffey with Wedbush Securities.
Yes. Good afternoon and thanks for taking my call. I was just looking through the deck and the uptick in PFSI correspondent. I assume lots of that's Ginnie Mae-related government products. But is that more we'll call it cyclical and tied or just tied to the housing wave that sort of comes in the summer or does that reflect gains in market share on your part into the correspondent business?
Look I think the correspondent story in the second quarter is a really interesting one and there's a lot that went on there. First off, we moved a lot of the bulk business that we have been purchasing in PMT. PMT sold those loans to PFSI as a way for PMT to further diversify its investments between MSRs and credit-related investments. And so we saw more of that business move over to PFSI. So we saw more conventional business come into correspondent.
Having said that the increase in correspondent quarter-over-quarter was about 5% and I think that there's a lot going on behind that number. First of all with the regional bank crisis in the first quarter we saw bank-owned correspondent divisions really pull back from the market. So we had a really big Q1. And so in Q2 we saw them come back which I think brought back more in line to what we to the pace that we've been running before the regional bank crisis really, really hit.
In addition, in correspondent Q2 on the conventional side we saw the GSEs implement pricing changes that felt to me that they weren't necessarily given to everybody and in the process, it had some adverse impact on results. We've begun to see those ease up in July and we're starting to see that in the pace of activity on the conventional side. And then on the government side look we've -- as you all know we have this -- we have a very well publicly-stated strategy of using correspondent in particular to deploy capital to buy high rate loans to preserve the opportunity for our consumer direct channel to refi those loans when rates decline.
The trend in the government market has been to retain larger servicing strips, which corresponds to a higher investment in the servicing. And that kind of reduces the effect that the refinance provides at the loan level in terms of a return. And so we began to look at some of these pricing strategies that others were implementing in the market and so we kind of took down our share a little bit on the high servicing strips. But we're seeing that kind of also return to kind of normalized levels in July. And so I think – look I think it validates and shows how this management team thinks about running these businesses. And while we've two years ago had some stated market share goals for correspondent broker consumer direct and Servicing the big one was 20 plus and that's the ROE that we're trying to guide this company to.
And that's something that will always be at the top of my list of issues. And look share is important. It provides scale. It provides pricing power. It provides halo effects in the multi-channel strategy between correspondent and retail and broker. But we're going to have quarters like we had in correspondent where we have some anomalies come up. We had a similar one in broker last year when we had irrational pricing and we kind of stepped aside.
So I'm generally pleased with the Production segment that returns this quarter. And look in our broker direct channel we were up 37%. In our consumer direct channel we were up 47%. We're the number three broker direct originator now. So I'm really pleased with what came out of our Production segment.
With the pricing that you talked about with the GSEs was that favorable to large independent originators like yourself, or was that more of a pricing penalty?
Look, I don't know nor can I really go into what the GSE – the specific pricing changes that they put in. Suffice it to say I don't think it advantaged us. I know it didn't. But I think the more I would say frustrating part was the fact that they didn't provide pipeline protection. They just implemented immediately.
So any loans that we are waiting to ship or any loans that we've given out interest rate lock commitments to were affected by it. Now we've changed our pricing methodologies so the borrower has to sort of bear that option cost now. But that's kind of what the pricing changes are that I'm referring to.
Well, thank you very much for taking my question and holding this call.
Thank you, Henry. Nice to hearing your voice.
Your next question is from the line of Kyle Joseph with Jefferies.
Hey, good afternoon, guys. Thanks for taking my questions. And sorry, I've been on and off, so apologies if this has been asked. But just – and I think you touched on it briefly on Henry's question but just in terms of the broker, I know you guys have moved up to number three there but kind of outlook for margins. Obviously, they recovered again in this quarter. But going forward is this a good run rate or is there potentially just more upside there?
Look I like – we always want more margin, and I'm always trying to convince Doug and the team to get margins up. But look we had really good margins last quarter in the mid-80s. I think there's a little bit of room there smidge. But I don't – I think we're at a really good level there and I think that it's giving us the opportunity to increase the number of brokers that we're dealing with provide a strong number two alternative to those who sell to the top two broker originators and we're making really good progress in terms of the tools that we are deploying into broker.
Got it. That’s it for me. Thanks for answering my questions.
Thank you.
Your next question is from the line of Eric Hagen with BTIG.
Hey, thanks. How are you doing guys. Got a couple of questions here. As the MSR portfolio maybe continues to grow, how much room do you have to borrow more on your MSR lines? How do you think about maybe using secured leverage versus possibly coming back into the market with unsecured debt to finance that portfolio if credit spreads continue to tighten?
Sure. So we've got a pretty significant amount of borrowing capacity versus our MSRs. Yes on page 22 of the deck you can see our secured revolving bank financing lines for MSR. We have about $3 billion. We only have $400 million drawn. So we have a fair amount of capacity there more than -- that allows for some room for growth and some room for appreciation if interest rates were to go up further as well.
In terms of how we're thinking about going forward and financing our balance sheet our preference generally is to move toward more unsecured debt over time. I think that'd be supportive of ratings and the ratings profile and sort of lead to better financing costs on the unsecured side. And there are also benefits in terms of reduction of any exposure to margin calls because although we do have term debt for the MSRs a lot of that is based on the total collateral base and can require margin calls.
Our hedging program helps to insulate against that but we do believe that unsecured debt over time would be preferable. We're continuing to look for opportunities where we might enter into the unsecured debt space again but really in some sense also depends on the differential between funding cost of the secured debt and the unsecured debt. And we have seen in recent periods, there be fairly attractive pricing in terms of some of the secured debt. We have issued secured term loans in PFSI. It was really in Q1 at an attractive spread 300 over SOFR. I think that the depth of that market is somewhat limited. So, but continuing to look at what the balance is between being able to issue that unsecured debt and what an attractive entry point might be in the current market versus where we can finance on a secured basis.
Look, I think we've done a really nice job in plumbing out different avenues for us to raise debt. You look at the term loan debt that we've issued. We have our VFN structure that we have with Wall Street banks that you can issue term notes off of. We've issued almost $2 billion of unsecured debt, kind of laid the groundwork for us to issue more unsecured debt. And so I really -- I think that, we're going to -- and we're going to try to keep all avenues available to us, but I think to Dan's point the unsecured debt rally has some really good effects for us as we think about ratings and we think about liquidity and driving down those costs. And so I think we'll continue to look to access all those markets.
That's really helpful. I think just one more for me. I know we're trying to wind down here but lots of discussion around loan modifications even the structure for FHA loan mods and how effective those can be at higher interest rates. Like how many loan mods are you guys doing right now? What kinds of things are you may be looking for to control the credit risk in the FHA portfolio even though the health of the consumer on many levels looks relatively good and strong right now?
Yes. Look I think the FHA has done a tremendous job in the loan modification programs that they do offer. We're seeing an uptick in the 40-year program. And it's -- and I think that's I think only going to grow as a way to extend out the term of the loan. But look our portfolio -- our delinquency numbers are really strong. And I think that, that's something that we're watching like a hawk like everybody is who owns servicing. But I think that that's really one of the best stories about the investment in servicing.
There was an ever so slight increase but still well below what we've historically seen and servicing advance balances were down as well. And so I just -- I think that we are we're set up that, if there is a churn in the economy of the market we do see delinquencies increase we have the capacity in place in our Servicing division to be able to meet the customers' needs. More importantly, we have the technology in place to be able to meet the demand. If you recall during COVID we've had a tremendous usage of our website and using electronic means to provide forbearances and that's something that we will continue to expect. So, we're enjoying the performance now but we're also prepared for whatever comes our way.
Q
Really helpful. Thank you guys very much.
Your next question is from the line of Trevor Cranston with JMP Securities.
Hey, thanks. Most my questions have been addressed. Maybe just one quick one on the consumer direct margins. You noted I think that a lot of the improvement this quarter was from a lower mix of streamlined refis. Can you comment generally sort of if you've seen any organic improvement in consumer direct margins and sort of the trends you're seeing within that channel? Thanks.
Look, you're right. We did, as I said, in the first quarter we had a period of time where rates got low. We were very efficient on our streamline refis. And for those of you who saw it our prepayment speeds came in higher than the rest of the market. And so we've put some controls in place to make sure that we deal with the issue now, which we have been and we're starting to see a normalization of those prepayment speeds.
And look the interesting part of that is as you can see from the increase in the margin, we are willing to work for a little less margin. There's a little bit less cost to originate, but if we've been able to continue it, we could have kept capacity in place. But suffice it to say I think that we value the Ginnie security and we want to be very careful that we don't do anything to put that at risk.
Look I think it's -- I think in the process we've been able -- as I said been able to increase our penetration of the portfolio in closed-end seconds and that's been very advantageous. And I think we're starting to see -- look we have a team that's focused on new customer acquisition and I think that they're starting to see some green shoots there.
Our purchase percentage went up a little bit last quarter and I continue to see that growing. And so it's -- there is -- I wouldn't just say okay it's just a rate and term opportunity in consumer direct. It's a lot more than that. And that's -- and I think that we have a great team in place that's focused on all of those channels and it's just -- I think we'll continue to see the upward progression of their hard work and effort.
Got it. Perfect. Appreciate the color guys. Thank you.
Your next question is from the line of Courtney Bahlman with Barclays.
Hi, David. Hi, Dan. Thanks for the question. Just a really quick one for me. With regards to leverage, I know you guys are on the lower end of the spectrum about 1.2 times non-funding debt to equity. How should we think about the leverage target for longer-term and the opportunity for bond buybacks and where that kind of sits in capital allocation priorities? Thanks.
Sure. So, yes, as you said in terms of the non-funding debt at 1.2 times, which is within the range that we've typically targeted, so we've typically been around one times or a little bit over one times in recent periods. We would expect to be in a similar vicinity potentially increasing a little bit, but really we would expect to be around the vicinity that we have been historically or vicinity that we're currently at. I mean that's roughly what the level that we're targeting.
With respect to bond buybacks, something that we've looked at from time to time. In terms of allocating capital to it, we do see those long-term unsecured debt, as I had been talking about as something that we want to continue sort of adding to. It seems sort of counterintuitive there to retire it. And so it's not something that's high on our capital priority list.
That being said, as we're moving through time if there are certain opportunities that really present themselves, it's something that we would consider, but not something that's high on the list of capital priorities for us.
Understood. Thank you so much. That's helpful.
Okay. Perfect. I don't like cutting things short, but we have our PMT call beginning in five minutes. So I'd like to thank everybody for joining us in this introductory call. I thought it was really helpful and it was good, and I appreciate you taking the time to join. And obviously, if you have any questions, please don't hesitate to reach out to us, and I look forward to speaking with all of you sometime in the near future. Thanks again.
Thank you for joining. You may now disconnect your lines.