PennyMac Financial Services Inc

NYSE:PFSI

Earnings Call Analysis

PennyMac Q3 Earnings Highlight Resilience

In Q3, PennyMac Financial reported outstanding results with a net income of $93 million and an annualized return on equity of 11%, marking a strong quarter despite a 50 basis point rise in mortgage rates near 8%. The company's balanced model, a top servicer and producer, proved advantageous in a higher rate environment. Their servicing portfolio, nearly 20% of which consists of mortgages above 5%, saw revenue from fees increase, with operating expenses relative to portfolio size decreasing. Additionally, interest income increased while interest expense decreased due to lower draws on servicing financing lines. Share repurchases were halted as the company focused on maintaining a leverage ratio below 1.5x and open to future capital deployment. Gain on sale margins are expected to remain stable or potentially improve as industry consolidation continues.

Steady Growth and Consistent Profitability Amidst Interest Rate Hikes

PennyMac Financial has showcased resilience and performance in the third quarter with a remarkable return to double-digit annualized return on equity and a 3% quarter-over-quarter increase in book value per share. Despite the average mortgage rates rising by 50 basis points and nearing 8%, the company capitalized on its diversified business model, yielding impressive operating income from its servicings, which has grown to nearly $600 billion in unpaid principal balance.

Challenging Market Conditions Met with Strategic Positioning

The industry is facing the lowest unit origination volume since 1990, with predictions showing current quarterly run rate origination volumes falling short of the anticipated average of $1.6 trillion. Even in this tough landscape, PennyMac Financial's comprehensive service offerings across various interest rate cycles have provided the firm with robust revenue streams from servicing and placement fees.

Expansion Plans to Broaden Customer Reach

A new marketing campaign targeting nonportfolio customers is set to launch, potentially harnessing a significant growth opportunity for the company. This initiative aims to expand its already formidable servicing portfolio and further solidify its market position.

Solid Financial Outcomes and Investor Returns in Q3

The third quarter saw a net income of $93 million, translating to $1.77 in earnings per share and an 11% annualized return on equity. Bolstered by the company's strategic moves, the production segment posted a pretax income of $25 million, with total acquisition and origination volumes maintaining a strong momentum at $25.1 billion, evidencing the company's lead in the correspondent lending space.

Dominance and Growth in Correspondent Lending and Broker Direct Channels

The correspondent lending platform retained its dominance with $21.5 billion in acquisitions, complemented by a growing network of 829 correspondent sellers. Simultaneously, the company has witnessed burgeoning trends in the Broker Direct channel, including a 6% quarter-over-quarter volume increase and greater market share, positioning PennyMac as a key player amidst a competitive landscape.

Consumer Direct and Servicing Segment Enhancements Drive Profits

The Consumer Direct channel, although small in volume, saw significant margin enhancement due to an increased focus on closed-end second liens. Meanwhile, the Servicing segment profoundly contributed to the company's pretax income, thanks to lower net valuation-related changes and an uptick in loan servicing fees, among other factors. Operating expenses in the servicing division remained low relative to the size of the portfolio, indicating efficiency gains.

Investment Management Segment and Outlook

The Investment Management segment modestly increased pretax income, with assets under management seeing a slight rise. Looking ahead, while acknowledging the potential impact of seasonality and continuing high-interest rates, PennyMac Financial stands confident in its strategic model's capacity to enhance returns going forward.

Earnings Call Transcript 2023-Q3

[Operator]

Good afternoon, and welcome to PennyMac Financial Services, Inc.'s Third Quarter 2023 Earnings Call. Additional earnings materials, including presentation slides that will be referred to in this call are available on PennyMac Financial's website at pfsi.pennymac.com.Before we begin, let me remind you that this call may contain forward-looking statements that are subject to certain risks 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 material.I would like to remind everyone, we will only take questions related to PennyMac Financial Services, Inc. or PFSI. We also ask that you please keep your questions limited to one preliminary question and one follow-up question as we'd like to ensure that we can answer as many questions as possible.Now I'd like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer; and Daniel Perotti, PennyMac Financial's Chief Financial Officer.

[David Spector, executive]

Thank you, operator. PennyMac Financial produced outstanding results in the third quarter, returning to a double-digit annualized return on equity. While average mortgage rates were up 50 basis points from the prior quarter, we demonstrated the earnings power of our balanced business model with exceptionally strong operating income from our large and growing servicing business, combined with continued profitability and production. As a result, book value per share grew 3% from the prior quarter.As you can see on Slide 4 of the presentation, mortgage rates have continued to increase from record lows in recent years and are now near 8%. As a result, many borrowers who locked in a low fixed rate mortgage have been incentivized to stay in their homes given their low mortgage payments. This has resulted in an extremely low inventory of homes for sale, driving expectations for the lowest unit origination volume since 1990.Additionally, we believe quarterly run rate origination volumes are trending lower than the average $1.6 trillion estimates from third parties for this year. Though the current origination market remains constrained, mortgage banking companies with large servicing portfolios are better positioned to offset the decline in profitability that has resulted from these lower origination volumes.Looking at Page 5 of our presentation, our balanced business model as a top 5 servicer and a top 2 producer of mortgage loans is a key differentiator that enables PennyMac Financial to profitably maneuver through varying interest rate cycles. Our servicing portfolio has steadily grown to nearly $600 billion in unpaid principal balance and 2.4 million customers. This consistent growth is driven by our ability to organically grow the portfolio through our strength as a leading producer of mortgage loans.The servicing segment drives the majority of our earnings in a higher rate environment, a large portion of which is cash earnings in the form of servicing fees and placement fee income on custodial balances and deposits. Our multichannel approach to production enables consistent access to the origination market. In the current high rate environment, our correspondent and broker direct channels of production provides strong access to the purchase market.As we add these higher note rate mortgages to our portfolio, we are creating additional opportunities for our consumer direct business to offer our customers a new lower rate mortgage when interest rates decline. As of September 30, nearly 20% of our servicing portfolio consisted of mortgages with note rates in excess of 5%.Turning to Slide 6. Revenue from servicing and placement fees has increased significantly in recent years due to growth in the portfolio and increasing short-term interest rates. At the same time, operating expenses as a percentage of total servicing portfolio UPB continued to decrease, demonstrating the operational scale and efficiency gains we have achieved. The substantial accumulation of home equity in recent years across the country has driven a large opportunity in the closed-end second lien product, enabling borrowers to tap the equity they have built up in their homes without relinquishing their low rate first lien mortgage.The 2.4 million customers we have active servicing relationships with represent cost-effective leads for our consumer direct channel, and we've been actively marketing to those who would benefit from a closed-end second product. Since the launch of our closed-end second lien product last year to our servicing portfolio customers, we have originated for sale into the secondary market approximately $450 million in unpaid principal balance, including approximately $200 million in the third quarter.I'm excited to announce that in the fourth quarter we will be launching a marketing campaign to non portfolio customers, representing a significant opportunity for our consumer direct group to attract additional customers given we currently service only about 4% of total U.S. mortgage debt outstanding. PennyMac Financial continues to lead the industry with strong financial performance given its large and balanced business model.I'm extraordinarily proud of this management team's ability to successfully navigate the challenging mortgage landscape while also positioning the company to generate increasingly stronger returns over time.I will now turn it over to Dan, who will review the drivers of PFSI's third quarter financial performance.

[Daniel Perotti, executive]

Thank you, David. PFSI reported net income of $93 million in the third quarter or $1.77 in earnings per share for an annualized return on equity of 11%. Book value per share was up 3% from the prior quarter to $71.56. PFSI's Board of Directors also declared a third quarter cash dividend of $0.20 per share. Production segment pretax income was $25 million in the quarter.Total acquisition and origination volume were $25.1 billion in unpaid principal balance, up from the prior quarter despite the continuation of a challenging origination market. $22.3 billion was for PFSI's own account and $2.8 billion was fee-based fulfillment activity for PMT.As you can see on Slide 10, PennyMac maintained its dominant position in correspondent lending with total acquisitions of $21.5 billion, with margins in the channel unchanged from the prior quarter. Notably, the number of correspondent sellers we maintain relationships with increased to 829 from 800 at June 30. October volumes continued to be strong in correspondent with $8.9 billion in acquisitions and $9.4 billion in locks.In Broker Direct, we continued to see strong trends as volumes, margins, market share and the number of brokers approved to do business with us all increased from the prior quarter. Block volumes were up 6% from the prior quarter despite a smaller origination market, and we expect to continue gaining market share as the top brokers increasingly see PennyMac as a strong alternative to the 2 top channel lenders. October volumes in Broker Direct were $0.8 billion in originations and $1 billion in locks.In Consumer Direct, volumes remained low, but margins increased meaningfully from the prior quarter due to the greater proportion of closed-end second liens, which have lower average balances. Production expenses net of loan origination expense were up slightly due to the overall increase in volumes.Turning to Page 14. The Servicing segment performed very well in the third quarter, with a contribution of $101 million to pretax income, up from $47 million in the prior quarter. The increase was primarily driven by strong operating results and lower net valuation-related changes. Excluding valuation-related changes, Servicing pretax income was $120 million or 8.2 basis points of average servicing portfolio UPB, up from $75 million or 5.3 basis points in the prior quarter.Loan servicing fees were up from the prior quarter, primarily due to growth in PFSI's own portfolio as PFSI has been acquiring a larger portion of the conventional correspondent production in recent periods. EBO income increased $9 million from the prior quarter, driven by redeliveries of reperforming loans for certain EBO investors. We continue to expect the contribution from EBO to remain low for the next few quarters.Interest income for the quarter was up primarily from increased placement fee income on custodial balances due to higher short-term interest rates, while interest expense was down due to lower average balances of secured debt outstanding. Operating expenses increased slightly from the prior quarter but remain low as a percentage of average servicing portfolio UPB.The fair value of PFSI's MSR before realization of cash flows increased by $399 million during the quarter, driven by higher market interest rates, which resulted in projections for decreasing prepayments and an increased contribution from placement fees on custodial balances. Hedging losses were $424 million, also driven by higher market interest rates. The net impact of MSR and hedge fair value changes on PFSI's pretax income was negative $25 million, and the impact on earnings per share was negative $0.34.And finally, the Investment Management segment contributed $400,000 to pretax income during the quarter. Assets under management increased slightly from the prior quarter due to PMT's strong third quarter results.This quarter demonstrates our ability to drive improvement in ROE, now back to the double digits. While we expect normal seasonality and a higher rate environment to have some impact in the next couple of quarters, we expect our strategic position and the strength of our model to continue to drive our returns higher over time.We'll now open it up for questions. Operator?

[Operator]

[Operator Instructions] We'll now take your first question from Kevin Barker of Piper Sandler.

[Kevin Barker, analyst]

Congrats on a good quarter. Just wanted to follow-up on some of the margins and the growth in the origination side. It seems like correspondent was fairly strong with margins flat. We've seen one of your competitors mention that there's been a pickup in competition despite the pullback from several large banks. What are you seeing in that market? And do you feel like the competitive environment is increasing or fairly stable?

[David Spector, executive]

Look, I think in correspondent, we had a really strong quarter in correspondent. And I think it's really for a couple of reasons. One, clearly, we're seeing the banks stepping back. We saw that really started in the second quarter. It's continuing as a lot of banks are looking at the Basel issues that they're facing. And I think that you're going to see more of that business in correspondent. It's kind of moved out of the bank, but it's going to continue to stay out of the banks.I think that another reason correspondent is so strong is the fact that sellers are not really retaining services. And so if you recall, during meatier times of margins, sellers would retain servicing because margins were at kind of the higher levels and they can retain that servicing. But right now, we're seeing many sellers not retaining the servicing. And so they're assigning the whole loans to correspondent aggregators versus selling to, for example, the GSEs, where they would -- they could retain the servicing.From my perspective as it pertains to PennyMac, I think we're seeing a flight to quality from the point of view that we're the leading correspondent aggregator, and we're seeing many of our customers continuing to deliver product to us and perhaps not delivering as much to some of the lower market share participants in the market. I was generally -- I was very pleased with the increase in sellers. And while the sellers themselves are smaller, so it's not meaningful to the UPB. I think it just -- it kind of talks to the quality issue. I mean, for us to add almost 30 sellers in a quarter is a pretty big number.And so I think that this all adds up to a really good quarter from a production standpoint, from a share perspective and also from a margin perspective. And I believe that the margin story should hang in there in Q4 and that's what we're seeing to-date. And I think from a correspondent perspective, we're in a very good place.

[Kevin Barker, analyst]

Great. And then just a follow-up on the broker channel as well. We've seen an increase in fallout locks and then an increase in margin as well. Obviously, there's been quite a bit of attrition within that channel over the last year. Just love to hear a little bit more about what you're seeing from a competitive standpoint within the broker channel?

[David Spector, executive]

Yes. So on the broker side, we're seeing some very good traction being made in the -- especially the top brokers as they themselves are getting concerned with the share of the top 2 participants. And so they're in need of a strong alternative. And so we're positioning ourselves as that strong alternative. And we're really -- between that and the technology that we've spent a long time creating to really -- in working with brokers to address their needs, we're seeing very good feedback on the technology. And so I'm really happy to see that we saw margins, that we saw share growth last quarter, we saw margin growth now.Some of that margin growth has to do with some execution enhancements after pricing. And so I think the margins that we saw this quarter were very good, but I continue -- I would expect them to continue to stay at the high end. And like -- in all 3 production divisions, we're seeing pricing stay rational. And I think that, that's a -- I don't see that changing. And I think if anything, over the next couple of quarters if we do see consolidation, that could provide some additional margin opportunity -- margin expansion opportunity for us.

[Operator]

Your next question comes from the line of Bose George of KBW.

[Bose George, analyst]

I want to ask first, your servicing fee increased -- its 26.7%, so it was up 1.7 basis points. I mean, could we see that go down if you do excess transactions? Or should we see the servicing fee kind of stay in this level going forward?

[Daniel Perotti, executive]

This is Dan. We generally are expecting the servicing fee most likely to go up over -- in basis points to go up over the next few quarters. We could see some impacts from sales of excess. But overall, given the servicing that we're bringing on, the fact that the significant bulk of the overall servicing that we're generating since the conventional correspondent volumes are now going through to PFSI and they're retaining those as MSR, the bulk of those rather than PMT retaining it over the last couple of quarters, that's contributed to the increase in the basis points of servicing fee.We do evaluate sales of excess, but those -- we would only -- or we only -- we would only engage in those to the extent that we see that as a benefit in terms of our deployment of capital. And so our overall lien, I would expect, over the next few quarters as we're bringing on additional servicing, some of it at higher servicing fee levels, we do you see that servicing fee in basis points go up over the next couple of quarters.

[Bose George, analyst]

Okay. Great. And then actually going back to the gain on sale margin, in that Slide 11, the gain on sale margin by channel has gone up the last -- over the last quarter, last year. But then there's that other line item that kind of offsets that. So if I look at the total gain on sale margin, it actually went down a little bit quarter-over-quarter. So I was just curious like what that line is? And also should we look at this on kind of at that bottom line basis? Or should we look at the line items?

[Daniel Perotti, executive]

Sure. Generally speaking, I would say you should look at the line items, and that will generally tell you how the margins are performing on a channel-by-channel basis. The shift in the overall margin quarter-over-quarter was really based primarily on the mix of volume. So we had a greater proportion of correspondent loans coming through in the third quarter as opposed to some of the earlier quarters.I mean, those are overall -- if you look at the blend, a lower margin for that volume. And so that overall is what is driving down the basis points on an aggregate basis quarter-over-quarter.

[Bose George, analyst]

Okay. And that other line, is that sort of -- is that hedging? Or what kind of flows through there?

[Daniel Perotti, executive]

The other line has a couple of components. The first is really just timing -- really some timing elements. When we're looking at locks, these are -- this is income associated with locks. There are certain elements from an accounting point of view where we only earn the income at the time of funding. So those could get shifted to a different period. But in order to track what we're expecting to -- what we see as the margin in that channel, we're really looking at what our expectation is for the lock gain in that period.And so if we have a timing difference, that could shift. And then if we do have, to your point, any sort of hedging gain/loss or other elements of that nature, that can also enter into that line.

[Operator]

Your next question comes from the line of Michael Kaye of Wells Fargo.

[Michael Kaye, analyst]

On the Production segment, do you think you could keep the profitability at these levels, just given we're entering the slower seasonal winter months, plus mortgage rates are much higher? Could that potentially swing back to losses?

[David Spector, executive]

Well, it's -- look, I think under the things we can't control and clearly from what we're seeing in October, I would expect Q4 to be profitable in production. We've got an industry-leading correspondent franchise that continues to operate at the levels that you saw in the third quarter. We have rational pricing taking place in the market. And so I don't see the margins really coming under severe pressure to swing it to the unprofitable side.And a similar story can be said on broker as well. I mean, we're -- and we're making inroads in broker. And while the current run rate of production is closer to $1.2 trillion to $1.3 trillion market, it's still more than enough to keep us operating profitably. I'll tell you -- I think that really in the consumer direct channel, the product that I'm really enthusiastic about is closed-end seconds. We had a very good quarter in closed-end seconds where we originated $200 million in the third quarter alone. We've originated $450 million to date. And the margins are very nice. It's a profitable product for us. We sell them all into the secondary market. So there isn't -- we're not retaining them.We do retain the servicing on them as we currently service the first on these loans as well. And one of the real added benefits is that it keeps capacity in place for our consumer direct channel. And ultimately, we will see a rate decline and having that capacity in place will be very important for us to be able to seize on the opportunity to refinance borrowers in higher rate mortgages.And so I'm enthusiastic about what we're seeing in Q4. And I think that we're setting ourselves up to continue to grow ROEs in an environment that's higher-for-longer or in an environment where rates are declining.

[Michael Kaye, analyst]

Just on expenses. I know you took a lot out. You were early. But I don't think anyone was thinking or anyone was planning for mortgage rate to be where they are now. I mean, are you positioned okay on expenses in production? Or do you think there could be potentially more trimming, just given the environment is probably worse than most of us were expecting?

[David Spector, executive]

I think on the production servicing side, we are very good at being able to bring up staffing or take down staffing based on the gearing ratios that we see for the market we're in. I think that there's a -- from my perspective and the rest of the organization, we're running a core functionality. And we're not -- we're clearly not sized for a $1.2 trillion market nor are we going to put ourselves in that position.Having said that, we're doing some things like looking at our technology infrastructure, and I suspect we're going to be looking to reduce expenses there. We're doing things like if there's attrition, we make our management team jump through hoops before we hire to replace that. But by and large to your point, we did -- we took our medicine earlier and we knew what we needed to do. We did it, I think, 3 or 4 times in '22 alone. But having said that, it's given us the opportunity to focus on growing ROE, which we did this quarter, getting it back up into the double digits.

[Operator]

Your next question comes from the line of Eric Hagen of BTIG.

[Eric Hagen, analyst]

First question here. I mean, can you talk about how you're maybe adjusting or pricing for different borrower credit characteristics? Any changes to the credit box even more generally as rates have moved up this high? Like whether you're intentionally targeting higher quality loans because rates are high and affordability is -- it is constrained?

[David Spector, executive]

Look, I think that the way we think about pricing mortgages is, number one, we only buy loans that are saleable to the GSEs or that meet FHA, VA or USDA guidelines. Having said that, I would say in late -- in the third quarter of last year alone, we made some conscious decisions in terms of pricing risk attributes to take into account higher rates.And so along those lines a lot of the lower FICO FHA loans and VA and USDA loans we believed were going to require, I would say, a higher return in the investment for servicing given that in a higher rate environment typically you see delinquencies increase, you see correspondent sellers stretching. And while we get more of due diligence on loans and we underwrite loans, inevitably you do start to see delinquencies go up.I think it's -- yes, I think this move while, again, is a little bit on the early side, I'd rather be early than late, as you can well imagine. And I think it's bearing out. If you look at the FICOs and the LTVs of our production versus the rest of the market, I think it's meaningful. It's something that the management team looks at on a regular basis. But I don't see us -- we're not arbitrarily making changes to the credit box.

[Daniel Perotti, executive]

And you can see, Eric, if you look on Page 33 of the deck are the characteristics of the loans that we're acquiring especially through correspondent over time. The FICO has increased significantly, and a lot of that is in response to some of the factors that David was talking about and some of the changes that we made going back to the third quarter of last year.

[Eric Hagen, analyst]

Yes. No, that's helpful. With the hedging results in the period, would you say that's a function of the level of rates? Or is it interest rate volatility? Is there sort of like an ideal environment you feel like for hedging the MSR? And maybe even kind of teasing apart and talking through the hedging results in the quarter would be helpful. And any hedging through October as well?

[David Spector, executive]

Sure. So we talked a little bit last quarter about the elevated hedging costs that we are seeing from volatility being very high and some of the impacts to the inverted yield curve. As a lot of that abated here in the third quarter, we saw a pretty meaningful deinversion of the curve as well as all come down. And we saw our hedge costs decline meaningfully.Our overall profile and our sort of strategy at this point is really given how high interest rates are -- typically, when rates were lower, more balanced, I would say, in terms of the moneyness of our servicing portfolio, we targeted a hedge ratio that was less than 100% so that we would allow for gains in a selloff because origination volume would decline and for potential losses, limited losses in a rally because we would see an uptick origination income.With rates at this level, where so much of the servicing portfolio is meaningfully out of the money. We've really flattened that hedge profile and are targeting a profile that's fairly close to 100%. So when we take out the cost of servicing, I mean, the cost of hedging rather, and then look at what our hedge ratio was compared to the change in value. We actually come up to pretty close to 100%, given the change in value that we saw during the quarter. So overall, there was relatively -- from our perspective, little leakage given the size of the servicing portfolio and the MSR asset and the change in interest rates that we saw during the quarter.To your point, and given how -- given where we are in rates and the fact that so much of our servicing portfolio is out of the money, we would expect that this targeting of the hedge ratio closer to 100% is where we'd be probably at least for the next few periods, barring a meaningful interest rate rally. I think that sort of covers where hopefully what we saw during the quarter here as well as what you might expect to see going forward.

[Eric Hagen, analyst]

So into October, there hasn't been a lot of slippage. It sounds like (crosstalk)

[David Spector, executive]

October has been pretty contained as well.

[Operator]

Your next question comes from the line of Kyle Joseph of Jefferies.

[Kyle Joseph, analyst]

A lot of my questions have been answered, but I just wanted to walk through the second lien product. And I know you emphasized that it's really been touch ground and whatnot. But just walk us through the kind of the impacts on the P&L and the balance sheet, specifically and what -- in terms of volumes and margins and whatnot and whether you expect that to continue?

[Daniel Perotti, executive]

So the second lien product, overall, as David mentioned, we originated about $200 million of it during the quarter. I think we mentioned in our -- we mentioned in the presentation that we are also looking at opening that up to beyond our just originating for our servicing portfolio to market -- to the market at large, which is obviously an even greater opportunity than what we have in our servicing portfolio.So we could -- we do expect that to continue to increase. It's been increasing over the past few quarters. If you look at the margin trends that we've seen in consumer direct, which is the channel in which we're originating these loans, that's been increasing pretty meaningfully on a basis points basis over the past few quarters. So a lot of that is due to the blend of the second lien product, versus the first liens because we are originating a greater proportion of second liens. And so given the smaller balance of the second lien product, we have a higher basis point target in terms of our gross margin there.So just given the blend, it's a bit above what the blend was here, so up into the 500 or 600 basis points in terms of margin on a UPB basis, where the overall UPBs of these loans can be $75,000 to potentially $100,000. And so that's really the revenue side on the production side. They -- it's pretty similar expense-wise to what we see for a normal consumer direct loan. So on a normal scale, a little bit under in terms of basis points, what you would see in terms -- what we collect in terms of the revenue. So we have -- there's a profitable contribution to the overall production business, but not as significantly profitable as if we were refinancing loans in a rally.But to David's point, if we do see an interest rate rally, one of the benefits of the second lien product or production is that we're able to keep the staff on hand in a profitable enterprise. And then when we do see the interest rate rally, we'll be able to shift those resources over to refinancing loans into first liens from the higher note rate balances that we've added over the past couple of quarters through correspondent.

[Operator]

Your next question comes from the line of Jay McCanless of Wedbush.

[James McCanless, analyst]

Two questions for me. I guess if you take the second lien loans that you're originating outside of your channel. I mean, what's kind of the annual market size or market opportunity you think could be out there?

[David Spector, executive]

Look, I think that clearly -- and if you go to Slide 8, you can see the opportunity for second lien expansion. I think that I would be disappointed if we didn't see production volumes grow in the second lien space. We did $200 million last quarter. We have a very big servicing portfolio with a lot of taxable equity on its own. We have 60% of the borrowers in the United States have a mortgage loan with a no rate of 4% or lower. And I think that one of the things in my years of experience is products, as people get -- as people understand products more and get more generally accepted in the marketplace, you just see demand for them go up. And you're seeing more and more people taking out second liens.And this is one of the reasons why we are introducing it in our consumer direct channel for nonportfolio customers. We are going to test it out in broker direct. And I would expect that to be sometime in late Q4, early Q1. But I think suffice it to say, the product that's here to stay, given the fact that we do have so many mortgage loans below 4%, and people have a lot of equity in their properties. And so it's something that they're going to want to -- life events are going to take place that they're going to want to tap the equity.I think as we stay higher for longer, obviously, you'll see more and more second liens being done. But I think that -- I think it's just -- it's a product that's necessary really given what's taken place in the last 3 or 4 years where people just refinanced into low-rate mortgages.

[James McCanless, analyst]

I guess the other question, share repurchase, any thought to doing that at these levels?

[Daniel Perotti, executive]

Share repurchase, that's obviously something that we've slowed down on from the levels that we have been at previously with that, that we haven't done any share repurchases this quarter, something that we continue to look at, but a couple of factors that we take into account. One is our overall leverage ratio. So we are targeting to be -- if we look at our nonfunding debt, we're at 1.2x leverage ratio this quarter. We've been in this area slightly above 1x. And we're very cognizant that we want to maintain that leverage ratio below 1.5x as we look out into the next few periods and ensure that our leverage ratio is in a good position to be able to facilitate any unsecured debt opportunities that we might see or might want to engage in.So while certainly, where the stock price has been recently, I'd say, a more attractive proposition. It's something that we're weighing against maintaining our leverage ratio in the area that it currently is as well as other potential capital deployment, whether it's in the $25 billion of correspondent servicing that we're adding a quarter or any other potential opportunities that might arise.

[Operator]

Your next question comes from the line of Priya Rangarajan of RBC Capital Markets.

[Priya Rangarajan, analyst]

On the second lien program that you have, are you seeing any consumer behavior difference between a cash out refi versus the second lien product? Are they like going one for the -- like do they have a presence in terms of which product they choose?

[David Spector, executive]

Well, one of the reasons -- Hi Priya, it's David. One of the reasons we came out with the product is I didn't like what I was seeing in the market, the people who are starting to refi out of low rate first links. And so from my perspective, we needed the product to give borrowers the ability to tap their equity without getting out of first lien mortgages. From -- when the borrower calls in for cash out refinance, we expose them and offer them the second lien product as a viable product. We don't -- we pay the loan officer the same amount. So there's no incentive for them to do a cash out refi versus a second lien mortgage. We want to really be focused on the compliance aspect of this product.And I think it's meaningful in terms of -- and I think it speaks to why we're doing so many second lien versus cash out refinances. There are life events that you require cash out refinances or refinance to take place. But I generally, am of the view that if borrowers want to tap their equity, the second lien product is the place for them to go. Now we do have minimum FICOs on the product. So the lower FICO product, if you see cash out refinances in the marketplace, that's probably the reason why. But generally speaking, given the high credit quality of our servicing portfolio, second lien is the product that I really want to see our borrowers using to tap the equity.

[Priya Rangarajan, analyst]

That's very helpful color. Secondly, on the origination side. As you look into 2024 to the extent that the markets don't change so much from an existing sales house market. How are you thinking about gain on sale margins? Do you think that the industry has rationalized enough that you should see stable margins? Or can gain on sale actually go higher as there is more consolidation?

[David Spector, executive]

Well, look, I think I didn't gain on sale margins for this remain relatively stable. There's some ebbs and flows that take place during a month or so. But -- and generally speaking, we are seeing gain on sale margins stabilize. And as I mentioned earlier, I think in correspondent, we're starting to see a little bit of opportunity with the banks stepping back for us to increase margin. I think that, look, from a mortgage size perspective, mortgage market size, given where the application index is showing right now, we're probably running a $1.2 trillion, $1.3 trillion run rate. Given the average balance, we're a unit run rate that we haven't seen since 1990.I generally think we will see rates come down when I don't -- I'm not in the prediction business. But I think when you look at the market as a whole, it's generally safe in the second half of next year, you'll start to see some pressure come off of rates. Having said that, as I said, I'm generally, I'm very pleased with where margins are, there's rational pricing taking place in all 3 channels. And I suspect that in Q4 and a little bit in Q1, given the high level of rates, you're going to start to see some more consolidation taking place, which will only lend itself to margins at a minimum, staying stable.

[Priya Rangarajan, analyst]

And then finally, from a credit perspective, you guys obviously did not do a dividend this quarter. Given where your debt trades, have you guys thought about doing open market purchases, tender like your 2025 refinancing? Anything would be really helpful color.

[Daniel Perotti, executive]

So we did do a dividend this quarter, just to be clear, in case I misheard you. So we did issue quarterly dividend. But we're not currently as I mentioned, we are looking at potential opportunities in the unsecured debt space or in the high-yield space, have not seized upon that yet. We've additionally been raising -- we've increased some of our -- we're in the process of looking at potential opportunities on the secured side to replace or move out some of our debt maturities there.The -- unless we -- or to the extent that we see an opportunity that makes sense for us in the high-yield market, we potentially would look at if there's how to address our maturity for unsecured debt that's coming up, not till later in 2025, but that still is a bit off. And we think that there's a pretty large window of opportunity here between here and when that maturity comes. And so we're not -- we don't necessarily expect anything in the near-term.

[Operator]

And your last question comes from the line of Kevin Barker of Piper Sandler.

[Kevin Barker, analyst]

I just wanted to follow-up on the interest income, which has been fairly strong. Obviously, you have some different moving parts with higher interest rates, higher custodial balances and then some seasonality associated with it, combined with some decline in debt. So maybe could you just provide us a little bit more color on what you expect from the direction of interest income, just given higher custodial balances? And then interest expense on the other side, given lower origination volume just seasonally?

[Daniel Perotti, executive]

Overall, when we look at the interest income to your point, there's a number of different moving pieces. So we tend to look at it on the interest income related to production and then the interest income related to servicing. Interest income related to production, given some of the changes in the yield curve toward the end of last quarter, at the beginning of this quarter, would tend to push up the note rate of mortgage rates versus the short-term rates have stayed relatively stable.So we'd expect that relationship between our financing lines and the note rate on the loans that are coming in to increase that interest spread, so that would generally move the interest income on the production side in a positive direction. On the servicing side, a couple of factors. So one, as we noted in our servicing income sort of disclosure, our servicing profitability slide, Slide 14, this in the slide deck. We did see interest expense decline quarter-over-quarter due to a lower draw on our servicing financing lines. We are keeping somewhat less cash. You may have seen the cash balance on our balance sheet declined somewhat. So we have begun to reduce the overall cash that we're holding on the balance sheet. We had been holding somewhat elevated levels due to the -- some of the market turmoil that we saw earlier in the year.So we've begun to reduce that, that really reduces some of the interest expense that we're seeing on the financing lines, would also reduce somewhat the interest income that we're earning on that cash. But overall, since we're paying a spread of 300 to 400 basis points on the servicing lines would bring down that interest expense and create an overall positive benefit. On the interest on the custodials, we do expect that to probably come down a little bit quarter-over-quarter just as to your point, the overall custodial balances or the escrow account balances tend to come down in the fourth quarter and be a little bit lower in the fourth quarter and first quarter due to seasonal tax payments that typically occur toward the end of the year or very beginning of the year.So hopefully, I know that was a lot of different components, but a couple of different countervailing effects. But overall, I would say, probably interest income ends up in a pretty similar place with all those effects is what we saw in this quarter if we're looking out into the next quarter.

[Kevin Barker, analyst]

Just from a seasonality perspective, what percent of the custodial the balance would you expect to decline in the fourth quarter and then in the first quarter just due to seasonality?

[Daniel Perotti, executive]

Yes. Typically, the average is lowest in the first quarter because the tax payments happen through the fourth quarter. So I think compared to the third quarter, I don't know the percentages off the top of my head. But I think roughly in the fourth quarter, down 10% to 15%. And then in the first quarter, a bit higher than that, probably down 20% or a little bit more.

[Operator]

We have no further questions at this time. I'll now turn it back to Mr. Spector for closing remarks.

[David Spector, executive]

Well, thank you, everyone, for joining today. We appreciate the time and the thoughtful questions. And if you have any additional questions, please don't hesitate to reach out to our IR team, and I look forward to speaking to all of you soon. Take care.

[Operator]

This concludes today's conference call. You may now disconnect.