PennyMac Financial Services Inc

NYSE:PFSI

Earnings Call Analysis

PennyMac Sees Strong Production Growth Amid Interest Rate Volatility.

PennyMac Financial Services reported a net income of $69 million and an 8% return on equity for Q3 2024, despite a drop in fair value on mortgage servicing rights due to interest rate fluctuations. The production segment's pretax income surged to $108 million, up significantly from $41 million last quarter, fueled by a 17% increase in total originations. The company anticipates annualized returns on equity in the high teens to low 20s for 2025. While origination volumes are expected to fluctuate with rates, the outlook remains strong due to a robust servicing portfolio and steady growth in the consumer direct lending segment.

Overview of Financial Performance

PennyMac Financial Services, Inc. (PFSI) reported a net income of $69 million in Q3 2024, translating to $1.30 per share and an annualized return on equity (ROE) of 8%. Notably, excluding fair value changes, the operating ROE stands impressive at 20%. The company's financial outcome was impacted by $160 million in MSR (Mortgage Servicing Rights) declines, amid fluctuating interest rates that showed a notable 60 basis point decline in the 10-year Treasury yield.

Production Segment Performance

The production segment exhibited robust growth, with pretax income rising to $108 million from $41 million in the prior quarter. Total acquisition and origination volumes reached $32 billion—up 17% from the previous quarter—with $26 billion attributed to PFSI's account and $6 billion from fee-based activities. Significant growth was also observed in the Consumer Direct channel, reflecting market dynamics and increased refinancing activity.

Understanding Origination Volumes

Acquisitions in correspondent lending surged to $26 billion, up from $23 billion, with channel margins improving to 33 basis points. However, a decline in retention is expected for Q4, projecting approximately 15% to 25% of total conventional correspondent production being retained, down from 42%. Conversely, lock volumes in Broker Direct increased by 24%, showcasing PennyMac's competitive edge as a strong alternative in the market.

Consumer Direct Growth Highlights

The Consumer Direct channel reported a remarkable increase, with lock volumes soaring by 93% and originations rising by 69%. This surge is largely driven by higher refinance activities. Despite lower margins stemming from a greater proportion of refinance loans, operational volumes are anticipated to remain in line with Q3 performance going into Q4.

Servicing Segment Insights

PFSI's servicing segment reported a pretax loss of $15 million, although excluding one-time valuation changes, the pretax income reached $151 million, consistent with prior quarters. Loan servicing fees rose due to portfolio growth, and custodial fund averages increased to $6.9 billion. However, the fair value of MSRs saw a decline of $402 million, driven by lower interest rates.

Future Projections and Market Outlook

Management projects annualized operating ROE to remain in the high teens to low 20s for 2025, supported by a balanced business model capable of adapting to varying interest rates. Market forecasts indicate total mortgage originations for 2025 could reach between $2.2 trillion and $2.3 trillion, contingent upon future rate changes.

Strategic Focus on Recapture Rates

The company is actively investing in technology and marketing strategies to enhance refinance recapture rates, which have shown improvement over the last five years. Approximately $200 billion of the loan portfolio is above a 5% rate, providing a significant refinancing opportunity as market conditions evolve.

Liquidity and Financial Management

PFSI maintains a robust liquidity position with $3.8 billion available for operations, including secured lines against MSRs. This liquidity provides flexibility for potential refinancing opportunities and operational stability in fluctuating market dynamics.

Conclusion and Strategic Positioning

PennyMac's strong positioning in both production and servicing markets, alongside innovations in technology, enhances its operational efficiency and profitability. Management remains optimistic about navigating current economic challenges while capitalizing on future opportunities through ongoing investments and strategic foresight.

Earnings Call Transcript 2024-Q3

[Operator]

Good afternoon, and welcome to PennyMac Financial Services, Inc.'s Third Quarter 2024 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 materials.

Now I'd like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer; and Dan Perotti, PennyMac Financial's Chief Financial Officer. Please go ahead.

[David Spector, executive]

Thank you, operator. Good afternoon, and thank you to everyone for participating in our third quarter earnings call. PFSI reported net income of $69 million for an annualized return on equity of 8%. Excluding the impact of fair value changes, PFSI produced an annualized operating ROE of 20%.

Our Production segment pretax income nearly tripled from last quarter as lower mortgage rates provided us the opportunity to help many customers in our servicing portfolio lower their monthly mortgage payments by refinancing. At the same time, our servicing portfolio now nearing $650 billion in unpaid principal balance and with nearly 2.6 million customers continues to grow driving increased revenue and cash flow contributions as well as providing low-cost feeds for our consumer direct lending division.

Turning to the origination market. current third-party estimates forecast total originations of $2.3 trillion in 2025, reflecting expectations for mortgage rates to continue their decline from current levels. driving growth in both refinance and purchase volumes. As we have demonstrated our balanced and diversified business model with leadership in both production and servicing enables strong financial performance and a foundation for continued growth as an industry-leading mortgage company regardless of the direction of interest rates.

Because we retain the servicing rights on nearly all mortgage loan production and have been 1 of the largest producers of mortgage loans in recent periods, we are uniquely positioned in the industry with a large and growing portfolio of borrowers who recently entered into mortgages at higher rates, and we would stand the benefit from a refinance in the future when interest rates decline. Our strong results in Consumer Direct with lots nearly doubling and originations up nearly 70% from last quarter demonstrate the future earnings potential of our flywheel providing outstanding service to our large and growing customer base, while offering them the home loan products best suited to their needs.

On Slide 6 of our earnings presentation, you can see as of September 30, a approximately $200 billion in unpaid principal balance, more than 30% of the loans in our portfolio at a rate above 5%, $90 billion of which was government insured or guaranteed loans and $108 billion of which was conventional and other loans. The opportunity ahead is highlighted in this slide, as indicated by our historic refinance recapture rates, which have improved significantly from 5 years ago as a result of our ongoing technology enhancements and process improvements.

We expect these recapture rates to continue improving given our multiyear investments, combined with the increased investment in our brand and use a targeted marketing strategy. Notably, we see higher recapture rates for government insurer guaranteed loans relative to conventional loans given the low cost and more efficient nature of streamlined refinance programs.

In 2022, when mortgage rates rapidly increased, we acted quickly to introduce the close-end second lien product to enable our borrowers access to the equity in their homes while also retaining their low rate first lien mortgages. We believe offering this product was a significant importance for our customers given our strong emphasis on providing our borrowers with a cost advantage went obtaining a second lien mortgage versus doing a cash out refinance at prevailing mortgage rates.

The light section of the bars on the 2 charts adjust our refinance recapture rates to include the impact of our closed end second lien program highlighting both the success in retaining our customers as well as our commitment to doing the right thing for them. Our large and growing servicing portfolio continues to anchor our core operating results. And in this higher interest rate period, we continue to realize the significant contribution from placement fees on custodial balances due to higher short-term rates.

Additionally, this management team has done a tremendous job enhancing our proprietary servicing system, which has the flexibility to rapidly adjust for regulatory changes and incorporate new and emerging technologies including artificial intelligence to drive operational efficiencies. We expect to gain additional operating leverage as the portfolio grows and as we continue to look for opportunities to drive down expenses, providing us with a strong base level of profitability in the future.

In total, we have built an operating platform that we believe is unmatched in the mortgage industry able to handle large growing volumes of loans at the highest quality standards, while also delivering strong performance across various markets. Our ability to swiftly react to the increased opportunity in the loan production market reflects our significant and ongoing investments in technology, the operational enhancements we have made and ultimately the scale we have achieved.

PFSI stands stronger than ever given the continued growth of our servicing portfolio and the higher efficient cost structure that sets us apart from our competitors. With the leadership position in the correspondent channel and growing market share in direct lending, we are the best positioned in the industry to capitalize on opportunities provided by growth in the origination market. In total, we expect to continue delivering strong financial results with annualized operating returns on equity in the high teens to low 20s in 2025.

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 $69 million in the third quarter or $1.30 in earnings per share for an annualized ROE of 8%. These results included $160 million of fair value declines on MSRs net of hedges as interest rates exhibited significant volatility during the quarter. The 10-year treasury yield declined approximately 60 basis points during the third quarter and range from a high of 4.5% to a low of 3.6%. The impact of these items on diluted earnings per share was negative $2.19. PFSI's Board of Directors declared a third quarter common share dividend of $0.30 per share, consistent with the prior quarter.

Turning to our production segment. Pretax income was $108 million, up from $41 million in the prior quarter due to higher volumes across all channels, with the largest increase in consumer direct. Total acquisition and origination volumes were $32 billion in unpaid principal balance, up 17% from the prior quarter. $26 billion was for PFSI's own account, and $6 billion was fee-based fulfillment activity for PMT.

PennyMac maintained its dominant position in correspondent lending in the third quarter with total acquisitions of $26 billion, up from $23 billion in the prior quarter. Correspondent channel margins in the third quarter were 33 basis points, up from 30 basis points in the prior quarter due to less competitive pricing from certain channel participants. In the fourth quarter, we expect PMT to retain approximately 15% to 25% of total conventional correspondent production, a decrease from 42% in the third quarter.

In Broker Direct, we continue to see strong trends and continued growth in market share as we position PennyMac as a strong alternative to channel leaders. Locks in the channel were up 24% from last quarter and originations were up 8%. The number of brokers approved to do business with us at quarter end was over 4,400 and up 25% from the same time last year, and we expect this number to continue growing as top brokers increasingly look for strength and diversification in their business partners. Broker channel margins were down slightly from the prior quarter but remained near normalized levels.

In Consumer Direct, lock volumes were up 93% from the prior quarter and originations were up 69%. Higher volumes were driven by an increase in refinance volumes, as David mentioned earlier. Margins in the channel were down given a higher percentage of refinance loans versus lower balance closed end second liens. Activity in October across all of our channels remains in line with third quarter levels. And though mortgage rates have increased, and we expect some impact from normal seasonality, we expect another strong contribution from our Production segment in the fourth quarter. Production expenses net of loan origination expense increased 18% from the prior quarter, primarily due to increased volumes in the consumer direct channel.

Turning to servicing. The Servicing segment recorded a pretax loss of $15 million. Excluding valuation-related changes in nonrecurring items, pretax income was $151 million, or 9.5 basis points of average servicing portfolio UPB, unchanged from last quarter. Loan servicing fees were up from the prior quarter, primarily due to growth in PFSI's owned portfolio. and earnings on custodial balances and deposits and other income increased due to higher average balances. Custodial funds managed for PFSI's own portfolio averaged $6.9 billion in the third quarter, up from $5.7 billion in the second quarter.

Realization of MSR cash flows increased $25 million from the prior quarter due to higher prepayment expectations due to lower mortgage rates. Operating expenses increased slightly but remained low at approximately 6.4 basis points of average servicing portfolio UPB. The fair value of PFSI's MSR decreased by $402 million driven by lower market interest rates from the prior quarter end. Hedging gains were $242 million and includes significantly elevated hedge costs due to interest rate volatility and the inverted yield curve. Excluding hedge costs, hedging gains offset 78% of MSR fair value declines.

We seek to moderate the impact of interest rate changes on the fair value of our MSRs through a comprehensive hedging strategy that also considers production-related income, which was up significantly this quarter versus last quarter, as David mentioned.

The Investment Management segment contributed $700,000 to pretax income during the quarter, and assets under management were essentially unchanged from the end of the prior quarter. Provision for income tax expense was $25 million, resulting in an effective tax rate of 26.1%. We ended the quarter with $3.8 billion of total liquidity, which includes cash and amounts available to draw on facilities where we have collateral pledged.

We'll now open it up for questions. Operator?

[Operator]

[Operator Instructions] Your first question comes from Doug Harter with UBS.

[Douglas Harter, analyst]

Hoping you could share a little bit what you're seeing in terms of lock volume and consumer direct in the past couple of weeks as post the Fed as rates have started backing up?

[David Spector, executive]

I mean, look, clearly, we've seen it come off of its highs from and where we were a month ago. I think that it's a function, obviously, of the higher rates. It's probably, I would say, down 30%, 30-ish percent. Well, look, having said that, I think we look at our direct lending businesses, both broker and consumer direct as being able to react to markets as they present themselves. I can tell you, in the Broker Direct channel, we continue to see nice share gains and you could see that last quarter, where in the third quarter, by our estimation, we're a 4% market share which is up from a little above 3% a year ago. And I'm really encouraged by what I'm seeing in that business as well.

On the Consumer Direct side, we were able to really to really seize on the opportunity when rates presented themselves. We're still seeing some good refinance activity, but it goes without saying that with rates increasing that you're going to see a bit of a slowdown from the highs.

[Douglas Harter, analyst]

And I guess along those lines, if you could just talk about capacity management kind of as volumes ramped up your ability to kind of meet that from capacity? And then if volumes are off, kind of how that plays through today?

[David Spector, executive]

Yes. Look, we're not going to get [ WIP on necessarily ] by the movements in the market. Suffice it to say, we spent '22, '23 really running capacity tight. Earlier this year, we made the decision to increase capacity and we're continuing to look to grow our capacity just given the natural growth in the portfolio. And really versus the alternatives in hedging the MSR, it's the least expensive -- it's the least expensive path that we can take with the most economic opportunity and the upside when rates do decline.

And so we're going to be running a little bit more excess capacity. But you look at, as I said, volatility and the cost of hedging servicing, and it's a very straightforward solution for what we need to do. to be able to manage the company.

[Daniel Perotti, executive]

The other lever that we have is that we still do have a significant number of loans in our portfolio with equity embedded. And so as rates increase and as we've talked about previously, our loan officers are focused more on second lien opportunities as we're growing the capacity, there's still a lot of opportunity in our portfolio there. And then when interest rates decline, again, we can redirect them back towards refinances of first lien loans.

[Operator]

Your next question comes from the line of Crispin Love with Piper Sandler.

[Crispin Love, analyst]

First, can you speak to your near-term outlook for ROE following the really strong third quarter, just with rates have backed up a bit in recent weeks? And then for 2025, presentation states expected ROEs in the high teens to low 20s. Can you just discuss a little bit what's implied in the estimates from the origination side? And then ROE expected to be higher as you move through the year in 2025?

[Daniel Perotti, executive]

Sure. So as we're looking in the fourth quarter, as you implied there the operating ROE is going to be somewhat dependent on what we see happen with rates. And I think if you look back prior to prior to the third quarter, we saw our operating ROEs in the mid moving up toward the high teens. So even at these rate levels, we believe we can achieve the same type of or slightly higher ROEs than what we saw earlier in the year.

Given the production levels that we're seeing today, if we see rates we see rates go higher, we still would expect to be in the mid-teens. And if we see lower that would obviously drive us back towards the level that we achieved in the third quarter. The outlook -- the ROEs, the operating ROEs that we cited in the low teens to -- or in the high teens, I should say, to low 20s for 2025. really what's implied in there is somewhat of an increase or I should say, the range there sort of covers a similar level or market level of production to what we've seen -- what we saw in 2024, maybe a little bit higher if we're on the low end of that range, similar to the operating ROEs that we've seen earlier in the year or slightly above that.

If we do see rates a bit lower as is embedded in the mortgage forecast that we've seen from other industry participants that David cited at $2.2 billion, $2.3 trillion market. and a bit higher, a bit more refinance activity that would drive us up. So that's one similar to what we saw here in the third quarter, which I would note, generally speaking, really the impact of lower rates in the third quarter was probably really only fell for 2 of the 3 months or 1.5 months of the 3 months. So if we saw a bit more of a sustained lower interest rate environment, we think that would drive us higher in that 20s range.

[Crispin Love, analyst]

Great. And then just following up on one comment you made there, just on the industry forecast I guess, $1.7 trillion in 2024, but probably more importantly, I believe it's right around $2.3 trillion in 2025. You have said in recent quarters that those might be a little ambitious. Do you still believe that might be the case? I apologies if you said that earlier, but just wanted to double click on that one.

[Daniel Perotti, executive]

I think a lot of it comes down to exactly what the interest rates are going to be in 2025. I think if we did see interest rates a little bit lower, similar to what we experienced or if rates have bounced around in the ranges that we saw during the third quarter, I definitely think a $2.2 trillion, $2.3 trillion market is achievable or would be in that range. If we see rates at sustaining at a higher level then that would probably be a little bit high, and we'd expect a little bit of a lower overall market size. But generally speaking, we don't think that, that range is unreasonable, but it does come down meaningfully to what happens with interest rates.

I would say that in either case, as we've talked about before, whether interest rates are higher or lower, given our balanced business model, we are built to perform well as I sort of gave the indication with the operating ROE. We are built to perform well in either environment. If rates do stay higher for longer, that will allow us to build up a higher -- a larger inventory of loans at higher mortgage rates that ultimately lead to even greater production income when rates eventually do decline. And in the meantime, we have really significant earnings generated by our -- the servicing side of the business as well as meaningful income from our production side as we've exhibited over the past year.

So in either way, we think we have a really great outlook for the company. But as I discussed previously, we could see a market ranging from probably the lower end slightly below $2 trillion up to the mid $2 trillion depending on what happens with interest rates next year.

[Operator]

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

[Bose George, analyst]

Actually, I wanted to go back to the MSR hedge. I mean, historically, your MSR hedge covered 80%. The mark, it was pretty close to that level this quarter, but you've been targeting higher levels recently. So can you discuss the hedge performance this quarter just relative to your expectations?

[Daniel Perotti, executive]

Sure, Bose. The hedge overall in terms of insulating the change from the MSR. The change in the MSR value as I cited, covered about 80% before the hedge costs. That was in line with what we were targeting. I think in the -- on the earnings call last quarter, we said we moved down from targeting a higher coverage level to 80%, 90%, so 78%, slightly lower than that. What we did see during the quarter was given the really, for a lot of the quarter, the further inversion of the yield curve, meaning that long rates going down and we didn't see short rates or financing rates go down until the very end of the quarter when the Fed lowered its target as well as the pretty significant interest rate volatility during the quarter.

So I mentioned covering, I think, over 100 basis 10 years covered, I think, over 100 basis points during the quarter. A lot of that was flowed through and implied volatility in option costs. We did see hedge costs that exceeded our normal 1% to 2% range during the quarter. And so as we continue to move through the next several periods, we are looking at how we how we adjust our hedge cost versus our overall coverage. As we move into the fourth quarter, we've seen rates -- we've seen that very short rates of long rates, deinvert somewhat.

We've seen our hedge costs come back down into our normal range, and we're still continuing to target overall coverage of around 80%. And so the long story short, the overall hedge protection, we think, operated as expected as it was at a higher cost than we have seen recently or would have targeted, but we've seen those costs come back into a range for a similar level of protection here in the fourth quarter.

[Bose George, analyst]

Okay. Great. And then actually, just a related question. So just your -- you talked about the targeted operating ROE. Is that -- should we assume your GAAP ROEs will be essentially are the same target for your GAAP ROEs as your hedge costs come down, that those 2 should be in line over time?

[Daniel Perotti, executive]

Generally speaking, we've seen -- as we talked about, there hedge costs in that 1% to 2% range. We've had instances where we actually get paid to hedge, and it goes the other way. And it's dependent somewhat on different factors of the interest rates, the different factors of the interest rate environment. So over longer periods of time, we would generally probably expect those to converge fairly closely. There may be there probably is some amount of hedge cost that exists over time. So GAAP ROE could be slightly lower than the operating ROE. But generally speaking, those 2 should be fairly close.

[Operator]

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

[Michael Kaye, analyst]

Has anything that surprised you with that mini refi boom we just had that 1.5 months, for example, where the higher note rate borrowers more likely to refi any thoughts?

[David Spector, executive]

I don't -- look, I think that -- I don't think anything surprised us per se. I'll tell you, I was encouraged by the amount of, for example, inbound traffic we saw in the call center, our ability to get borrowers to take refinances and block loans, I thought was really impressive and really executing on the flywheel I think the thing that, in a way, surprised me in the quarter is just the increase in jumbo activity that we've seen. We had a year ago, our locks for the quarter were $22 million. This quarter, they were $1 billion. And I think we're -- broker was 11% of total production as we're seeing banks stepping back.

So I thought that was -- that to me was really interesting. And that also, I think, speaks to what's driving the share gains that we're starting to see take place in broker. I think it's nice margins are kind of holding in check to going up and consumer direct a bit. And I think that, by and large, the tripling of production to me, kind of really speaks to the power of the flywheel. And so as we think about the hedging of the asset and the holes that get opened up, 1 of the things we often talk about as a team is to is to take into account that we have this production engine that's going to produce high levels of profitability, and we delivered on that front. So I thought it was a very good quarter for us.

[Michael Kaye, analyst]

I was wondering if you just give a subservicing update. I know you talked previously about expecting some subservicing deals to happen in Q4, I don't think I heard anything in the prepared remarks. Any update to that? Do you still expect that to happen and excited about the opportunity?

[David Spector, executive]

We do, we do. We expect to have 1 or 2 smaller customers by year-end. It's going to take a month or 2 to onboard them. We're in discussions with larger clients. Nothing to really report out yet in terms of, I would say, in terms of diligence or things that are getting close to the finish line. But word's getting out there I think that we're getting a lot of interest in the technology. And look, a lot of it is because of the -- a few things.

Number one, we're seeing a reduction in the expenses as you see every quarter, and then there seems like last quarter, we introduced the [ BA VAS ] program, which we're able to sell 917 loans back to totaling $267 million in UPB that really we had a negative mark on the servicing of close to $4 million. And so look, I think that people see what we're able to do with the technology. And by the way, we were the first ones out with the VAS program. I don't think too many others are out yet. But it just -- it shows the power of the technology. And I think we're getting some really good inbound inquiry into subservicing and the opportunity. So look, I'm hopeful that by the end of the year, we'll have 1 or 2 smaller customers inked, and then we'll be able to continue to grow that business.

[Operator]

Your next question comes from the line of Mark DeVries with Deutsche Bank.

[Mark DeVries, analyst]

You just highlighted, you've had some nice share gains in Broker Direct. And as you point out in the presentation, approved brokers signed on is up like 25% year-over-year. was just hoping you could talk about any kind of natural lag there is between getting someone signed up and kind of ramping to a full run rate? And maybe also a sense of the size of the brokers you've been signing recently to other ones to help us think through kind of what other future share gains we could expect there?

[David Spector, executive]

Look, look, we're doing -- the team is doing a great job in really making the case that you have numbers 1 and 2 who are going after one another on an exclusive basis. And our brokers are understanding that they need a second alternative at a minimum. And so we're able to provide that opportunity. We've got great tech support in our brokers. And we've spent a lot of time over the last 2 years developing that technology. The final piece will be coming out in Q4.

Our share is in existing brokers who do large volumes and we're adding to our sales force in a meaningful way. I've been pretty vocal about expecting share growth to continue at a pretty good pace, and the team understands that I don't want to be too far ahead of myself here as per as I have in the past, by putting markers out there on a quarter-by-quarter basis.

But I think that the fact that brokers need that strong second option, the fact we have a jumbo product that is providing consistent execution is meaningful. We've launched closed end second into the broker channel. And I look at our tech versus the tech that's provided by 2 very well-run organizations in the #1 and 2 slots. And I think we are just as good, if not better, in our tech. So I am highly encouraged by what I'm seeing in that channel.

[Mark DeVries, analyst]

Got it. And then, Dan, I was hoping you could clarify, I missed -- I think you provided some forward-looking commentary on the fourth quarter for the production segment. Could you just repeat that?

[Daniel Perotti, executive]

So I didn't give anything in specific on -- in terms of guidance for the production segment. We did say that overall, a lot of the quarter left to go. But that in terms of our operating we -- depending on what happens with rates for the rest of the quarter, we still expect to probably be in that high teens range with overall production. We're still seeing some positive effects in terms of the total overall availability of loans to be refinanced and a certain amount of production for correspondent that's sort of carrying over from the third quarter since that volume tends to lag a little bit for purchasing closed loans.

So we do expect production income to still be strong and meaningful in the fourth quarter. But depending on rates and the backup that we've seen might not be at the same levels as what we saw in the third quarter.

[Operator]

Your next question comes from the line of Terry Ma with Barclays.

[Terry Ma, analyst]

So your servicing margins kind of held steady at about basis points the last 2 quarters. Can you maybe just talk about how sustainable that is into next year even as kind of delinquencies continue to tick up?

[Daniel Perotti, executive]

Sure. So overall, I think we've shown the ability over the last several quarters to maintain that margin, and we do expect it to maintain at a similar level as we're moving into 2025. As you -- to the extent that we do see delinquencies pick up somewhat that could contribute a bit in terms of our operating expense I think the flip side of that is that we've shown our ability to drive down our operating expense over time through both the combination of efficiency enhancements including those that we get through our SSE, our proprietary servicing platform, and that's driven that 30% reduction in servicing costs over time over the last few years. And then -- and as we continue to increase scale by growing the servicing portfolio.

So I think the combination of those factors to the extent that we do see a bit of an uptick in delinquencies next year, we see offsets from those continued efficiency enhancements and potentially even -- depending on what we see and we're not necessarily expecting or I should say we're not really expecting a meaningful uptick in delinquency next year. So absent that, absent an uptick, we think we'd be able to continue to drive down costs as we move through the next year.

[Terry Ma, analyst]

Got it. And then for production, your correspondent market share and margins have held up pretty well in spite of some of the competitive pressures you've mentioned in the last few quarters. Can you maybe just talk about what you've seen in that channel in the third quarter and also early on in the fourth quarter?

[David Spector, executive]

Look, I think that there's -- to your point, we've in a period of some irrational pricing. We've managed to keep share pretty much flat to a year ago, we were up a decent amount in Q3. I would say that, look, we can -- margins were up from last quarter, margins continue to stay strong. We're obviously focused on profitability as well as maintaining share. And look, I think that given the size and the scale of this market, we can continue to grow share. We want to do it in a meaningful way.

But I think that the market knows that we're going to be the consistent bid out there. We're going to be in the market every day. And so we're back to -- we're getting closer back to that 20% share in correspondent and we're run above there and if we see irrational pricing, we may fall below there. But I think by and large, I'm really pleased with the 20% Q-over-Q increase in locks in correspondent fundings were up a little bit less than that. But again, in that -- and our -- and we're still -- our seller base is still holding in strongly at close to 800. And so it's still an industry-leading powerhouse that we have in correspondent.

[Operator]

Your next question comes from the line of Trevor Cranston with Citizens JMP.

[Trevor Cranston, analyst]

Looking at the chart of the servicing operating expenses on Slide 7, there's been a pretty consistent improvement there over the last few years. I guess as you look forward, would you say we're at a point where that improvement starts to level out a little bit? Or as you think over the next couple of years and some of the new technology on board comes on board? How much lower do you think the expense efficiencies can realistically get on the servicing side?

[Daniel Perotti, executive]

Sure. So yes, we think there's still a significant amount of room left to run in terms of servicing efficiencies and continuing to drive down that operating expense metric it may not be at quite the clip that we've seen over the past few years, which is pretty substantial, but we do think that there is a lot of a lot of runway, and we're going to continue to progress on that in a meaningful way. We don't really want to set a -- we don't want to set a specific floor necessarily, but looking at what we think we could achieve through a combination of both continued scale as well as increased operating efficiencies.

We believe there's at least 3 further reduction that could be achieved in that operating expense metric over time. That's not all going to be next year, but we can continue to move that down in a meaningful way as we move through the next several periods.

[Operator]

Your next question comes from the line of Derek Sommers with Jefferies.

[Derek Sommers, analyst]

Just looking at the production expenses, I think in your prepared remarks, you attributed the increase to the consumer direct channel. And kind of plugging the gap there, how should we think about Broker Direct kind of volume-related or variable expenses as that channel continues to gain market share?

[Daniel Perotti, executive]

Our overall variable expenses on the broker side or I guess the way to think about it is sort of mid -- what we've disclosed previously is really in terms of basis points, say, in the midrange around -- the mid-range of double digits. So that -- as we increase, we should continue to get meaningful scale from that channel. As David mentioned, we are that's probably on the variable expense side.

We are continuing to grow our overall platform there. And so that may not all be realized in as you would see it as we're sort of continuing to ramp up share in a meaningful way as we're bringing on additional resources to grow the channel. But as from a pure variable standpoint, that's what we would expect.

[Derek Sommers, analyst]

Got it. And then on Consumer Direct volume expectations, do you expect kind of the product mix from 3Q to kind of filter over to 4Q? Or are we going to see kind of more of a reversion back to second lien mix?

[Daniel Perotti, executive]

If rates stay higher, we would expect a bit of a reversion back to more of a second lien mix. So it will be a bit rate dependent. If we see more interest rate volatility and dips in rates, then we would see a bit of a shift back toward first lien refinances. And that's really -- as we discussed, part of our strategy is being able to toggle between those products and maintain our capacity in the channel by rotating between the second liens and the higher interest rate environment and the refinances or first lien refinances as rates decrease or when rates decrease.

[Operator]

Your next question comes from the line of Eric Hagen with BTIG. Your next question comes from the line of [ Brian Fiorino ] with Wedbush.

[Unknown Analyst]

Great. Just one quick one for me. I wanted to get your view on custodial balance earnings. I know there's probably going to be some seasonal declines in the fourth quarter. just thoughts on how that part of the business trends into next year, if we do see a steeper decline in short-term rates. Is that something that could have an impact on servicing profitability? And how does that factor into your ROE expectations for next year?

[Daniel Perotti, executive]

Brian, could you repeat that?

[Unknown Analyst]

Yes. Just views on the custodial balance earnings in terms of how that could impact servicing profitability if we do see a bigger decline in short-term rates next year?

[Daniel Perotti, executive]

Sure. So to the extent that we see a decline in short-term rates next year that would impact the earnings that we've been earning on custodial balances which is generally driven or somewhat driven by what we see in short-term rates. We would also see and you can sort of see it this quarter as well, some reduction in terms of our floating rate debt and the expense that we see there, which has somewhat of an offsetting impact.

The other aspect to take into account is relating to our realization of servicing cash flow. So part of our when we project out the cash flows for the servicing asset and look at what should sort of fall off in any given period, that's really what flows into our realization of servicing cash flows line, that amortization line. And so since we are projecting lower given what at least recently the forward curve has projected lower short-term rates over time that would drive a lower amount of cash flow to be realized in any given period, which maintaining a yield in terms of our cash flow would result in a lower realization of cash flows. So those 2 impacts, we would expect to offset the lower custodial balances or the lower earnings on custodial balances, I should say.

[Operator]

Your next question comes from the line of [ Sienna Chu ] with Barclays.

[Unknown Analyst]

It looks like delinquencies increased sequentially by 70 basis points in FHA and 50 basis points in USDA portfolios. I know you mentioned it remains within expected levels and on a prior question, you cited that you don't expect a meaningful uptick in delinquencies next year. Can you just comment on what drove that sequential increase in delinquencies and kind of what gives you confidence on delinquency formation going forward for more of the recent [ Ginnie Mae ] originations if rates stay elevated?

[David Spector, executive]

I would say that a lot of the delinquency that what we would call the noise around the increase in delinquency has to do with, for example, how many how many business days in a month or where does the month end? Or are there 5 Fridays in a month because people get paid on every other Friday. I would say, by and large, delinquency rates continue to remain at very, very low levels. And I think I think that, one, given the state of the economy, combined with the lack of supply in the marketplace, those are -- that, to me, gives me great confidence in terms of the continued profitability in servicing.

I think that we -- for borrowers who do find themselves struggling, there are a tremendous amount of forbearance programs offered by FHA, VA, USDA, Fannie, Freddie, really with the ultimate goal to keep borrowers in their homes until they can get back on their feet. I think that's 1 of the great lessons learned of the great financial crisis that we want to give borrowers every opportunity to stay in their homes. In the event that's not the case, given the supply issues in the marketplace, orderly dispositions are clearly to be expected which will help continue to provide lower servicing costs for borrowers who do go into foreclosure.

And so by and large, I think it's one of the great stories. And then also the fact there's so many low rate first lien mortgages in the marketplace. So the alternatives for borrowers are pretty slim if they are mortgages below 5%, given what we're seeing in the rental markets and the alternatives. I think that staying in their homes is probably at the top of their list in terms of what they want to do. So by and large, I think that we'll see some gyrations monthly, quarterly, but I expect that they'll continue to run at these historically low levels.

[Unknown Analyst]

Great. And then last one for me. How should we think about refinancing the 5 3/8% bond in October 2025. I mean those are fairly low coupon, but they're now current. So how should we think about financing costs going forward?

[David Spector, executive]

Sure. So as you mentioned, we've got the maturity for that 5 3/8% bond later in the year next year. As we're moving through 2025 through the next few quarters, we will be looking to see if there are good opportunities to be able to issue debt and refinance that bond. But as you mentioned, it is at a pretty attractive coupon. And so we are not necessarily in a rush to refinance it. We do have, as we mentioned in the prepared remarks, $3.8 billion of liquidity available, including amounts available to be drawn on our secured lines against our MSRs, for example, which we have a really significant amount of capacity and committed capacity available on.

So to the extent that we don't see an opportunity or an attractive opportunity to be able to refinance, we do have the ability to draw on those lines to retire the debt at maturity. If that's -- if we don't see an opportunity to issue before then, but it is our expectation that we would issue between now and the maturity to refinance that issue.

[Operator]

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

[David Spector, executive]

Well, thank you. I'd like to thank everyone for joining us today on this call. If you have any additional questions, as always, please feel free to contact our Investor Relations department, and we will be at your availability to answer those questions. And again, thank you for joining us.

[Operator]

This concludes today's conference call. Thank you for your participation, and you may now disconnect.