PennyMac Financial Services Inc

NYSE:PFSI

Earnings Call Transcript 2018-Q4

[Christopher Oltmann, executive]

Good afternoon, and welcome to the Fourth Quarter 2018 Earnings Discussion for PennyMac Financial Services, Inc. The slides that accompany this discussion are available from PennyMac Financial's website at www.ir.pennymacfinancial.com.

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

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

[Stanford Kurland, executive]

Thank you, Chris. Let's begin with Slide 3. PennyMac Financial's results reflect the strength of our balanced mortgage banking business platform to drive solid results in a market environment characterized by continued rising interest rates and a somewhat smaller purchase-oriented mortgage production market.

PennyMac financial earned pretax income of $58.3 million and diluted earnings per share of $0.63.

Fourth quarter results included a benefit from the remeasurement of state tax-related items totaling $0.11 per share. Additionally, our tax provision rate was reduced to 26.9% from 27.4%.

Book value per share increased to $21.34 from $20.67 per share at September 30. Pro forma to adjust for the impact of the company's corporate reorganization completed in November 2018.

During the fourth quarter, we repurchased approximately 24,000 shares of PFSI common stock at a cost of $500,000, representing a weighted average price of $19.75 per share.

Production segment pretax income was $25.4 million, down 1% from the prior quarter and 54% from the fourth quarter of 2017.

Acquisition and origination volume totaled $19.4 billion in UPB, up 8% from the prior quarter and 14% from the fourth quarter of 2017.

Total correspondent government, nondelegated and direct lending locks were $11.2 billion in UPB, down 1% from the prior quarter and 5% from the fourth quarter of 2017.

The Servicing segment recorded pretax income of $29.3 million, down 13% from the prior quarter and 8% from the fourth quarter of 2017.

Excluding valuation-related items, pretax income for the Servicing segment was $44.5 million, up 49% from the third quarter and 57% from the fourth quarter of 2017.

Valuation-related items for the third quarter included a $67.2 million decrease in MSR fair values, partially offset by a $59.8 million increase from associated hedging activities.

We continue to grow our Servicing portfolio, which totaled $299.3 billion in UPB at quarter-end, up 5% from September 30 and 22% from December 31, 2017.

The year-over-year growth was driven by $67 billion in UPB of production and origination activities, along with approximately $18 billion in UPB of bulk MSR acquisitions.

Turning to Slide 4. Our Investment Management segment delivered pretax income of $2.5 million, flat to the prior quarter and up from $1.5 million in the fourth quarter of 2017.

Net assets under management were $1.6 billion, essentially unchanged from the prior quarter-end and December 31, 2017.

On November 1, the company completed the previously announced corporate reorganization that simplified its corporate structure through the conversion of all equity ownership to a single class of publicly traded common stock.

After quarter-end, PennyMac Financial completed the acquisition of an additional bulk Ginnie Mae MSR portfolio with a UPB of approximately $798 million.

Also, after quarter-end, we launched several new products to meet customer needs. Importantly, we launched a home equity line of credit, or HELOC, initially directed to select customers of our Servicing portfolio that will offer them the opportunity to tap into their home equity while retaining their current first mortgage interest rate.

We also launched a prime nonqualified mortgage loan product, also known as prime non-QM, to our correspondent clients to offer them greater flexibility to provide borrowers with the right mortgage product to fit their needs. Both of these products benefit PennyMac Financial through our partnership with PennyMac Mortgage Investment Trust, which has the ability to securitize and invest in HELOC assets and prime non-QM products, ultimately, driving growth in our investment management activities.

Now let's turn to Slide 5 and discuss the current market environment.

The fourth quarter saw increased market volatility as a result of global growth concerns and uncertainty regarding the trajectory of the Federal Reserve monetary policy. However, the Federal Reserve recently signaled it will be patient in regards to any future rate hikes, which has helped reduce volatility.

During the fourth quarter, the average 30-year fixed mortgage rate was 22 basis points higher on average than in the prior quarter. However, at quarter-end, mortgage rates retreated about 50 basis points from their mid-quarter high of nearly 5% in mid-November and have remained at those levels after year-end, driving expectations for a modest increase in refinance activity.

Credit spreads widened and finished the year 40 to 80 basis points wider than they were at September 30, as the increase in volatility during the quarter contributed to a higher premium for risk assets. This year, so far, however, spreads have substantially recovered.

A healthy overall economy, low unemployment and favorable trends among home-buying demographics in addition to slowing home price appreciation growth are driving a purchase market outlook that is expected to grow by mid-single digit percentages over the next couple of years.

Mortgage delinquencies improved further quarter-over-quarter, with the total U.S. loan delinquency rate falling to 3.9% at year-end, down from 4% at September 30, and 4.7% a year ago, driven by a favorable U.S. economy, high quality mortgage underwriting standards and strong home prices.

Now let's turn to Slide 6 and review the composition of PennyMac Financial's balance sheet. PennyMac Financial has developed into a leading independent nonbank mortgage company as a result of its comprehensive mortgage platform and balanced model with profitable production and Servicing businesses, each with leadership positions in their respective markets. We have achieved this position by building a high quality balance sheet utilizing modest leverage compared to our competitors, with diversified liquidity sources, nearly $5 billion of warehouse financing and a strong capital base.

We have also put in place a financing structure that provides cost-effective term financing for the largest asset on PennyMac Financial's balance sheet, mortgage servicing rights, with flexibility that provides the company the ability to expand financing as the MSR asset grows.

Our financial position is further supported by a well-developed and sophisticated risk management and governance infrastructure, developed and overseen by our highly experienced executive management team. Our risk management infrastructure combines our extensive market expertise and technology to identify and monitor risks across the enterprise.

Our strength is further supported by the steps we have taken to simplify our corporate structure, converting all equity ownership of the company into a single class of publicly-traded common stock. This reorganization has the potential to expand the investor universe and demand for the company's stock and increase PennyMac Financial's market capitalization from approximately $500 million to $1.5 billion.

Now let's turn to Slide 7 to discuss our development and utilization of technology. Throughout PennyMac Financial's history, we have focused on the utilization of technology to improve and streamline operations across the enterprise. Our technology utilization strategy involves a combination of systems developed in-house, using the expertise of our information technology development teams, along with third-party technology that we deploy strategically.

We place significant emphasis on creating innovative mortgage production and servicing systems that drive both cost savings and scale efficiencies as well as facilitates new business opportunities. This includes a focus on both enhanced customer-facing portals and interfaces as well as developing automated back office technologies that help improve profitability and realize new competitive advantages.

Let's start with pricing and margin management systems. These systems feature greater pricing granularity and real-time pricing updates. We are also in the process of developing a sophisticated loan bidding system that incorporates statistical analysis and machine learning.

Next is our servicing system enhancements. This multiyear project is nearing completion with a focus on increasing the efficiency of our loan servicing platform. Key features include the automation of certain repetitive tasks and creating efficiencies to better serve our $1.5 million mortgage customers. With this project, we expect that we will realize additional cost savings across our loan-servicing platform.

In terms of origination and fulfillment workflow, the key element in this technology upgrade features rule-based engines and applications in development to streamline workflow processes across the platform.

Finally, in our enterprise risk management area, we are currently focused on installing a proprietary risk intelligence system that will enhance our risk monitoring capabilities across the organization and strengthen our capabilities to identify and mitigate risks as they emerge.

With that, I now would like to turn the discussion over to David Spector, PennyMac Financial's President and Chief Executive Officer, to discuss our operational performance during the fourth quarter.

[David Spector, executive]

Thank you, Stan. On Slide 8, let's begin with the review of market share and volume trends across PennyMac Financial's businesses.

According to fourth quarter industry data reported by Inside Mortgage Finance, PennyMac Financial remained the eighth largest servicer and became the third largest producer of mortgage loans. PennyMac increased its correspondent market share by over 3 percentage points during the fourth quarter, growing production volumes, while many of the larger correspondent channel participants saw their volumes decrease.

Production volume this quarter was driven by strong growth on behalf of PMT in conventional conforming activity, from which it creates and retains attractive credit risk transfer and MSR investments.

Turning to Consumer Direct, our market share increased this quarter despite a modest quarter-over-quarter volume decrease as the overall retail market decreased even more. We estimate that our Servicing portfolio now represents over 2.7% of all mortgage debt outstanding in the U.S. at quarter-end, up from 2.6% at September 30.

Finally, net assets under management in our Investment Management business were $1.6 billion, essentially unchanged from the prior quarter.

Now let's turn to Slide 9 and discuss correspondent production highlights. Correspondent acquisitions by PMT in the fourth quarter totaled $18.1 billion in UPB, up 9% from the prior quarter and up 17% from the fourth quarter of 2017. Government loan acquisitions accounted for 49% of total correspondent acquisitions or $8.9 billion in UPB in the fourth quarter, down slightly from $9 billion in UPB in the prior quarter and down $9.5 billion in UPB in the fourth quarter of 2017.

Conventional conforming acquisitions, for which PennyMac Financial performed fulfillment services for PMT, totaled $9 billion in UPB, up 21% from the prior quarter and up 54% year-over-year. As I mentioned earlier, this volume supports PMT's creation of long-term investments in CRT from the majority of the conventional conforming loans that it acquires. CRT has been a major driver of PMT's improved performance, and the higher loan volumes that are made possible as a result also drive growth in fee revenue for PennyMac Financial.

Total lock volume in the fourth quarter was $19.1 billion in UPB, up 7% from the prior quarter and 20% year-over-year. Government locks totaled $9 billion in UPB in the fourth quarter, down 2% from the prior quarter and down 6% year-over-year. Conventional locks totaled $9.8 billion in UPB, up 15% from the prior quarter and up 56% year-over-year.

Revenue per fallout-adjusted government lock commitment was 29 basis points in the fourth quarter, a decrease from 35 basis points in the prior quarter, reflecting our focus on strategically maintaining our market leadership position. The weighted average fulfillment fee paid by PMT to facilitate loan production on its behalf was 32 basis points in the fourth quarter, down from 35 basis points in the previous quarter.

Throughout 2018, we have benefited by receiving incentives under one of our master repurchase agreements to finance mortgage loans that satisfy certain consumer relief characteristics. We expect to cease accruing the incentives beginning in the second quarter of 2019. While there can be no assurance, we expect that the loss of such incentives will be partially offset by improvements in pricing margins.

Purchase money loans accounted for 88% of our correspondent acquisition volume in the fourth quarter, up from 87% in the prior quarter and 76% in the fourth quarter of 2017.

We experienced substantial growth in our correspondent seller relationships during the fourth quarter, reaching 710 correspondent clients at quarter-end, up from 655 at September 30. This growth reflects our ongoing strategic initiatives to attract community banks and credit unions, which can derive significant benefits from the broad capabilities of our platform, including interest rate risk management activities and a continued focus on growing our nondelegated business.

In the fourth quarter, we originated $120 million in UPB of nondelegated correspondent locks, up 61% from $75 million in the prior quarter.

Monthly production volumes remained strong in January, with total correspondent loan acquisitions of $5.2 billion in UPB, up from $4.8 billion in January 2018. Interest rate lock commitments in January also totaled $5.2 billion in UPB, up from $4.4 billion in January 2018. Additionally, in January, we launched a prime non-QM loan product that utilizes a technology-based underwriting solution.

Now let's turn to Slide 10 and discuss Consumer Direct production highlights. Consumer direct production volume totaled $1.2 billion in UPB in the fourth quarter, down 8% from the prior quarter. This decline was primarily driven by higher mortgage rates during most of the fourth quarter, which adversely impacted our refinance-driven volume. As a result, revenue per fallout-adjusted consumer direct lock decreased modestly to 356 basis points in the fourth quarter from 363 basis points in the prior quarter.

The decline in mortgage rates at the end of December held through January and improved the benefits from refinancing for many of the 1.5 million borrowers in our Servicing portfolio, increasing demand for both rate-and-term and cash-out refinance mortgages.

January consumer direct originations totaled $357 million in UPB, while locks totaled $761 million. The committed pipeline was up from $593 million at quarter-end to $790 million at January 31.

After quarter-end, we launched our HELOC product in our Consumer Direct channel, designed to support the financing needs of our Servicing portfolio customers while giving them a flexible way to use their home equity to finance a variety of purchases or expenses while maintaining their current first mortgage interest rate. By taking this step, PennyMac Financial is currently the only major nonbank lender to directly offer HELOC product.

Our wholly owned subsidiary, PennyMac Loan Services, has begun accepting applications from customers in 5 states, including California, Florida, Oregon, Virginia and Washington, and will roll out the product to customers in additional states throughout the year. As we expand our HELOC program, we also plan to offer to prospective customers who do not yet have a lending relationship with PennyMac.

Now let's turn to Slide 11 and discuss Broker Direct channel highlights. In the fourth quarter, Broker Direct production volumes grew 80%, totaling $199.1 million in UPB. The quarter-over-quarter growth was driven by the continued buildout of our sales force as well as the addition of 161 broker relationships during the quarter. The broker market environment has become increasingly competitive in recent months, driving quarter-over-quarter revenue margins to 75 basis points from 84 basis points in the prior quarter.

During the fourth quarter, we made progress in expanding our menu of products and features to our broker clients. Notably, we launched Fannie Mae's HomeReady product, an enterprise paid mortgage insurance, otherwise known as EPMI, which will help support broker production growth throughout 2019.

In January, total channel originations were $66 million in UPB, while locks were $91 million in UPB. The committed pipeline was $73 million at January 31, essentially unchanged from the end of 2018.

We also continued to enhance the capabilities of our broker portal, also known as POWER. This quarter, we plan on releasing several new additions to our portal, the most noteworthy of which are expanded notifications that facilitate enhanced origination status updates between the broker and the borrower and real-time visibility for the broker into the status of their loan pipeline, along with expansion of the systems capabilities to help manage it.

Now let's turn to Slide 12 and discuss Servicing highlights. Our loan servicing portfolio grew to $299.3 billion in UPB at the end of the fourth quarter, up 5% from September 30 and up 22% from December 31, 2017. The quarter-over-quarter growth was primarily driven by organic production activities in addition to the completion of previously announced bulk acquisitions, totaling $3.6 billion in UPB.

After the quarter-end, we completed an additional bulk MSR acquisition of $798 million in UPB. Driven by higher average mortgage interest rates during the fourth quarter, prepayment speed in PennyMac Financial's own portfolio, which includes mostly Ginnie Mae MSRs, slowed to 9.8% from 12.3% in the prior quarter. Similarly, the prepayment speeds of PennyMac Financial's subservice portfolio, which includes mostly Fannie Mae and Freddie Mac MSRs owned by PMT, slowed to 7.5% from 8.7% in the prior quarter.

Higher mortgage interest rates also led to a 49% quarterly decrease in EBO transaction volume, which totaled $495 million in UPB in the fourth quarter. However, the decline in mortgage rates in December has since increased the eligible buyout population and has improved EBO-related economics. And we anticipate an increase in EBO volumes and contribution to income in the first quarter of 2019.

Now let's turn to Slide 13 and review the Investment Management segment. PennyMac Financial benefited from a strong contribution in the Investor Management segment during the fourth quarter, driven by incentive fees that were earned based upon PMT's continued strong performance. PMT's earnings increased significantly in 2018 as a result of growing investments in CRT and MSR assets. During the quarter, we also made significant reduction to PMT's distressed loan investments through the completion of $267 million in UPB of previously announced distressed loan sales. As a result, distressed loan investments now represent only 8% of PMT shareholders' equity, down from 22% a year ago.

While PMT continues to pursue its core investment strategies of CRT and MSR investments, it is also partnering with PennyMac Financial to facilitate the buildout of its product menu to include HELOC and prime non-QM loans and expand PMT's investment strategies. We expect PMT will utilize its ability to invest in securitization interests backed by these new products originated by PennyMac Financial.

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

[Andrew Chang, executive]

Thank you, David. I will highlight some of the key trends and factors in our financial results on the next couple of slides. We encourage you to read our press release on fourth quarter earnings for further details.

Slide 14 summarizes the impact of our hedging approach on earnings for the fourth quarter and full year. Our hedging strategy is designed to moderate the impact of volatility and interest rates on the fair value of the MSR asset. In the fourth quarter, we recorded fair value losses on our MSR asset totaling $67.3 million, which resulted from expectations for increased prepayment activity in the future, driven by lower mortgage rates at the end of the fourth quarter.

MSR fair value losses were largely offset by $59.8 million in associated hedging gains and $0.5 million decrease in the fair value of the ESS liability.

While there was significant volatility in interest rates throughout 2018, PennyMac Financial's approach to hedging the MSR asset was successful as we recorded a $34.1 million gain in the MSR fair value, net of hedges and the ESS liability.

Now let's go to Slide 15 and review the profitability of our Servicing segment. Pretax income, excluding valuation-related changes, was $44.5 million, up from $29.9 million in the prior quarter and $28.2 million in the fourth quarter of 2017. This core operating profitability of our Servicing segment has increased considerably over the last several quarters and reached its highest level thus far in the fourth quarter of 2018.

Operating revenue increased by approximately $20 million quarter-over-quarter, driven by the 5% growth in our Servicing portfolio due to organic production activity and the bulk MSR acquisitions completed during the quarter.

Operating expenses were flat to the prior quarter on a dollar basis and down as a percentage of our Servicing portfolio's average UPB. Credit losses and the provision for defaulted loans were in line with prior period levels.

EBO-related revenue decreased from the prior quarter as a result of higher average interest rates during the fourth quarter. As David mentioned, higher mortgage rates also reduced the population of loans eligible for buyout, resulting in fewer buyouts and lower transaction-related expenses.

Interest expense decreased by $4 million quarter-over-quarter. Interest expense in the third quarter was elevated due to the accelerated recognition of costs related to the refinancing of MSR-backed term notes.

Overall, the core financial performance of our Servicing business remains strong, and we are confident that investments we are making in our operations to capture greater efficiencies and scale will deliver meaningful cost savings in the future.

And with that, I would like to turn it back over to Stan for some closing remarks.

[Stanford Kurland, executive]

Thank you, Andy. PennyMac Financial is well-positioned for growth in 2019 as we continue to pursue opportunities we find attractive. We are proud of both a firm-wide effort that resulted in the company becoming the first nonbank lender to directly offer its customers a HELOC product and the launch of a prime non-QM loan product in our correspondent channel.

We continue to realize operational efficiencies across our enterprise, such as in our Servicing business, as our investments in technology and portfolio growth add to greater efficiency and scale, driving improved operating profits. We remain focused on further development of our direct lending channels and building out our product menu to provide mortgage solutions that meet our customers' evolving financial needs.

Our scale, platform and ability to adapt to a changing market environment are reasons why we expect to be a beneficiary of market consolidation and continue delivering strong financial performance in the future.

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

[Christopher Oltmann, executive]

This concludes PennyMac Financial Services, Inc.'s fourth quarter earnings discussion. For any questions, please visit our website at www.ir.pennymacfinancial.com or call our Investor Relations department at [phone]. Thank you.