PennyMac Financial Services, Inc. (NYSE:PFSI) Q3 2022 Results Conference Call October 27, 2022 5:00 PM ET
Company Participants
Isaac Garden – Vice President, Investor Relations
David Spector – Chairman & Chief Executive Officer
Doug Jones – President
Dan Perotti – Senior Managing Director & Chief Financial Officer
Isaac Garden
Good afternoon and welcome to the third quarter earnings discussion for PennyMac Financial Services, Inc.
The slides that accompany this discussion are available on PennyMac Financial’s website at ir.pennymacfinancial.com.
Before we begin, let me remind you that our discussion contains forward-looking statements that are subject to risks identified on Slide 2 that could cause our actual results to differ materially, as well as non-GAAP measures that have been reconciled to their GAAP equivalent in our earnings presentation.
Now I’d like to begin by introducing David Spector, PennyMac Financial’s Chairman and Chief Executive Officer, who will review the Company’s third quarter 2022 results.
David Spector
Thank you, Isaac. In the third quarter, PennyMac Financial once again delivered strong financial performance with net income of $135 million or $2.46 in earnings per share. Meaningful income contributions from both our production and servicing segments led to an annualized return on equity of 16% and continued growth in PFSI’s book value per share despite mortgage rates climbing to their highest levels in more than a decade.
We ended the quarter with a servicing portfolio of $539 billion in unpaid principal balance as additions from loan production continued to offset prepayment activity. Importantly, I believe the growth of our servicing portfolio will continue to differentiate PFSI from its competition, serving as an increasingly important asset while the origination landscape remains challenging. Our balanced business model with leadership positions in production and servicing, combined with our robust risk management disciplines, supports our ability to profitably navigate different market environments. In the current environment, our servicing portfolio is contributing the majority of PFSI’s earnings while also providing significant cash flow to support investments across our businesses.
We remain active in repurchasing shares, which at current price levels is accretive to book value and beneficial for our future earnings. This quarter, we repurchased 1.9 million shares of PFSI common stock at an average price of $51.13, for an approximate cost of $100 million. Through October 26, we repurchased an additional 882,000 shares at an average price of $45.73, for an approximate cost of $40 million. In the near term, we expect the pace of share repurchases to trend lower in order to maintain our flexibility to address potential risks and opportunities in the evolving market environment.
In PFSI’s investment management segment, net assets under management were $2 billion at quarter end, down slightly from the prior quarter due to PMT’s financial performance. In total, this strong financial performance drove continued growth in book value per share, which was up 4% from June 30 to $68.26 at the end of the quarter. PFSI’s Board of Directors also declared a third quarter cash dividend of $0.20 per share.
Dan Perotti, PFSI’s Senior Managing Director and Chief Financial Officer, will review additional details of our financial performance later on in this discussion.
With mortgage interest rates currently around 7%, the most recent third-party forecasts for originations have decreased meaningfully, indicating an annualized run rate of $1.7 trillion to $1.9 trillion in upcoming quarters. We believe mortgage banking companies with large servicing balances and diversified business models like PennyMac Financial are better positioned to offset the decline in origination profitability that has resulted from these lower volumes.
In our production segment, purchase activity has been impacted by the affordability challenges created by higher mortgage rates and significant home price appreciation over the last several years. Refinance volumes are expected to remain subdued, as nearly all outstanding mortgages are currently out of the money.
In the correspondent channel, we are seeing our customers increasingly sell loans servicing released to stable capital partners like PennyMac as they seek to manage profitability and enhance liquidity. We believe the challenging environment will continue in upcoming quarters as higher rates persist. That said, we expect a decline in PFSI’s production revenue to be largely offset by disciplined expense management activities, which I will speak about later.
Turning to our servicing business. We are forecasting continued portfolio growth as we leverage our low-cost structure and industry-leading position in correspondent lending to profitably add current [higher note rate servicing] to our portfolio, providing opportunities for recapture when interest rates decline. We also expect to see attractive opportunities to acquire bulk MSRs over the next 12 to 18 months as originators look to monetize servicing due to decreased origination profitability. According to top economists, the probability for recession has increased in recent periods. While we recognize the challenges this may present for our servicing business, we believe the risks are mitigated by the fact that consumers are financially in a strong position given the equity built up in their homes over the last couple of years, combined with low levels of unemployment at present.
Turning to our investment management segment. Credit spread widening in recent periods resulted in fair value declines in PMT’s credit investments, translating to a decline in PMT’s equity and lower base management fees for PFSI. In addition, we do not expect performance-based incentive fees to be earned in the foreseeable future due to PMT’s losses in recent quarters. Nonetheless, as the largest correspondent lender with an orientation towards purchase money loans and strong fundamentals underlying its seasoned investment portfolio, we believe PMT’s long-term return potential remains attractive.
As I mentioned earlier, expense management continues to be a top priority for PennyMac Financial. We implemented meaningful expense savings and capacity reductions beginning early this year as shifts in the market were developing. In fact, quarterly operating expenses have been reduced by more than $170 million or 37% compared to average quarterly 2021 levels. And we have taken additional actions in the fourth quarter to further align our expense base to the lower expected levels of activity. We will continue to monitor the market and make additional adjustments as needed in order to rightsize our business appropriately.
PennyMac Financial has produced strong results so far this year with an annualized return on equity of 17%, which has driven growth in book value per share of 14% year-to-date. Though I believe we are well positioned to successfully navigate the current market environment, it is our expectation that PFSI’s return on equity will decline from current levels before returning to our pre-COVID range over time.
Now I’ll turn it over to Doug Jones, PennyMac’s President and Chief Mortgage Banking Officer, who will review our market share trends and third quarter mortgage banking results.
Doug Jones
Thanks, David. Overall production was solid in the third quarter given the market environment, with total production volumes down only 3% from the prior quarter. PennyMac maintained its leadership position in correspondent lending, as our strong capital position and consistent commitment to the channel provides our partners with stability and support they need to successfully navigate a challenging mortgage market. We estimate that, over the past 12 months, we represented approximately 14% of the channel overall.
Total correspondent loan acquisition volume in the third quarter was $22.4 billion, of which 46% were conventional conforming loans for which PFSI earns a fulfillment fee from PMT. Government loan acquisition volumes were up 14% from the prior quarter, while conventional correspondent acquisitions were down only 1%. Government correspondent lock volume was up 9% from the prior quarter. Revenue per fallout-adjusted government lock in the third quarter was 24 basis points, down from 27 basis points in the prior quarter.
The scale we have achieved in our correspondent business, combined with our low-cost structure and operational excellence in the channel, allow us to operate efficiently through the volatile market environment. In October, we estimate correspondent acquisitions will total $7.5 billion and locks will total $8 billion.
Turning to consumer direct, we estimate that we accounted for approximately 1.4% of total originations in the channel over the last 12 months. Origination volumes for the third quarter were $2.3 billion and interest rate lock commitments were $3.8 billion, reflecting a steep decline in refinance volume. Purchase lock volume for the quarter of $1.4 billion was 36% of total locks, up significantly from 22% in the prior quarter. Margins in this channel expanded as we focused on meeting the needs of customers in our servicing portfolio. And revenue per fallout-adjusted lock was 366 basis points, up from 355 basis points in the prior quarter.
We estimate total originations for our consumer direct channel in October will total $500 million, and locks will total $700 million. We estimate the committed pipeline at October 31 will be $600 million.
Originations in our broker direct channel totaled $1.3 billion and locks totaled $1.9 billion, also down significantly from the prior quarter, reflecting intense competition from channel leaders. Revenue per fallout-adjusted lock was 70 basis points, down from 77 basis points in the prior quarter. We estimate that, in the last 12 months, we represented approximately 2.2% of the origination volume in the channel.
Despite elevated levels of competition currently, we continue to see opportunity over the long term given our excellence in the correspondent lending and consolidation in the channel. We remain committed to providing our broker partners and the customers that they serve new products and a superior mortgage experience.
To that end, we earlier this month announced the launch of POWER+, our next-generation broker technology platform combining a more efficient, precise and convenient loan process with better data collection and communication capabilities. We believe this new technology provides brokers with the tools they need to successfully grow their business and convert leads into loans. We estimate that broker originations in October will total $400 million and locks will total $500 million. We estimate the committed pipeline at October 31 will be $500 million.
As David discussed earlier, these acquisition and origination volumes continue to drive the organic growth of our servicing portfolio. I’m pleased to report that we ended the quarter with a servicing portfolio of $539 billion or approximately 4.1% of all residential mortgage debt in the U.S.
Prepayment speeds have slowed meaningfully given the rapid and significant increase in mortgage rates. PennyMac Financial’s own servicing portfolio represented a prepayment speed of 9% in the third quarter, down from 12% in the prior quarter. Similarly, prepayment speeds in PennyMac Financial’s sub-serviced portfolio, which includes mostly Fannie Mae and Freddie Mac mortgage servicing rights owned by PMT, were 6.9%, down from 9.3% in the prior quarter. PFSI’s owned servicing portfolio, which consists primarily of Ginnie Mae MSRs, had a 60-day-plus delinquency rate of 3.5%, up from 3.2% at the end of the prior quarter, while our sub-servicing portfolio, consisting primarily of conventional loans, reported a 60-day-plus delinquency rate of 0.5%, unchanged from June 30.
The UPB of completed modifications was $2.4 billion. And the UPB of EBO loan volume totaled $250 million, both down significantly, as opportunities have declined due to higher mortgage rates. We expect EBO revenues to continue to decline in the coming quarters, as lower overall volumes and redelivery gains are expected to be limited due to the higher interest rate environment.
I’ll now turn it over to Dan, who will review PFSI’s financial results, stress scenarios for servicing advances and the new eligibility rules introduced by Ginnie Mae and FHFA.
Dan Perotti
Thanks, Doug. As David mentioned earlier, PFSI’s net income was $135 million or diluted earnings per share of $2.46. Production segment pretax income was $39 million.
As you will see on Slide 10, we provide a breakdown of the revenue contribution from each of PFSI’s loan production channels, net of loan origination expenses, including the fulfillment fees received from PMT for conventional correspondent loans.
Production revenue margins were mixed, with margins up in our consumer direct channel and down in our correspondent and broker direct channels. Revenue per fallout-adjusted lock for PFSI’s own account was 99 basis points in the third quarter, unchanged from the prior quarter. This includes $36 million in gains realized related to the timing of revenue and loan origination expense recognition, hedging, pricing and execution changes and other items.
As David mentioned, we remain focused on expense management activities given the current market environment. And although fallout-adjusted locks were down only 2% from the prior quarter, production expenses net of loan origination expense were down 21%. The servicing segment recorded pretax income of $145 million, down from pretax income of $168 million in the prior quarter and up from $8 million in the third quarter of 2021.
Pretax income excluding valuation-related items for the servicing segment was $70 million, down from the prior quarter as higher loan servicing revenue, higher earnings on custodial balances and deposits and lower expenses were more than offset by higher realization of MSR cash flows and lower EBO-related income.
Operating revenues increased from the prior quarter as loan servicing fees grew by $11 million, primarily due to growth in our servicing portfolio. Earnings on custodial balances and deposits increased by more than $30 million. As rates continue to rise, the earnings on these custodial balances will rise as well, with a meaningful contribution to overall servicing profitability and largely offsetting the expected decline in EBO revenue.
Operating expenses as a percentage of average servicing portfolio UPB decreased. Payoff-related expenses, which include interest shortfall and recording and release fees related to prepayments, decreased by $9 million.
Realization of MSR cash flows increased by $20 million, driven by higher average MSR values during the quarter. In order to protect the value of our MSR asset, we utilize a comprehensive hedging strategy. This strategy is designed to moderate the impact of interest rate changes on the fair value of our MSR asset and also considers production-related income. On Slide 14, you can see the fair value of our MSR increased by $237 million in the third quarter, driven by higher mortgage rates, which resulted in expectations for lower prepayment activity in the future. Hedging losses totaled $165 million, primarily driven by higher interest rates.
Finally, our investment management segment delivered pretax income of $1.6 million, up from $247,000 in the prior quarter. Net assets under management totaled $2 billion as of September 30, down 3% from June 30. Segment revenue was $10.4 million, up 7% from the prior quarter.
Now I would briefly like to review the projected needs for servicing advances in different market scenarios. For delinquent borrowers, PFSI has the responsibility to fund servicing advances for its own portfolio of predominantly Ginnie Mae MSRs. For the sub-serviced portfolio, any servicing advances are the responsibility of the MSR owner or PMT.
For the owned portfolio, this obligation includes principal and interest or P&I advances, advances related to property taxes and insurance or T&I advances and default-related or corporate advances. While we fund T&I and corporate advances throughout the delinquency of a loan, delinquent principal and interest payments are often offset by other prepayment activity in the portfolio; and do not require us to fund P&I advances, except in adverse scenarios where high rates of extended delinquencies combine with low prepayment speeds.
On the left side of the table on Slide 15, we have presented the current advance balances for our owned portfolio as of September 30 as well as the current delinquency rate and prepayment speed. On the right side of the table, we have presented projections of peak advance balances over the next 12 months in both an adverse and high-stress scenario. In our high-stress scenario, we assume delinquencies follow the trajectory we observed during the onset of the COVID-19 pandemic, where payment forbearance was mandated to be available to all borrowers who claimed hardship, in combination with prepayment speeds declining to the lowest monthly level observed in the last 30 years. Even in such a scenario, we project peak advance balances would be less than $2 billion over the next 12 months or an increase of about $1.6 billion from the current level of advances.
With total available liquidity of $2.8 billion as of September 30 and the ability to borrow up to $600 million against Ginnie Mae servicing advances, we believe PFSI is well positioned to address the potential impact servicing advances may present in a recessionary environment.
Finally, though they are not required to be implemented until September 2023 or later, I’d like to briefly speak about the new eligibility standards recently introduced by Ginnie Mae and the FHFA. As discussed in Note 22 of our second quarter Form 10-Q, these eligibility requirements are assessed at the servicer entity and not at the holding company or PFSI.
PennyMac Loan Services or PLS is a wholly owned subsidiary of PFSI and is the approved issuer and servicer of securities guaranteed by Ginnie Mae. PLS also holds the licenses required to sell and service Fannie Mae and Freddie Mac mortgage loans. As you can see on Slide 17 of our slide presentation, on a pro forma basis, PLS is well in excess of all prospective capital liquidity and leverage requirements from both Ginnie Mae and the FHFA.
And with that, I would like to turn it back to David for some closing remarks.
David Spector
Thank you, Dan. We remain focused on the broader challenges facing our industry in the near term. We will remain vigilant in our risk management disciplines and continue to actively pursue opportunities to further improve efficiency across our businesses. I continue to believe PennyMac is strategically well positioned in the mortgage market given our strong levels of capital, our large and growing servicing portfolio and our efficient and low-cost operating platform run by a best-in-class management team.
We encourage investors with any questions to reach out to our investor relations team by e-mail or phone. Thank you.
Question-and-Answer Session
A – Isaac Garden
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