PennyMac Financial Services, Inc.
Q1 2017 Earnings Call Transcript

Published: 7 May 2017

[Operator:]

Good afternoon, and welcome to the first quarter 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:]

Thank you, Chris. Let's begin with Slide 3. PennyMac Financial's first quarter results reflects a higher mortgage rate environment and a seasonally slow period for home-buying activity. For the first quarter, PennyMac Financial earned pretax income of $62 million and diluted earnings per share of $0.47. This compares with earnings per share of $1 in the prior quarter, and $0.23 per share in the first quarter of 2016. Book value increased to $16.01 per share, up from $15.49 at December 31, and from $12.59 at March 31, 2016. Looking at earnings contributions by segment. The Production segment pretax income was $47.5 million, down 49% from the prior quarter and down 31% from the first quarter of 2016. The quarter-over-quarter performance was driven by lower volumes and margins in both Correspondent and Consumer Direct production channels. Total production volume was $14.9 billion in unpaid principal balance for the first quarter, a decrease of 32% from the prior quarter and up 37% from the first quarter of 2016. Total interest rate lock volume was $16.3 billion in UPB, down 24% from the fourth quarter and up 29% from the first quarter of 2016. The Servicing segment generated pretax income of $13.4 million compared to pretax gain of $35.1 million in the prior quarter, and a loss of $39.5 million in the first quarter of 2016. Excluding valuation-related changes, pretax income for the Servicing segment was $22.3 million, down 9% from the previous quarter and up 36% from the prior year period. Our Servicing portfolio grew to $202.9 billion in UPB, up 4% from December 31, 2016, and up 23% from March 31, 2016. Continuing with our highlights on Slide 4. The Investment Management segment recorded pretax income of $1.1 million compared with pretax income of $0.4 million in the prior quarter and $1.1 million in the first quarter of 2016. Net assets under management were $1.6 billion, up 0.5% from $1.5 billion at December 31, 2016, and down 4% from $1.6 billion at March 31, 2016. During the first quarter, we issued $400 million in three year term notes from our structured MSR financing vehicle. We are very pleased with this transaction and we'll discuss it in more detail later in my presentation. Lastly, after quarter end, we acquired a bulk portfolio of Ginnie Mae MSRs with UPB of approximately $4.3 billion, deploying some of the proceeds from the term note issuance. Now let's turn to Slide 5, and look at the current market environment. Mortgage rates during the first quarter were volatile, moving up and down within a relatively narrow range for most of the quarter, but ultimately ended the quarter down 18 basis points from their recent high levels at the end of last year. Fixed rate mortgages ended the quarter at 4.1%, and have declined further to 4% as of April 27. The rapid onset of higher rates has slowed prepayment activity in agency MBS. During the first quarter, prepayment speeds on 30 year Fannie Mae and Freddie Mac MBS averaged 11.8 CPR and 10.8, respectively, compared to an average of 17.6 and 16.4, respectively, for the full year 2016. The slowdown in prepayment speeds for Ginnie Mae MBS was similar to Fannie Mae and Freddie Mac MBS, down nearly 6 points to an average of 15.7 in the first quarter. While home sales slowed in the first quarter due to typical seasonal factors, they remain at multiyear high levels. The recent decline in interest rates has supported affordability, although tight inventories continue to pose a challenge for homebuyers in much of the country. However, we are seeing a broad base pickup in pending home sales, which suggests that the spring and summer home-buying season could be strong. As we have discussed since the presidential election, any regulatory or policy changes affecting the mortgage industry remain uncertain. While we continue to believe that a more balanced consideration of costs and benefits of regulation is needed, we believe that any significant near-term impact is likely to be limited. Now let's turn to Slide 6, and discuss our outlook for U.S. mortgage originations. This slide provides an outlook for both single-family mortgage originations and a range of projections for where the 30 year fixed rate mortgage could be in 2017. The graph on the left side shows estimates for the size of the U.S. residential mortgage origination market in 2016 from Fannie Mae, Freddie Mac and the Mortgage Bankers Association contrasted against expectations for this year's origination market. Despite the recent decline in mortgage rates in April, the latest forecasts indicate little change in the outlook for 2017 origination market, remaining at just under $1.6 trillion. Mortgage rates are expected to remain low relative to historic levels, however, forecasts anticipate that mortgage rates will increase modestly through the remainder of 2017. Recently rates have moved lower, and the mortgage origination activity has increased. If current mortgage rates persist, we may see an upward revision to 2017 origination forecasts. Now let's turn to Slide 7, and review our Ginnie Mae MSR financing arrangement, marking what we believe is a watershed development for the mortgage banking industry. Last December, we put in place a financing structure, where we pledged our Ginnie Mae MSRs and ESS to a trust. We can borrow against their collateral value in two forms

[David Spector:]

Thank you, Stan. On Slide 10, I would like to begin my remarks by reviewing market share and volume trends across PennyMac Financial's businesses. PennyMac Financial was the fourth largest producer of mortgage loans in The United States during the first quarter according to Inside Mortgage Finance, and we estimate that we remained the 11th largest servicer. Correspondent production market share grew to 11.3% in the first quarter, up from almost 10.8% in the prior quarter. In our Consumer Direct business, the rapid onset of a higher interest rate environment in November and heightened competition drove a reduction in market share to levels in line with the second and third quarters of 2016. We estimate that the market share of our loan servicing portfolio grew to almost 2% of all mortgage debt outstanding in The United States. And lastly, assets under management by our Investment Management segment were $1.56 billion, up modestly from $1.55 billion in the prior quarter, driven by a preferred share issuance by PMT this quarter. Now let's turn to Slide 11, and discuss correspondent production. Correspondent acquisitions by PMT in the first quarter totaled $13.9 billion in UPB, a 31% decrease from the fourth quarter and up 44% year-over-year. Government loan acquisitions accounted for 67% of total correspondent acquisitions were $9.3 billion in the first quarter, down 26% from the prior quarter and up 44% from the first quarter of 2016. Conventional conforming acquisitions, whereby PennyMac Financial performed fulfillment services for PMT, totaled $4.6 billion in the first quarter, down 38% from the prior quarter and up 42% from the first quarter of 2016. Total lock volumes $14.5 billion, down 25% from the prior quarter and up 39% from the first quarter of 2016. The decline in our acquisition volumes this quarter primarily resulted from the sharp rise in mortgage rates last November, which drove a significant reduction in total refinance market activity. The increase in mortgage rates occurred at the same time mortgage activity typically begins to slow in the winter months. Combined, these two factors contributed to a 34% quarter-over-quarter decrease in total mortgage market production, according to Inside Mortgage Finance. PennyMac's Correspondent channel fared a little better than the market overall, and we believe gained market share as a result. Looking at April volumes, correspondent loan acquisitions totaled $4.4 billion in UPB, while interest rate lock commitments totaled $4.8 billion in UPB. The modest decline in mortgage rates after quarter end has helped boost mortgage refinance activity from first quarter levels, and we see increased purchase money activity as well. Purchase money loans accounted for 73% of our correspondent production during the quarter, up from 62% in the fourth quarter. The purchase money orientation of our correspondent production volume is an important differentiating factor and one, which positions us well for the anticipated origination mix in 2017. We continue to grow our seller relationships during the quarter, driven by success in expanding our non-delegated correspondent program and smaller seller relationships, which utilizes more of our platform's extensive capabilities. At the end of the first quarter, we had 557 seller relationships, up from 522 in the prior quarter. Now let's turn to Slide 12, and discuss Consumer Direct production. Consumer Direct production volume totaled $1 billion in UPB in the first quarter, down 49% from the fourth quarter and down 14% year-over-year. The committed pipeline at the end of the first quarter was $741 million. The magnitude and speed of the rise in interest rates, along with heightened competition in a smaller mortgage market significantly impacted our refinance focus, Consumer Direct volumes and margins this quarter. We are seeing a pickup in volume from the recent rate decline. In April, Consumer Direct originations totaled $324 million in UPB, and interest rate lock commitments were $713 million in UPB. The committed pipeline was $780 million in UPB as of April 28, 2017. We are implementing a variety of technology enhancements and workflow efficiencies in Consumer Direct to drive down origination costs and improve the speed and precision of the loan application decisioning processes. These enhancements will allow us to respond to applicants within hours rather than days, and drive improved lead conversion as a result. We are also enhancing our portfolio of lead generation strategies to better capture the potential opportunities in our Servicing portfolio. A key strategic focus going forward is growing our non-portfolio business by developing affinity relationships, with the goal of having non-portfolio volumes comprise a meaningful percentage of our overall origination volume. We've increased the number of agreements with Affinity Partners to help deliver on this objective. The success we've achieved thus far leads us to believe that we can grow the non-port volume to 10% of total volume by the second half of this year. To help facilitate these initiatives and position consumer direct for the next phase in its evolution, we have opened up a new processing center in St. Louis, Missouri. We remain optimistic regarding our strategic direction and our ability to meaningfully grow our Retail business in the coming years. Now let's turn to Slide 13 and discuss our loan servicing business. In the first quarter, our loan servicing portfolio grew to $202.9 billion in UPB, an increase of 4% from the fourth quarter and up 23% year-over-year. During the first quarter, our servicing portfolio reached a significant milestone when we surpassed 1 million customers. Penny MAC is unique among large nonbank mortgage servicers and our proven ability to deliver consistent portfolio growth, driven by the volumes added by our leading production activities. Prepayment activity slowed considerably during the quarter as a result of higher rates. The CPR on the MSR portfolio slowed to 12.7% from 20.7% in the fourth quarter. After quarter end, we acquired a bulk portfolio of Ginnie Mae MSRs, totaling $4.3 billion in UPB. PennyMac Financial acquired the portfolio with funding provided by proceeds from our new Ginnie Mae MSR facility. We continue to seek additional opportunities to supplement the organic growth of our servicing portfolio through additional MSR acquisitions. As Stan discussed earlier, our EBO transaction volume increased significantly in the quarter. Our expertise in loss mitigation enables us to rehabilitate a significant portion of these loans, allowing customers to remain in their homes. Now let's turn to Slide 14 and discuss the Investment Management segment. As we mentioned earlier, net assets under management were $1.56 billion compared with $1.55 billion at December 31, 2016. The growth in net assets was driven by PMT's preferred equity raise, which was partially offset by investment fund distributions to investors. In March, PMT issued 4.6 million shares of 8-1/8 Series A fixed-to-floating-rate preferred shares for gross proceeds of $115 million. This was PMT's first preferred share issuance and its first capital raise since August 2015. Proceeds from the issuance are being used to fund PMT's business and investment activities, repayment of indebtedness and potential common share repurchases. PMT also continues transition of capital towards newer investment opportunities such as MSRs and CRT on its correspondent production. During the quarter, PMT delivered $1.8 billion in UPB of loans to Fannie Mae, which will result in approximately $64 million of new CRT investments once the aggregation period is completed. With that, I'd now like to turn it over to Andy Chang, PennyMac's Chief Financial Officer, to discuss the first quarter's financial results.

[Andrew Chang:]

Thank you, David. Slide 15 is an overview of PennyMac Financial's results by operating segment. Stan reviewed these figures for the first quarter earlier, and the table shows trends for the last 5 quarters. Let's turn to Slide 16 and take a closer look at the results of our Production segment. Production segment revenues were $110 million for the first quarter, down 37% from the prior quarter. The decrease was primarily the result of a 39% decrease in net gains on mortgage loans held-for-sale, reflecting lower total lock volumes and margins in both the correspondent and Consumer Direct production channels. Gross margins, which represent the revenue per lock commitment, were 84 basis points in the first quarter, down from 101 basis points in the prior quarter. Revenue per consumer direct lock decreased to 218 basis points from 292 in the prior quarter, while revenue per correspondent lock decreased to 53 basis points from 61 in the prior quarter. These margins are at the low end of the ranges that we've seen over the past several quarters. Fulfillment fee revenue was $16.6 million in the first quarter, down 39% from the prior quarter, driven by a 38% quarter-over-quarter decrease in acquisition volumes by PMT. The weighted average fulfillment fee rate during the quarter was 36 basis points, unchanged from the prior quarter. Production segment expenses were $62.5 million, a 23% decrease from the prior quarter, driven by the lower volumes of activity. Let's turn to Slide 17 and review the financial performance of the Servicing segment. Servicing segment revenues were $89 million in the first quarter, a decrease of 18% from the prior quarter. Net loan servicing fees totaled $74.2 million for the first quarter compared with $95.5 million in the prior quarter. Net loan servicing fees included $129.3 million in loan servicing fees reduced by $48.5 million of amortization and realization of MSR cash flows. Amortization and realization of cash flows decreased 3% from the prior quarter. Net loan servicing fees also included $12.7 million in MSR fair value gains and impairment recovery, primarily reflecting expectations for lower prepayment activity in the future. In addition, net loan servicing fees included $22.2 million in hedging losses and a gain of $2.8 million due to the change in fair value of the ESS liability, resulting from higher-than-projected prepayment activity during the quarter. The net loss in MSR value after hedge losses and gains due to ESS fair value changes was $6.7 million. The securitization of reperforming government-insured and guaranteed loans resulted in $24.1 million of revenue in net gains on mortgage loans held-for-sale at fair value in the first quarter versus $24.5 million in the prior quarter. These loans were previously purchased out of Ginnie Mae securitizations, known as early buyouts or EBOs, and brought back to performing status through PennyMac Financial's successful servicing efforts, primarily with the use of loan modifications. Additionally, net interest expense was reduced by approximately $4 million of interest income from EBO loans held on our balance sheet. Servicing segment expenses for the quarter were $75.6 million, a 4% increase from the prior quarter driven by growth of the portfolio, increased allocation of compensation expense to the segment and higher technology-related costs. Now let's turn to Slide 18, and discuss the valuation of PennyMac Financial's MSR asset. MSRs are a significant portion of PennyMac Financial's assets, and their fair value generally increases when interest rates rise and decreases when interest rates fall. We account for originated MSRs at the lower of amortized cost or fair value or LOCOM when the underlying note rate on the loans is less than or equal to 4.5%. MSRs related to loans with note rates above 4.5% and all purchased MSRs are accounted for at fair value. PennyMac Financial accounted for $93.2 billion in UPB of its originated MSRs under LOCOM at March 31. The fair value of these MSRs was $8.9 million greater than their carrying value on our balance sheet. The remaining $42.1 billion in UPB of MSRs are accounted for at fair value. Most of our purchased MSRs are subject to an ESS liability. The UPB related to the loans underlying those MSRs totaled $30.5 billion at March 31. The outstanding ESS liability at March 31 relates only to Ginnie Mae MSRs. Now let's turn to Slide 19, and look at the financial performance of the Investment Management segment. Investment Management revenues were $5.4 million, down 6% from the fourth quarter of 2016. Segment revenues include management fees, comprised of base management fees from PMT and the private investment funds, any earned incentive fees from PMT, any carried interest from the funds and other revenue. The quarter-over-quarter decline in revenue was primarily driven by a carried interest loss of $128,000 due to the performance of the investment funds. No incentive fees were received from PMT in the first quarter. Segment expenses were $4.3 million, a 19% decrease from the fourth quarter of 2016 driven by a refinement in the expense allocation methodology across segments. And with that, I would like to turn it back over to Stan for some closing remarks.

[Stanford Kurland:]

Thank you, Andy. PennyMac Financial's first quarter results reflect a mortgage market that is transitioning from a period of historically elevated margins to a period of more normal margins. We have consistently demonstrated an ability to operate through market volatility of various kinds and continue to invest in initiatives that we believe will drive our company forward. These include our consumer direct production channel, non-delegated correspondent initiatives, the future launch of our wholesale mortgage origination platform and the completion of our structure to expand financing for our largest asset, our Ginnie Mae mortgage servicing rights. We are confident that such investments and innovations will help ensure our company's long-term financial and operational success. Lastly, we encourage investors with any questions to reach out to our Investor Relations team by e-mail or phone. Thank you.

[Operator:]

This concludes PennyMac Financial Services, Inc.'s first 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.