PennyMac Mortgage Investment Trust (NYSE:PMT)
Q2 2013 Earnings Conference Call
August 8, 2013 00:00 pm ET
Stanford Kurland - Chairman & CEO
David Spector - President & COO
Anne McCallion - COO
Hello, and welcome to the PennyMac Mortgage Investment Trust’s Second Quarter 2013 Earnings discussion. The slides that accompany this discussion are available from the PennyMac Mortgage Investment Trust’s website at www.pennymac-reit.com. Before we begin, please take a few moments to read the disclaimer on slide two of the presentation. Thank you.
Now, I’d like to turn the discussion over to Stan Kurland PMT’s Chairman and Chief Executive Officer. Stan?
Thank you, Chris. I would like to begin my comments by reviewing the highlights of PMT’s strong financial performance in the second quarter. I would also discuss several new transactions that PMT has entered into since the end of the quarter that we think underscore our continued momentum.
PMT earned $54.5 million of net income or $0.86 per diluted share in the second quarter. Net investment income was $129.7 million driven by strong earnings from both PMT’s business segments, investment activities and correspondent lending. The investment activities segment earned $38 million in pre-tax income driven a solid performance in our growing distressed whole loan portfolio including valuation gains from the loans moving towards resolution and improvements in home prices.
Pretax earnings in the correspond lending segment were approximately $30 million, higher lock volume versus the first quarter and disciplined pricing and edging drove the strong financial results. Correspondent loan acquisition volume totaled over $8.6 billion in the second quarter and total lock volumes were $9.9 billion.
Due to distressed whole loan investments during the second quarter totaled $397 million an unpaid principal balances which were largely non-performing loans. Additionally, in the second quarter PMT issued $250 million in exchangeable senior debt that matures in 7 years.
The offering at an attractive term financing to PMT’s capital structure and provides capital for continued growth across our business and investment activities. Subsequent to the end of the second quarter PMT engaged in transactions for loans totaling nearly $1.4 billion in unpaid principal balances. PMT recently acquired $493 million in unpaid principle balance or UPB of non-performing whole loans. PMT also entered into an agreement to purchase another pool of non-performing loans totaling $502 million in UPB which is expected to settle later this month.
In addition, PMT acquired $393 million in UPB of prime quality non-agency jumbo mortgage loans in a bulk transaction. We expect to combine these jumbo loans with non-agency jumbo acquisitions from PMT’s corresponding lending business and a private label securitization targeted for later in the third quarter.
Lastly, PMT invested $12 million in a credit risk bond issued by Freddie Mac. This was the first such detail by either of the GSEs who are working with their business partners and investors to share credit risk on newly originated prime agency loan. We think that this is an attractive investment for PMT and we are encouraged by the potential for additional credit risk transactions with GSEs going forward.
Now, let’s move on to slide 4. On slide 4, I want to emphasis the track record of financial performance that PMT has established to-date. Our investment strategies and PMT’s access to strong operational execution what drives PMT’s strong return on equity which was 16% for the full year 2012 and 18% for the current year-to-date. PMT invests opportunities across the residential mortgage market, leveraging its relationship with its investment manager, fulfillment in servicing provider PennyMac Financial Services Inc., or PFSI.
PFSI provides PMT access to the necessary expertise and operational capabilities. We have demonstrated the ability to successfully deploy new capital into investments that are accretive to the returns on equity and EPS. PMT’s book value growth highlights its unique investments strategies which I will discuss in just a minute.
Looking forward, we believe that PMT has the right business model and is focused on the right investment strategies to continue delivering superior returns in the future.
Turning to slide 5, PMT’s portfolio of mortgage assets has continued to grow and we believe that our investments are favorably positioned in the current market environment. PMT’s long-term investments consist of the distressed whole loans which include both non-performing and performing loans and mortgage servicing rights or MSRs.
Distressed whole loans are purchased at discounts to the UPB and to the value of the real property underlying the loans and are subsequently restructured or liquidated to realized returns. MSR investments generated through our correspondent lending activities have seen significant growth since 2011. Both distressed whole loans and MSRs are assets that are well-positioned in an improving economy with gradually rising rates.
Although the primary drivers of our returns from distressed investing our discounts at acquisition and the operational execution of our servicer improving home prices can enhance returns as well. With respect to PMT’s mortgage servicing rights, its important to know that this portfolio has been originated in a low interest rate environment and its economic value benefits from rising interest rates which results in lower pre-payment activity and a longer life of the asset. Anne McCallion will discuss the value of the MSRs in further detail.
PMT’s assets have grown by $1.8 billion over the last year which has been driven by planned expansion of levels to 1.7x equity. The correspondent lending business relies more on debt financing during the inventory holding period than distressed whole loans, so as correspondent lending activity grows it will have a greater influence on our leverage.
We also continued to grow PMT’s investments in distressed whole loans and the overall leverage that we have against the portfolio has increased modestly. Over time, we expect the company’s leverage to increase somewhat and we believe that this is prudent given the composition of PMT’s investments.
Looking ahead, we expect this picture of our investment portfolio to evolve we pursue additional opportunities for PMT. In particular, we expect to add retained interests from prime jumbo securitizations issued by PMT to our long-term investments. Securitization of prime jumbo loans represents a new opportunity for PMT, which David Spector will discuss later in the presentation.
I would like to turn to slide 6, and take a few minutes to discuss our outlook on the market and the implications for PMT’s business strategy and performance. PMT participates in the residential mortgage market. So mortgage rates and housing have a significant impact on our performance.
The housing market and the price of homes impacts the distressed loan portfolio and the recent improvement in home prices have contributed to the valuation gains in PMT’s distressed whole loans. With respect to home prices, we remain optimistic in our outlook for housing going forward. As it appears that there are sound underlying fundamentals supporting its recovery.
Demand from home buyers and investors is strong, housing inventory is tied helping to drive price appreciation and home affordability remains high despite the recent jump in mortgage rates. Our own experience through the sale of OREO tells us that the demand for residential real estate remains strong, which bodes well for the returns in PMT’s distressed loans. Despite the higher mortgage rates, we expect these trends to continue. The recent rise in mortgage rates has caused refinancing activity to slow considerably, which is adversely impacting industry volumes and margins. While correspondent business remains attractive, we expect margins to continue to decline from what were historically elevated levels as the origination markets contract.
Despite challenges in the market, we expect to continue capturing new business and remain disciplined in our pricing to drive profitable returns for PMT. Also, we believe that the decline in the overall origination market is somewhat offset by increased low through aggregators such as PMT.
Jumbo originations have also been affected by the recent rise in rates and a widening in the spreads of mortgage back securities has affected the economics of private label securitization. In the short-term, this has resulted in a somewhat diminished jumbo opportunity. Securitization produces attractive investments for PMT and over the long-term we remain optimistic that there is considerable opportunity for jumbo loans and private label securitization to expand.
The distressed whole loan market remains robust. PMT has seen more supply and invested in more distressed loan pools, this year so far than in all of 2012 and in fact, I would have to say that the new opportunities in distressed loans have exceeded our expectations going into this year. All indications suggest that the distressed whole loan opportunity will remain strong through at least 2014.
We continue to see opportunities to acquire mortgage servicing rights and pursue these details to our PMT. Although PMT has not acquired a large MSR portfolio to-date, we remain optimistic about the opportunity and expect to see several large legacy MSR portfolios in the market this year. We continue to evaluate so called mini-bulk MSR opportunities. But, we are more optimistic about transacting with these sellers as correspondence on a whole loan flow basis due to pricing and due diligence demands. We have been developing a structure to co-invest in MSR acquisitions along PSFI, PMT’s servicing provider, which would take the form of an isle strip owned by PMT.
During the second quarter, we negotiated $450 million in UPB a smaller acquisitions for such a structure and have been working through the technical issues along with the GSEs. We would expect to apply the same technology and structure in a potential acquisition of a large bulk MSR portfolio as well.
Now, let’s turn to slide 7, and discuss the reason shifts in the mortgage origination market and our expectations going forward. The rate on the 30-year fixed rate mortgage increased more than 4 percentage point from early May to the end of June. The sudden increase in mortgage rates have taken many borrowers out of the market for refinancing.
On the positive side, we expect home purchase activity to rise with the improving trend in housing, I discussed on the previous slide but not enough to offset the lower refinanced volumes. As a result, we think its is likely that market origination volumes in the second half of 2013 will be down more than 30% from the first half of the year. We also expect to see an increase in demand for adjustable rate and a fixed period adjustable rate mortgages or hybrid products which have become more attractive alternatives relative to fixed rate loans.
For example, sophisticated home buyers can utilize ARM and hybrid products to lower their payments. Even the home prices have risen in most areas of the country, they are still generally far below their peak levels and ownership still compares favorably versus renting in many markets.
This shifts in the origination market present challenges for PMT’s correspondent lending business with a doubt. However, PMT’s share of the correspondent lending market remains approximately 6% and we believe that we have continued opportunities to capture additional business in a declining market.
For example, we are continuing to add new sellers to our correspondent network and optimizing that group to ensure that we have the right sellers to prosper in this market. David Spector will discuss our mortgage investment activities and go into initiatives in greater detail. David?
Thank you, Stan.
I like to begin my comments in slide 9 and review our recent investments in distress whole loans. Here we show, PMT’s acquisition volume over the last five quarters by unpaid principle balance or UPB, in addition to the acquisition thus far in the quarter. Assuming if they settle as planned, these transactions bring total distressed acquisitions for the year-to-date to just under $1.8 billion in UPB, nearly twice the $1 billion of distressed acquisitions in 2012. Thus far in 2013, we have seen a greater diversity of sellers in the market and several new entrants.
One of the recent pool was sold by a bank, we have not transacted with previously. The recent purchases are mostly non-performing loans in geographically diverse pools and are generally similar to other pools PMT has acquired. Looking forward, we remain optimistic in our outlook for the distressed market and opportunities for additional acquisitions by PMT in the future.
On slide 10, I would like to step back for a moment and discuss the value of the distressed whole loan portfolio, which as Stan noted earlier comprises most of PMT’s long-term investments today. We believe that PMT offers investors an effective way to gain exposure to an improving housing market in the U.S. and we also believe that there are significant embedded value in distressed portfolio which is illustrated well here in slide 10.
The slide shows were PMT’s distressed loan portfolio was marked as of June 30, still between non-performing and reperforming loans in the distressed portfolio. The bars on the left in grey are the outstanding principal balance or face value of the loans. The green bars in the middle show the estimate of the current collateral value referred value of the properties underlying the loans.
We use several methods to estimate the current value of the properties. But, they are primarily based on broker price opinions or BPOs. The bars on the right in blue are fair value marks for the assets is recorded in our PMT’s balance sheet. While you note that the fair value of the loans held by PMT is significantly lower than the value of the underlying properties. The mark and the non-performing loans is 68% of the current property values and the mark and performing loans is 66% of the current property values.
This embedded value is realized over time through a variety of loan resolution strategies we pursued which are executed by the servicing operations of PSFI. In the case of non-performing loans, valuation gains are recorded as loan progresses closer to the liquidation. Performing loans also the significant embedded value but the resolution option is different until restructured through modification refinanced strategies. Many of PMT’s performing loans acquired is non-performing loans and will drop back to performing status through successful servicing activities which may include a loan modification.
Distressed whole loans have been a primary investment strategy for PMT since inception. And a major contribute to earnings as we continue to see in recent quarters. We believe that our distressed portfolios position will continue delivering strong earnings for PMT for the foreseeable future.
Now let’s go to slide 11, and turn to the correspondent lending business. Correspondent loan acquisitions totaled $8.6 billion in the second quarter, conventional jumbo loan acquisitions were 50% or $4.3 billion of that volume. Correspondent lock volume for the quarter was $9.9 billion, conventional and jumbo locks were $5.2 billion or 53% of total lock volume.
In July, total loan acquisitions totaled $3.2 billion of which 51% were conventional and jumbo volumes and lock volume is $2.4 billion of which 49% were conventional and jumbo loans. The recent increase in mortgage rates have slowed refinance activity as Stan discussed and industry forecast predicated the mortgage origination work will decline by more than 30% in the second half of 2013.
So while we think this may result in more production through aggregators like PMT, a smaller market will clear present challenges. We are focused on several initiatives and correspondent loan to address these challenges. One is the continued growth of our correspondent seller network. In the second quarter, our network have approved sellers of 220 from 179 at the end of the first quarter.
New sellers drove additional volume over time, however, the growth in the network stake of growth is not our objective. We want to make sure that we are doing business with the right sellers. Faster relationships that are productive and will allow PMT to grow in a prudent and profitable manner.
We are also focused on growing in geographies where we are under-penetrated as the Northeast and rounding our product make to further deepening relationships. Our correspondent sellers in general participated in the purchase money market is evidenced by the percentage of our acquisitions where the loan was for the purchase of a home. As the market transitions away from refinances to mostly purchase money originations working with customers focused on this market becomes increasingly important.
We are executing our strategies that will continue to deliver long-term growth in the correspondent business. However, origination volumes just slowed and the market is contracting. Even with our growth initiatives which we expect to drive market share growth over time at the moment we anticipate that our corresponding acquisition volume will decline in proportion with the overall market.
Lastly, PMT’s contractual fee arrangement with PFSI provides with a variable expense structure which minimizes the operational risk associated with cyclicality in production of volumes.
Now, let’s turn to slide 12 and go over the economics of the correspondent lending business and how we managed interest rate risk? The primary source of revenue in the correspondent lending is the net gain our mortgage volumes have acquired for sale, which represents the capitalized value of the MSR created plus or minus the realized and unrealized gains with the losses on the mortgage loans lock MBS and associated edge instruments.
The net gain of mortgage loans acquired for sale in the second quarter was 85 basis points on the quarter’s conventional and jumbo lock volume. However, PMT also earns a net interest spread also on inventory which includes both conventional and government loans as well as other income in the form of origination fees collected from its corresponding sellers on commercial loans.
In total, PMT earned a 112 basis points in revenues as the ratio of the lock volume. And expenses the pretax income was 54 basis points to ration of the lock volume. We use risk management to protect the value of our production pipeline from large moments in interest rates such as what we experienced in the latter half of the second quarter. We used different types of edging instruments mainly consisting of MBS forward trades and MBS based options to protect against extreme market moves. We attribute some of the strong results in the second quarter, the results of our edge, which performed well and offset the impact of interest rate moves.
Turning to slide 13, I would like to take a few minutes and discuss the progress of our non-agency jumbo initiatives and our progress towards PMT’s first private label securitization.
We have been focusing and acquiring jumbo loans to our correspondent customers since the start of the year. In the second quarter, PMT’s non-agency jumbo lock totaled $158 million compared to just over $100 million in the first quarter and second quarter acquisition volume totaled $107 million.
In addition, as Stan mentioned earlier, we acquired $393 million of fine non-agency jumbo mortgages on a bulk basis after the end of the quarter. We expect to securitize the bulk pool loan along with the jumbo loans acquired through our correspondent business. We continue to make progress towards a private label securitization in the third quarter. We intend to hold the subordinated tranches of the securitizations and view them as a attractive long-term investments for PMT.
Now, I would like to turn the discussion over to Anne McCallion, PMT’s Chief Financial Officer to discuss the second quarter’s financial performance. Anne?
Thank you, David.
On slide 15, we show the pretax earnings contribution from each segment in the last several quarters. For the second quarter total pretax earnings amounted to $58 million of which 59% was from investment activity and 41% came from the correspondent lending segment.
The takeaway is that both of these segments are meaningful contributors to PMT’s earnings. These results demonstrate the power of PMT’s approach of pursuing multiple opportunities across the residential mortgage market.
As conditions in the market change, for example, with fluctuations in prevailing interest rates as we have seen so far this year, the relative earnings contribution from each strategy may differ but we believe that PMT’s multiple strategy approach should produce superior returns for shareholders over time.
Now, let’s turn to slide 16, and look at the results for the investment activity segment. The investment activity segment revenues consist evaluation and pay off gains from performing and non-performing loans, interest income and servicing fees from PMT’s prime servicing portfolio.
In the second quarter, the investment activity segments revenue totaled $73 million down 6% from the first quarter. The decline was primarily due to a decrease in evaluation gains on performing loans which I will discuss in further details in just a moment.
Partially offsetting lower valuation gains with an 82% quarter-over-quarter increase in interest income from a growing portfolio of performing loans and 100% quarter-over-quarter increase in other income which is largely comprised of net servicing fee revenue.
Expenses in this segment increased 20% quarter-over-quarter due to higher interest expense from PMT’s exchangeable senior note issued early in the second quarter and higher servicing cost on a growing portfolio of MSRs and distressed whole loans.
Now, I would like to turn to slide 17 and dive a little deeper into the performance of the distressed whole loan portfolio in the second quarter. Total gains on mortgage loans in the second quarter were $47 million, which included $39 million in evaluation gains from both performing and non-performing loans.
Gains on non-performing mortgage loans total $34 million in the second quarter up 4% from the first quarter. Greater than forecast home price depreciation was a major driver of gains on the mortgage loans followed by evaluation gains on loans as they progressed toward their ultimate resolution.
Gains on performing loans totaled $4.7 million in the second quarter compared to $23 million last quarter. Portfolio additions and continued improvement in home prices drove the gains on performing loans in the second quarter. Performing loan gains in the first quarter reflected a significant improvement in the absorbed market yields for performing loans and the second quarter’s performance is more reflective of our expectations for performing loans going forward.
Distressed loans continue to generate significant cash flows for the second quarter, growth cash proceeds totaled $104.4 million of quarter-over-quarter increase of $11 million. The increasing cash receipts reflects a growing portfolio of distressed loans and solid operational activity by PMT’s servicer PFSI.
Now, I would like to turn to slide 18, and discuss PMT’s mortgage servicing rights asset. PMT’s mortgage servicing rights portfolio continue to grow ending the second quarter at $19.7 billion in UPB, up from $16.6 billion in UPB at the end of the prior quarter. As Stan mentioned earlier, MSRs are a growing portion of PMT’s long-term investments and their economic value generally improves in a rising interest rate environment.
The chart on slide 18, shows some of the key metrics of PMT’s MSR portfolio and highlights the difference between the carrying value of PMT’s MSRs and their fair value.
We account for originated MSRs as a lower of amortized cost or fair value when the underlying note rate on the loan is less than or equal to 4.5%. MSRs with note rates on the underlying loans above 4.5% are accounted for using the fair value method.
Given this a vast majority of the loans underlying PMT’s servicing portfolio have note rates below 4.5%, most of the MSRs asset is accounted for under the lower of amortized cost or fair value accounting method or LOCOM.
At the end of the quarter the carrying value of PMT’s MSR asset was $17 million less than its fair value. This increase in the underlying economic value should result in PMT’s MSRs generating more income over time than initially effective.
Now let’s shift gears and talk about the correspondent segment results. In the second quarter, revenues from correspondent lending activities totaled $58.5 million compared to $41.1 million in the first quarter. Conventional and jumbo lock volume increased 20% quarter-over-quarter and pricing margins remain fairly consistent with the levels at the end of the first quarter.
Also benefiting the second quarter’s correspondent segment results was effective edging, which protected the value of the inventory and pipeline and offset the impact of the sudden rise in mortgage rates during the quarter. Expenses in the correspondent segment fell 6% quarter-over-quarter primarily as a result of lower fulfillment fee expense partially offset by higher interest expense due to increased financing facility utilization.
Overall, pretax income in the segment with $28.1 million compared to $8.9 million in the first quarter or 54 basis points as a percentage of conventional and jumbo locks.
The concludes my comments. Now, I would like to turn the discussion back over to Stan to review the quarter’s key takeaways.
Thank you, Anne.
PMT is unique in its ability to be able to pursue a broad range of investment opportunities to the capabilities of our manager and servicing and fulfillment provider. We believe that the company is poised or continuing superior financial returns and many opportunities exit for PMT going forward as the mortgage market continues to evolve.
Distressed whole loan investment remain a key focus for PMT and a very strong contributor to earnings. Thus far in 2013, we have been very successful in acquiring distressed loan pools and we think that the outlook for this opportunity is very good through at least 2014.
We have achieved a prominent position in the correspondent lending business and are optimistic about its growth prospects over the long-term. As I said earlier, we expect margins to tighten and refinancing volumes to slow but we remain disciplined and we believe that we have initiatives in place that allow us to compete effectively as the market adjusts to higher rates.
Furthermore, PMT benefits from the variable expense structure of its contract with PFSI which minimizes the operational risk in periods of defining volume.
The non-agency jumbo program remains in its early days. The recent acquisition of the prime jumbo loan pool helps jump start our ability to begin PMT’s private label securitization activities and we may look to opportunistically invest in additional pools in the future.
The GSE risk sharing transaction is a positive step forward as the market transition towards normalization and we anticipate additional investment in these types of risk sharing structures in the future. They are an attractive investment for PMT and further our partnership with the GSEs as they rose and the market continued to evolve. We continue to pursue the acquisition of MSR portfolios as co-investments with PFSI as they provide attractive investment opportunities for PMT. The issuance of the exchangeable senior bond introduces diversity in PMT’s capital structure and attractive financing. As PMT’s acquisitions continue, we expect to raise capitals so that we can continue to pursue accretive investments for PMT’s shareholders.
In summary, we believe that PMT’s approach of multiple investment strategies across the residential mortgage market continues to produce superior returns and we are well-positioned to capitalize on these opportunities.
Finally, we encourage investors with any questions to reach out to our Investor Relations group by email or phone. Thank you.
This concludes the PennyMac Mortgage Investment Trust’s Second Quarter Earnings Conference Call. For any questions please visit our Investor Relations website at www.pennymac-re.com or call our Investor Relations department at 818-224-7028. Thank you.
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