Right. Next up we have PennyMac Financial Services here to present today. The company is a specialty finance company focused on originating and servicing mortgages. Pleased to be joined by Mr. Stanford Kurland, who is the Chairman and Chief Executive Officer along with David Spector, President and COO, and Andrew Chang who is here also Chief Business Development Officer. So without further ado?
Stanford Kurland - Chairman and Chief Executive Officer
Thank you, and god afternoon. We appreciate your interest in PennyMac Financial Services. PennyMac Financial Services is an organization that we have built over the last 5.5 years into one of the leaders in the U.S. mortgage market and a company that has deployed us for substantial growth as the mortgage industry continues to evolve.
The U.S. mortgage market is very large and we believe that there are substantial opportunities available across the mortgage industry. Today, mortgage production and servicing are concentrated in money center and regional banks yet many banks are reconsidering their commitment to the mortgage business. The non-agency mortgage markets are just starting to re-emerge and we anticipate additional opportunities as the GSEs reduce their involvement in the market. The mortgage markets have a need for a non-bank company with the requisite capital expertise, operational capabilities and breadth of management skills, PennMac has in place an organization, operation and management that we believe are the best in the mortgage industry and the company is able to support many times our current volumes of business activities.
PennyMac Financial’s operations were developed organically to create a first class mortgage platform free from legacy issues. PennyMac Financial is a unique company that conducts several mortgage-related businesses which I will explain shortly. Of note, we are the largest non-bank today and what is known as correspondent lending business and the fourth largest participant in that market overall. We also have a unique partnership with PennyMac Mortgage Investment Trust, or PMT. PMT is a tax efficient investment vehicle that invests in a variety of residential mortgage related assets and is managed by one of our subsidiaries, PNMAC Capital Management. The mortgage business requires substantial capital to invest in assets such as mortgage servicing rights. Our ability to produce attractive long-term investments for PMT provides PennyMac Financial with competitive advantage while addressing the balance sheet constraints of a non-bank operational mortgage company.
On Slide 3, I want to provide an overview of the businesses that makeup PennyMac Financial and the drivers of our revenue. The company has engaged in three main businesses, loan production, loan servicing, and investment management, which are organized under two segments, mortgage banking and investment management. In correspondent lending, PennyMac purchases in aggregates newly originated loans from approved third-party sellers. All correspondent loans are first acquired from external originators by PMT. PennyMac Financial purchases government-insured loans from PMT pools of the loans and delivers them into Fannie Mae securitizations earnings a gain on those mortgage loans. PennyMac Financial also retains the mortgage servicing rights and earns servicing fees over the life of those loans. For conventional and jumbo mortgage loans, PMT securitizes the loans and retains the resulting mortgage servicing rights.
PennyMac Financial receives a fulfillment fee for performing the correspondent lending activities for PMT, which includes reviewing the loan data, documentation and appraisals to assess the loan quality and risk, the approval of correspondent sellers and the monitoring of the ongoing performance and the subsequent sale and securitization of the loans in the secondary market. PennyMac Financial also earns loan origination fees and warehouse spread, warehouse spread it is the difference between the interests received from payments on the loans and our financing costs during the inventory period prior to securitization.
Our retail lending business is a consumer direct lending business that originates loans to consumers for the purchase or refinance of their home including conventional and government-insured loans. In general revenues in this business are gains on the mortgage loans including the retained MSRs as well as loan origination fees and warehouse spread. In our loan servicing business we administer loans after origination including the collection and the remittance of loan payments, responding to customer inquires, accounting for loan payments, default and collection activities for these activities we earn servicing fee on the MSRs that we own. We also earn sub-servicing fees from our Advised Entities for the specialty servicing activity on their distressed whole loan portfolios as well as for servicing PMT’s prime mortgage servicing rights generated from its correspondent production activities. Ancillary income includes loan level activity fees, late charges and interest on the escrow balances that we hold as the servicer.
In our investment management business we serve as an external management for investment vehicle specializing in mortgage related assets. Today we manage PMT and the investment funds which collectively recall the Advised Entities. Together they comprise approximately $2.1 billion of equity under management. Investment management fees include base management fees plus incentive fees or carried interest based on the financial performance of the Advised Entities. Investment strategies of the Advised Entities are complex and require specialized expertise and resources including those in sourcing of investments, valuation analysis and due diligence activities. In sum, PennyMac Financial’s revenue sources are a combination of traditional mortgage banking and fee for service activities. More than half of PennyMac’s revenues including those related to conventional correspondent production are fee based cash revenues that are driven by business volumes.
On Slide 4, I’d like to review the opportunities in the correspondent lending business which is the largest contributor to our revenues today. In the mortgage market many small and mid size originators sell their loans to aggregators who acquire pool and then deliver the loans into the secondary market. Correspondent customers sell to aggregators for a variety of reasons. For instance they may lack the capital markets expertise to hedge an origination pipeline or the operational capabilities to service loans or the financial capacity to own and manage the mortgage servicing rights. Last year some 30% of the mortgages originated in the U.S. flowed through the correspondent market.
This market has large accounting for more than $500 billion in origination volume last year. We believe that there is potential for the correspondent share of the mortgage market to increase as tighter origination margins cause small and midsize lenders to sell more of the loans that they originate to aggregators on a servicing released basis. Moreover, there is plenty of potential for PennyMac to grow its market share. Although we are the fourth largest correspondent lender, we only capture 6% of the market substantially less than the top three banks. A bit later I will detail some of the specific initiatives that we are pursuing to capture additional opportunities.
On Slide 5, I would like to turn to the market opportunity and growth potential for PennyMac Financial retail lending activities. First, there is a significant opportunity for non-bank lenders to regain share in the retail origination markets. Since the financial crisis, retail originations have been dominated by the large money center banks and regional banks. However, banks are reducing their mortgage exposure as a result of more stringent capital requirements intensifying regulatory scrutiny and an increased focus on core customers within their own branches.
Furthermore, we think that the consumer direct lending model has significant advantages. It is already gaining favour with consumers for refinanced transactions and we believe it has potential to have become the channel of choice for purchase money originations as well. A traditional branch – there we go, a traditional branch based originator may have hundreds or thousands of small branches, each with the loan officer and managers hunting for business. By contrast, a call center based model results in more efficient concentration of loan officers and better leverage of management expertise with centralized lead generation driven by corporate marketing initiatives. A centralized platform also results in more controlled origination process and for example allows a lender to more efficiently deploy new improvements in technology. There are very few organizations that can develop a major consumer direct platform given the capital and the financing required in the new regulatory environment and the continuing investment to remain competitive. We believe that PennyMac Financial is uniquely positioned to capture this opportunity over time.
I’d like to turn to Slide 6 and discuss our outlook for the more origination market and the implications for PennyMac Financial. The interest rate on the 30-year fixed rate mortgage has increased by more than a full percentage since early May and this sudden increase in mortgage rates has taken many borrowers out of the market for refinancing. As a result, we think it 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. Rising rates should drive an increased demand for adjustable rate and fixed period adjustable rate mortgages or hybrid products which have become more attractive alternatives relative to fixed rate loans. For example, a sophisticated homebuyer can utilize an ARM or hybrid ARM to keep their mortgage payments low. These loan products will help to support the purchase money lending activity as the market adjusts to a higher interest rate environment.
We expect margins to remain under pressure and to decline from what were historically elevated levels as the mortgage market contracts. Despite these challenges in the market we expect over time to continue gaining market share in both correspondent and retail activities and remain disciplined in our pricing and risk management to drive profitable returns.
I want to emphasize that our management team understands how to manage through different interest rate environments and origination markets. Investors can expect that we will effectively manage the things that we can’t control. While we expect the correspondent and retail markets face some near-term challenges, our servicing portfolio continues to experience significant growth. We are aligning our headcount growth with the market opportunity and continue to emphasize efficiency and expense management. However, these initiatives are also balanced, so that we have continued investments in our systems, our infrastructure and capabilities necessary to position the company for long-term growth.
Turning to Slide 7, I’d like to discuss the growth – the growth trends of PennyMac Financial services businesses. Our loan production volumes have grown over the past year in both correspondent and retail lending. In correspondent we are focused on disciplined initiatives to capture additional market share profitably. Our retail lending business continues to develop products, technologies, and processes to drive significant additional growth. Presently both the both correspondent and retail production businesses have a relatively small share of the total origination market and we believe we can prudently and profitably capture additional share even as mortgage origination volumes decline. Our loan servicing business has grown consistently, primarily from the volumes added through PMT’s loan production activity. We are growing our special servicing portfolio as a result of continued distressed whole loan investments made by PMT.
And we expect that bulk and flow MSR acquisitions will provide additional growth to the servicing portfolio. Our investment management business is driven by our net assets under management and the performance of our Advised Entities. Net assets under management have grown as PMT has raised additional capital to deploy in new investment opportunities. The market opportunity to invest residents and residential related assets is significant. And going forward, we expect to manage additional capital in PMT and possibly other investment vehicles.
I would like to close by discussing the set of initiatives that we are focused on in order to expand market share in each of the loan production businesses over the long-term. In correspondent lending our objective is to continue developing a complete platform to serve smaller originators that form the profitable core of our customer base. The changing dynamics of the mortgage industry are resulting in many small mortgage banks focused on their local and regional markets. We want to be the value business partner to these originators versus their alternatives of selling loans to a large bank aggregator or directly to the agencies. That means continuing to provide relevant products and pricing to these customers and a complete array of delivery methods that align with how they conduct their business. We are focused on adding new additional seller relationships specifically we are focused on expanding in certain geographies such as the Northeast where for example we have identified the potential to add $200 million to $400 million per month in production volume.
Overall, we are focused on optimizing the seller network to make sure that we have the right 230 or so sellers with each one being a meaningful relationship to PennyMac. Finally, lower market volumes in the near-term and tighter margins require a continued emphasis on disciplined execution in pricing and risk management as the origination markets transition. In our retail lending business we are striving to bring the efficiencies of the consumer direct model to what has become a purchase money origination market. PennyMac’s objective is to tell you realtors who are a key to the home purchase transaction and the end consumer through effective service, products and pricing. We have developed distinctive products such as the approved buyer certification program that seeks to provide certainty to perspective home buyers in a way that the industry’s typical pre-qualification letter does not. We are investing in new technology that can have a real impact on our customer experience for example a mobile phone app that provides progress, updates to borrowers and to realtors.
And we are focused on delivering a superior loan origination process and service through our platform including specialized personnel who work on purchase transactions. We are developing a disciplined approach to lead generation from multiple sources. First and foremost we seek to leverage our growing servicing portfolio including purchase money opportunities that arise from the distressed loan investments that we mange. We are focused on targeted marketing to drive non-portfolio leads and MSR acquisitions can drive additional opportunities for our retail business as well. In summary, we are focused on these long-term initiatives to fulfill our growth potential and loan production businesses that we participate in spite of the near term challenges in the origination market.
So thank you. And with that, I guess we are open to questions.
First before we get to questions we have some audience response questions, so if you pick up your handheld device. First question if you currently don’t own shares of PFSI or underweighted stock what would cause you to change your mind hit 1 for improved servicing margins, 2 for origination growth or 3 for increased mix of retail originations. And we got a relatively even split 42% of you said origination growth and the second highest one was improved servicing margin. So moving on the next question, which business segment do you think has the most growth opportunity 1, loan production, 2, loan servicing or 3, investment management. And the vast majority of you said loan servicing, very few are saying investment management.
So moving on to the next question, over the next 6 months to 12 months what do you expect will happen to your exposure to PFSI increase, maintain, decrease or remain uninvolved? And of the majority that are actually involved most of you said increase exposure, only 6% are saying decreased exposure. Do we have one more. Yes, one more alright so if you own shares of PMT are you more or less likely to own shares of PFSI 1, for more likely, 2 for less likely or 3 for no opinion. And I think more likely and less likely both coming in the front, so we can talk PMT tomorrow and we guess for that. With that, we will open up to questions in the audience.
How are you doing, can I just ask a couple of questions could you talk about your fees on the distressed part of servicing versus the prime part. And then just maybe HARP gain on sale how much of HARP do you guys have in your gain on sale. And then just talk briefly about the jumbo market potentially securitization and things of that nature?
So David, why don’t you just give an update on the jumbo?
Yes, so first we will go in reverse order here. On the jumbo front as we announced with PMT’s earnings we in June purchased a bulk portfolio of jumbo loans, the unpaid principal balance about $400 million. These were sold at a major money center bank and it was a strategic acquisition from a bank, who was looking to sell loans during a period of time where we saw spreads gap out. These are 80% of those loans were originated by sellers that are already approved to sell to our correspondent network, the remaining 20 we knew of – to our experience and we did some seller credit beforehand. And it’s very representative of the organic, but I call the organic growth that we have through our correspondent network and that’s a UPB of about half that amount. It’s at the beginning of the year we reintroduced our jumbo program with an eye towards securitization. So between the two, we have about $600 million and we said that we are going to look to do a securitization by the end of the quarter, which is in three weeks and have that securitization and that would move us forward, which we are hopeful for that. We are going to – for PMT, we’ll look to retain the sub-bonds in the I/O and the servicing with PFSI being the sub-service from the transaction.
So you asked about servicing fees and so we act as a specialty servicer that was the kind of an initiation of PennyMac. And we have a fee structure for distressed mortgages that is different than for our prime conforming mortgages in a similar way is based on the status of the loan what if it’s delinquent or not delinquent and has a set of milestone type fees for accomplishing certain initiatives. From PFSI’s position, it’s the build of the distressed mortgage portfolio, which coincidentally with the rise in interest rates that’s resulting from a stronger economies also causing values to increase in home values, which is not only good for the existing portfolio that we already own and manage and receive incentives on, but it’s also encouraging banks to sell more of their distressed mortgages. And so we have been acquiring in PMT greater levels of distress and that in turn it results in not only base management fees, but also servicing fees as well and potentially incentive fees for results that exceed certain performance hurdles. On the prime side, we receive fees that are very customary with what other sub-servicers charge and again it’s based on the status of the loan whether it’s current or delinquent.
I don’t know the precise numbers, but it would be like on a prime loan, you receive about $7.50 a month for current mortgage, whereas to get to I don’t know if that is exactly right in, but I think it’s about $30 a month for a distressed loan. And then there are certain fees for, for example, accomplishing restructure and sale of the mortgage that are based on the unpaid principal balance of the mortgage loan. And so there I mean you can kind of work through the financials and see what I think what they come out to on a per basis point level.
And just out in the distress side we talk about $30, but as it rolls down and gets more delinquent and moves through foreclosure that’s fee increases, okay, such that it grows as it needs more work and it’s a stance point upon the end of that loan whether it’s for a (indiscernible) or short sale on where the completion of the sale of the OREO, there is a completion fee assort that PFSI gets?
The problem with multiple questions as I think we left one of them out. So we don’t have enormous portion of our activity which is HARP. We do market to outside portfolios on HARP and it’s really the margins are a little bit wider than new mortgage, but it’s not like what you are used to seeing in some of the bank owned portfolios. It’s pretty consistent or close to what you would charge for a new origination.
Obviously, some of the larger servicing peers have been discussing the very large pipelines that are out there on the servicing side. Can you talk a little bit about what your intentions are with regard to participating in bidding on some with what’s out there and some with what may come over the next 18 months? And also just some clarity as to who holds what between both yourselves and PMT when there is an acquisition and how it gets financed?
Okay. So what we are seeing in the market today is pretty sizable increase in the volume of large mortgage servicing portfolios that are being put on the market by primarily the money center banks and that is I think in the market kind of gives them a level, there has been some $75 billion of servicing in the market? We need to view ourselves as a very string bid for agency related mortgage servicing rights, so Ginnie Mae in particular and Fannie and Freddie, and less likely bidder on the private label servicing and we have all of the capabilities of actually doing the private label activities, because it’s much like the specialty servicing activities in distress. Our concentration in terms of the packages that have been in the market have been on the agency side. We think that it’s a tremendous opportunity for us to expand the portfolio. We are participating in the activities and we are hopeful that we will be a winner of one of the bids. And we believe from what we have heard that the intention is that there will be more servicing that’s going to be put on the market.
Our structure for doing this is a structure that allows for co-investment by both PFSI and PMT. And what we believe is the most efficient activity for us or structure for us is to have the mortgage servicing rights owned directly by PFSI and then a I/O strip with an acknowledgement agreement where PMT owns an I/O strip. So we are free from operational risk and we think that’s very efficient structure actually for PMT, because done in that fashion, you produce a qualified REIT asset and that’s very important to PMT. From the combined enterprise, it creates a level of capital to participate and to be very competitive. And we think we have a tremendous structure for participating in the servicing. Servicing is also important in terms of origination activity as well, because many in these legacy portfolios there is still refinance activity. I think for the most part a lot of the lower balance mortgages have been ignored. And so within some of these portfolios, there is opportunity to still pursue refinance initiatives as well.
Question in the back?
Can you help me understand what kind of business flows through PFSI versus PMT and what was the rationale for creating those two different entities?
Sure. So, PMT is think of as more as an investment company and its activities are engaged in looking at relevant mortgage related investment opportunities that exist in the market and that started with distressed mortgages. And it grew as that market evolved it grew its activities into participating in the aggregation of mortgages and then investing in mortgage servicing rights and as David discussed subordinate pieces of jumbo mortgage securitization. And so we look at a variety of investment opportunities. Some of them may be typically we could do – we can invest in mortgage – in mortgage-backed securities or mortgage-backed securities of private label securitizations that we do and some of it’s very unique like the activity of investing in distress and a lot of those activities are basically fueled by the expertise that exist in the operating mortgage company at PFSI.
And so PFSI is a fulfillment provider of mortgage originator in terms of retail mortgages. It is the – it has all of the platform for servicing – a big distinction is PFSI has some 1100 employees and PMT has no employees. So just we manage those activities for them and what the purpose is that we think that investors – not all investors want the same type of exposure, so PMT is very tax efficient dividend distributor to investors that want exposure to mortgage assets that for many of the cases there is really no other way to get exposure to for example mortgage servicing rights or distressed mortgage loans. And that’s different I think from the franchise build of a mortgage bank or a non-bank mortgage company that’s provided in PFSI which has building the operations and the franchise to position itself in the future as a leader and the evolving industry.
One thing I’d add to that is that if you look on the screen you can in PFSI, the PFSI is aggregating and securitizing the government loans and retaining the mortgage servicing rights on those loans and that’s the function of the fact that PFSI has the license to do so with Ginnie Mae which is not available to the REIT and so that business does get split between the two. PMT is the client facing entity for the correspondent business. PMT buys the government loans into it’s operation and sells the loans to PFSI.
Yes, to follow-up the prior question regarding your funding sources, when PFSI and PMT hit the $75-ish billion or so servicing broke into market, what’s your funding source?
We didn’t get all $75 billion by the way the force of it. But – so PFSI has existing capital from the IPO to invest. In addition to that we have access to credit facilities to leverage slightly that investment. And then PMT in terms of creating an IO strip provides another level of capital that’s devoted to the acquisition of the mortgage servicing rights.
Great. Well, if there are any question, one more question.
What happens in the case again on sell margin, it kind of falls under costs 50 basis points or 60 basis points than the fulfilment fee, is there a recoup on that or how would that work for PFSI for PennyMac, the fulfilment fee is like 50 bps, so what if again I will say below that?
Right. What – you are talking about the fulfilment fee with PMT?
Right, PMT PFSI if it’s Fannie or Freddie I believe something in that range?
So the arrangement is that for the activities of conducting their correspondent activity, we generally receive fulfilment fee which is 50 basis points at UPB. So when we set out to price mortgages for acquisition by PMT, we know the full economics of the price that we are offering and so we have certain pricing or yield targets or return on equity targets that includes the 50 basis point fee to the extent that we ever go where the 50 basis points would result in the return on equity for PMT being structurally below their sort of floor or target floor. We have the ability at PFSI to discount the fee. So the example I think that should be fairly understandable is that if we are 49 basis points we can get PMT there, required return on equity, but otherwise we would miss that transaction. PFSI has the ability to waive or reduce its fulfilment fee to 49 basis points. And so it’s very carefully orchestrated fee arrangement that benefits both parties.
Great, well thank you all for coming. There will be a breakout session in this room. So if you need to have additional questions, please stick around, but join me in thanking management for the time today.
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