PennyMac Mortgage Investment Trust (PMT) Q3 2013 Earnings Call November 6, 2013 ET
Good morning and welcome to the third quarter 2013 earnings discussion for PennyMac Mortgage Investment Trust. The slides that accompany this discussion are available from the PennyMac Mortgage Investment Trust 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.
Thank you Chris. I would like to begin my comments by reviewing the highlights of PMT’s third quarter performance. I would also like to discuss several new transactions that PMT entered into since the end of the quarter that we think underscore the attractive investment opportunities available to PMT and the significant acquisitions it has been able to successfully pursue.
PMT earned $39.7 million in net income, or $0.57 per diluted share, in the third quarter. Net investment income was $86.1 million, driven by strong earnings from PMT’s Investment Activities segment.
The Investment Activities segment earned $36.4 million in pretax income driven by solid performance of our growing portfolio of distressed whole loans, including valuation gains as a result of loans moving towards resolution and improvements in home prices.
The Correspondent Lending segment had a small pretax loss of $293,000. The loss is the result of a significant contraction in the mortgage market that resulted in lower lock volumes and tighter margins.
In August, PMT issued $250 million in new equity capital to pursue additional investment opportunities. While the higher share count had a dilutive impact on earnings per share and return on equity in the third quarter, we are deploying this capital into accretive long-term investment opportunities.
During the third quarter, PMT deployed over $350 million in equity capital into a variety of investments. We acquired two non-performing whole loan pools totaling $930 million in unpaid principal balance; completed PMT’s first jumbo securitization, retaining $366 million of senior, subordinate and I/O securities; acquired PMT’s initial investment in excess servicing spread on mortgage servicing rights acquired by PennyMac Financial; and organically grew our investments in mortgage servicing rights by $43 million.
Finally, Correspondent loan acquisition volumes totaled just over $7.7 billion, down 11% from the second quarter and total lock volumes were $6.7 billion, down 33% from the second quarter. PMT’s decline in acquisitions and lock volumes appear to be in-line with the mortgage industry as we indicated in the presentations that we made during the quarter.
On slide four we discuss PMT’s investment activity subsequent to the end of the third quarter. We are pleased to partner with PennyMac Financial and co-invest in the acquisition of two bulk portfolios of Agency MSRs totaling $21 billion in unpaid principal balance.
PMT will acquire excess servicing spread investments from the two portfolios totaling $147 million. This is an investment opportunity that we have been pursuing for some time and one that fits well into PMT’s long-term investment portfolio; $62 million of the excess servicing spread investment is from MSRs on a $10.3 billion portfolio of recently originated loans serviced for Fannie Mae. The other $85 million of excess spread investment is from MSRs on a $10.8 billion portfolio of seasoned loans serviced for Ginnie Mae. PennyMac Financial has entered into a letter of intent for this acquisition, which we expect to complete in the fourth quarter.
PMT also entered into an agreement to purchase an additional $563 million of non-performing whole loans, which we are expected to settle at the end of November. These recent investments will be purchased using a combination of cash and debt financing. PMT is well-positioned to grow and replenish its investments, producing valuable returns for our shareholders.
Turning to slide five, I’d like to discuss the significant transition in the mortgage origination market that had a significant impact on PMT’s results this quarter.
The average rate on the 30 year fixed rate mortgage was approximately 75 basis points higher in the third quarter than the second quarter, reflecting a market adjustment for the possibility that the Fed would begin tapering its quantitative easing program. The rise in rates from near-historic-low-levels resulted in a significant slowdown in refinance activity and a reduction in the expectations for the size of the total mortgage origination market going forward.
The rapid contraction in the mortgage origination market increased competition among lenders who sought to maintain volumes through more aggressive pricing. The consequence was a reduction in margins during the quarter in both conventional and government loans.
Mortgage origination volumes are forecast to decline by approximately 30% in the second half of 2013 compared with the origination volumes in the first half of the year, with reduced volumes forecasted for 2014 as well. Recently, the concerns over tapering has diminished, which had led to lower interest rates and a pickup in mortgage origination activity.
However, the composition of mortgage originations continues to transition towards a larger percentage of purchase-money loans. Purchase-money origination volumes are expected to comprise approximately 60% of the market going forward, driving originators to focus on strategies to increase their share of the increasing important purchase market.
Conversely, higher rates and an improving housing market have also helped create other opportunities for PMT, such as investment opportunities in MSRs, as smaller originators face profitability and liquidity constraints and rising MSR values heighten regulatory capital considerations for larger banks.
Now let’s move on to slide 6 and discuss PMT’s co-investment with PennyMac Financial. PMT is investing in excess servicing spread from two bulk MSR portfolio acquisitions by PennyMac Financial. These investments will be similar in structure to the excess servicing spread investments PMT completed in the third quarter. In an excess servicing spread investment, PMT acquires the right to receive a portion of the contractual servicing fee on MSRs acquired by PennyMac Financial.
The example on slide six shows a sample transaction where the total MSR is 25 basis points. In this example, PMT acquires the right to receive the cash flows on 12.5 basis points, or half of the total servicing fee, through its investment in the excess servicing spread. PennyMac Financial retains the base MSR, which represents the remainder of the contractual servicing fee. PennyMac Financial retains ownership of the MSR; PMT’s investment in the excess servicing spread does not change PennyMac Financial’s contractual obligation to the Agency for whom PennyMac Financial is servicing the loans.
To illustrate: PennyMac Financial receives an annual servicing fee of $250 on a loan with a $100,000 unpaid principal balance. PMT would be entitled to receive half of that amount, or $125. Excess servicing spread has the same embedded prepayment risk as the underlying MSR, but without any operational risk. The base servicing retained by PennyMac Financial is the remaining 12.5 basis points of servicing fee.
PennyMac Financial bears the expense of performing the loan servicing activities and it is also responsible for advancing certain cash payments for delinquent loans as required by the servicing agreement. This includes principal and interest, tax and insurance and other corporate protective advances. However, it is entitled to keep the ancillary income, which includes late fees, float on escrows and certain other fees.
The expected yield on the excess spread investment can vary dependent on the level of interest rates, the recapture arrangement with the servicer, and its success at recapturing loans that refinance.
Generally, higher rates extend the expected cash flows on the excess servicing spread investment due to lower prepayment activity and the opposite is true if rates decline. As loans are refinanced by PennyMac Financial’s retail lending activities, PMT shares in the recapture economics of the resulting new MSR, enhancing the return on the asset.
Let’s now turn to slide seven and look at the details of PMT’s excess spread investments in the two bulk portfolios. The prospective investments in excess servicing spread by PMT will be derived from two distinctly different loan pools.
Pool one has an unpaid principal balance on the underlying loans of $10.3 billion. It is comprised of recently originated loans serviced for Fannie Mae with a relatively low weighted-average note rate of 3.52% and almost no delinquent loans. The amount of capital PMT will invest in the excess servicing spread on this pool is $62 million.
Pool two has an unpaid principal balance on the underlying loans of $10.8 billion. The loans are seasoned loans serviced for Ginnie Mae with a higher weighted average note rate of 5.44% and 11.3% of the pool is delinquent. The amount of capital PMT expects to invest in the excess servicing spread on this pool is $85 million.
The tables on slide seven show the illustrative yield on PMT’s investment assuming different outcomes for recapture rates and prepayment speeds. In pool one, expected prepayments are lower given the relatively low coupon of the underlying loans compared to pool two, where the weighted average coupon is above prevailing market rates. While the likely prepayment speeds are different for each pool, we view the likelihood of recapture by PennyMac Financial as being the same between the two pools.
We are very pleased about the prospects of these excess servicing spread investments as they represent attractive opportunities on an unlevered basis and we are working on debt structures to obtain financing on these assets. They also add diversity to PMT’s portfolio of long-term investments, and we will continue seeking additional opportunities in this asset class.
Turning to slide eight, let’s take a few minutes to discuss our outlook for the market and the implications for PMT’s business strategy and performance. PMT’s primary source of investments is the residential mortgage market, so mortgage rates and housing have a significant impact on our performance.
As we touched on earlier, higher mortgage rates have caused production activity to slow, reducing the size of the available opportunity in the mortgage market and creating a more competitive and volatile market environment. Origination forecasts indicate that the composition of mortgage originations will shift to a greater percentage of purchase-money originations over the next two years and possibly longer. However, the underlying fundamentals of housing continue to remain positive and housing data released in the third quarter continued to indicate strong demand for homes.
With respect to the direction of home prices, we remain optimistic in our outlook for housing going forward. Demand from homebuyers and investors remains strong, housing inventory is low, and home affordability remains high despite the rise in mortgage rates. While the recent debt ceiling debate and partial government shutdown, along with higher rates, have moderated expectations for future home price appreciation, forecasts still predict continued appreciation across most of the U.S. for the foreseeable future.
Turning to distressed whole loans, we continue to see opportunities in this investment class. PMT has doubled its investments in distressed loan pools thus far in 2013 versus 2012, and new opportunities continue to emerge. Going forward, it appears increasingly likely that more non-foreclosure resolutions will occur through modifications, short-sales and deeds-in-lieu than were available previously. This is a result of increasingly streamlined processes, more favorable eligibility criteria for certain government programs and a generally improving housing market. These changes help to shorten resolution timelines and enhance the expected returns on the loans.
All indications suggest that the distressed whole loan opportunities will remain strong through at least 2014.
The Jumbo private label securitization market remains an opportunity that has tremendous promise long-term. However, for the foreseeable future, we expect that the GSEs will remain large players in the high balance loan market and a meaningful reduction in conforming limits are not likely to occur until late 2014 and possibly later. The high level of government involvement makes it difficult for the non-agency market to grow and attract the necessary investor participation required for a healthy market.
Turning to correspondent lending, the third quarter was a difficult transitional period for PMT and mortgage aggregators broadly. However, mortgage rates have trended downward recently, reducing some of the market pressures. While the market contraction is difficult for existing participants, it also creates higher barriers for new entrants, primarily because it becomes harder to grow the aggregation volumes to levels that are necessary to achieve economies of scale required for long-term viability.
With respect to MSRs, PMT expects to co-invest with PennyMac Financial in the acquisition of two MSR portfolios totaling $21 billion, where PMT acquires the excess servicing spread from these portfolios. We continue to see a consistent flow of bulk MSR portfolios in the market, and we remain optimistic about the opportunities for additional excess servicing spread transactions in the future.
Turning to slide nine, PMT’s portfolio of mortgage assets continued to grow and diversify. PMT’s long-term investments consist of distressed whole loans, which include both non-performing and performing loans, Mortgage Servicing Rights, and new investments which include retained interests from PMT’s private label securitization of $366 million, Agency mortgage-backed securities of just over $200 million and approximately $3 million in excess servicing spread investment.
The addition of the new investment categories provides diversification to PMT’s portfolio and represents a significant milestone in the evolution of the company’s balance sheet. The addition of retained interests from PMT’s recent securitization provides attractive spread income from the loans underlying the securitization and the high quality attributes of the collateral makes us very comfortable regarding the retention of credit risk. Investments in mortgage-backed securities are opportunistic and help meet REIT eligibility requirements.
The excess servicing spread investment was generated from a series of purchases totaling approximately $450 million in unpaid principal balance of mortgage servicing rights purchased by PennyMac Financial in the second quarter. This investment has similar characteristics to mortgage servicing rights, without the operational requirements or risk.
As a result, they are well positioned in the current environment and this investment category will grow significantly next quarter with the addition of the recently announced excess servicing spread acquisitions.
MSR investments generated through our correspondent lending activities continued their solid organic growth trajectory despite the slowdown in origination volumes. The acquisition of distressed whole loan investments reached their highest quarterly total since PMT’s inception and we see a consistent flow of opportunities in this market.
Mortgage servicing rights and excess servicing spread investments are assets that are positioned to perform well in rising interest rate environments. Distressed whole loans benefit from an improving economy and an improving housing market and should continue to perform well.
PMT’s assets have grown by nearly $1.7 billion over the last 12 months, which has been driven by the planned expansion of leverage to 1.8 times equity. 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.
I would now like to turn to discussion over to David Spector, PMT’s President and Chief Operating Officer.
Thank you Stan. I would like to begin my comments on slide 11, and review our recent investments in distressed whole loans. Here, we show PMT’s acquisition volume over the last five quarters by unpaid principal balance, in addition to the acquisitions thus far in the fourth quarter.
Subsequent to the end of the quarter we entered into an agreement to purchase an additional $563 million in non-performing loans. This pool is geographically diverse and is generally similar to other pools PMT has acquired recently. Assuming that the loans settle as planned, these transactions will bring total distressed acquisitions for the year to-date to just over $2.25 billion in unpaid principal balance, over twice the $1 billion of distressed acquisitions in 2012. We continue to see an ongoing flow of portfolios in the market. Looking forward, we remain optimistic in our outlook for the distressed market and opportunities for additional acquisitions by PMT in the future.
Now let’s go to slide 12 and turn to the correspondent lending business. Correspondent loan acquisitions totaled $7.7 billion in the third quarter. Conventional and jumbo loan acquisitions were $3.7 billion, or 48% of that volume. Correspondent lock volume for the quarter was $6.7 billion. Conventional and Jumbo locks were $2.9 billion, or 44% of total lock volume. In October, loan acquisitions and lock volumes both totaled $2.1 billion.
Higher mortgage rates have slowed refinance activity, as Stan discussed, and industry forecasts predict lower mortgage origination volumes for the remainder of this year. Recently we have seen a drop in interest rates and margin pressures decrease. However it is difficult to know how sustainable recent trends are, but we believe that PMT is well positioned to grow as the market adjusts to higher rates.
We are focused on several initiatives in correspondent lending to address these challenges, one of which is the continued optimization of our correspondent seller network. Our network of approved sellers grew to 221 at the end of September, from 220 at the end of June. This net change is small, but what you see is that we added 17 sellers, while terminating 16 relationships as well. We want to make sure that we’re doing business with the right sellers and fostering relationships that are productive and which allow PMT to grow in a prudent and profitable manner.
While there can be difficult periods along the way, the initiatives we have in place will continue to deliver long-term growth in the correspondent business. We expect to drive market share growth over time as the market improves and competitive behavior normalizes.
Now let’s turn to slide 13 and go over the economics of the correspondent lending business. The primary source of revenue in correspondent lending is the net gain on mortgage loans acquired for sale, which represents the capitalized value of the MSR created plus or minus the realized and unrealized gains or losses on the mortgage loans, interest rate lock commitments, and associated hedge instruments.
The net gain on mortgage loans acquired for sale in the third quarter was 37 basis points of the quarter’s conventional and jumbo lock volume. PMT also earns a net interest spread on its mortgage loan inventory, which includes both conventional and government loans, as well as other income in the form of origination fees collected from its correspondent sellers on conventional and jumbo loans. In total, PMT earned 64 basis points in revenue as a ratio of the lock volume. Net of expenses, the pre-tax loss was 1 basis point as a ratio of the lock volume.
The loss in correspondent for the third quarter was primarily driven by a decline in conventional and jumbo lock volumes and tighter margins on conventional loans. Also impacting this quarter’s results was loan fulfillment expense, which increased as a percentage of lock volumes. Fulfillment fee expense is based on the funding volume of conventional and jumbo loans, which declined by just 15%. The primary revenue driver in correspondent is lock volume, which declined by 44%. We expect this recognition timing difference to normalize in the fourth quarter.
Turning to slide 14, I’d like to spend a few minutes discussing PMT’s private-label securitization that was completed in the third quarter. The securitization was backed by prime quality jumbo loans totaling $550.5 million in unpaid principal balance. The collateral was a combination of $393 million in unpaid principal balance of jumbo loans acquired in a bulk purchase transaction earlier in the third quarter and jumbo loans acquired through PMT’s correspondent business throughout the year. $170 million of the senior bonds were sold in the third quarter and PMT has retained the remaining securities. The subordinate and I/O securities from the securitization are attractive long-term investments for PMT, which provide spread income over time and which also act as an economic hedge to other assets in PMT’s investment portfolio. The retention of the senior securities, similar to the decision to purchase agency mortgage backed securities, is viewed as more of an opportunistic investment.
As Stan mentioned in his comments, the private label securitization market currently faces some significant challenges. We like the long-term opportunity, but today’s environment leads us to conclude that PMT will probably not issue another private label jumbo securitization until 2014.
Now I’d like to turn the discussion over to Anne McCallion, PMT’s Chief Financial Officer, to discuss the third quarter’s financial performance. Anne?
Thank you, David. On slide 16 we show the pre-tax earnings contribution from each segment in the last several quarters. For the third quarter, pretax earnings totaled $36 million, all of which came from Investment Activities.
The third quarter origination market contraction was significant. We transitioned from a period of near-historic low interest rates to much higher rates in a relatively short period of time.
Inflection points such as the third quarter can create timing mismatches and distort financial performance in certain cases. What is important for investors to keep in mind is the significant success PMT had this quarter deploying capital into several accretive investments that should drive earnings and dividend growth in future periods.
Now let’s turn to slide 17 and look at the results for the Investment Activities segment. This segment’s revenues consist of valuation and payoff gains and interest income from performing and non-performing loans, servicing fees from PMT’s prime servicing portfolio and interest income from retained interests and Agency MBS.
In the second quarter, the Investment Activities segment’s revenue totaled $67.1 million, up 4% from the second quarter. The increase was primarily due to strong valuation gains on non-performing loans, and higher net interest income from capitalized interest on modifications, which increased by $6.6 million from the second quarter, and higher average earning assets from a growing portfolio of reperforming loans.
Expenses in the segment increased 24% quarter-over-quarter due primarily to increased servicing expense from growth in PMT’s investments in MSRs created by its correspondent lending activities and distressed whole loan acquisitions, and expenses from the securitization.
Now I’d like to turn to slide 18 and dive a little deeper into the performance of the distressed whole loan portfolio in the third quarter. Total gains on mortgage loans were $48 million, which included $41.9 million in valuation gains from both performing and non-performing loans.
Gains on non-performing mortgage loans totaled $41.9 million in the third quarter, up 23% from the second quarter. Greater than forecast home price appreciation was a major driver of gains on the mortgage loans, followed by valuation gains on loans as they progress towards their ultimate resolution.
Performing loans in the portfolio saw a very small valuation loss in the third quarter, compared to $4.7 million in valuation gains in the second quarter. This reduction was largely driven by an increase in capitalized interest resulting from loan modifications, versus the second quarter. Capitalized interest on modifications increases interest income and tends to reduce valuation gains.
Distressed loans continue to generate significant cash flows. For the third quarter, gross cash proceeds totaled $102.2 million, a quarter-over-quarter decrease of $2.2 million. The decrease in cash receipts reflects lower cash inflows from liquidations, partially offset by an increase in principal and interest payments on performing loans.
Now let’s turn to slide 19 and discuss PMT’s mortgage servicing rights asset. PMT’s mortgage servicing rights portfolio continued to grow, ending the third quarter at $23.7 billion in UPB, up from $19.7 billion in UPB at the end of the second quarter.
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 19 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 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 with note rates on the underlying loans above 4.5% are accounted for using the fair value method.
Given that the vast majority of the loans underlying PMT’s servicing portfolio have note rates below 4.5%, most of the MSR asset is accounted for under LOCOM. At the end of the quarter, the fair value of PMT’s MSR asset was $19 million greater than its carrying value. The higher underlying economic value compared to the carrying value may result in PMT’s MSRs generating more income over time than their recorded values indicate.
Now let’s shift gears and talk about the correspondent segment results. In the third quarter, revenues from correspondent lending activities totaled $18.9 million compared to $50.9 million in the second quarter. Conventional and jumbo lock volume decreased 44% quarter-over-quarter as the mortgage market contracted in response to higher rates. Net interest income increased from a larger average balance loan inventory in addition to higher yields. Expenses in the correspondent segment fell 16% quarter-over-quarter, primarily as a result of lower fulfillment fee expense from a 15% decline in conventional and jumbo loan fundings.
Overall, the segment generated a pretax loss of $293,000 compared to pretax income of $28.1 million in the second quarter. As David mentioned in his comments, the loss was largely the result of a timing difference that occurs when lock volume declines outpace declines in fundings resulting in lower revenue and relatively higher expenses.
That concludes my comments. Now I would like to turn the discussion back over to Stan for some closing comments.
Thank you, Anne. The outlook for PMT remains strong. Our investments in excess servicing spread, in partnership with PennyMac Financial represents an attractive new strategy for PMT. The pipeline of distressed whole loan investments remains robust, and we expect to continue seeing significant opportunities for new investments through 2014. In correspondent lending we expect to resume increasing acquisition volumes as the origination market stabilizes. In summary, I believe PMT is well positioned to continue growing its investments and delivering shareholder value.
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 third quarter earnings discussion. For any questions, please visit our website at www.pennymac-reit.com, or call our investor relations department at 818-224-7028. Thank you.
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