PennyMac Mortgage Investment Trust (NYSE:PMT)
Q4 2013 Earnings Call
February 5, 2014 4:30 PM ET
Stanford Kurland – Chairman and CEO
David Spector – President and COO
Anne McCallion – CFO
Good afternoon and welcome to the Fourth 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’d 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, PMT’s Chairman and Chief Executive Officer. Stan?
Thank you, Chris. PMT flashed a successful 2013 with a strong fourth quarter, which is reflected in higher earnings per share and the increase in our quarterly dividend. We continue to grow and diversify PMT’s portfolio of long-term investments, our investments in distressed whole loans continued to perform well and despite various challenges in the mortgage origination market, our correspondent lending business delivered meaningful profits.
I would like to begin my comments by reviewing the highlight of PMT’s fourth quarter performance. PMT earned $52.7 million in net income or $0.69 per share in the fourth quarter. Net investment income was $96.1 million driven by positive earnings contributions from both of the company segments investment activities and correspondent lending.
As we previously announced PMT declared a dividend for the fourth quarter of $0.59 per share an increase from the prior dividend level of $0.57. The investment activity segment earned $48.4 million in pretax income driven by the solid performance of our portfolio of distressed whole loans valuation gains and higher net loan servicing fees.
The correspondent segment earned $6.3 million in pretax income driven by relatively more stable margins and lower fulfillment fee expense. During the fourth quarter PMT completed several important previously announced acquisitions, including investments totaling a $136 million in excess servicing spread and the acquisition of a pool of non-performing whole loans totaling $507 million in unpaid principal balance.
Correspondent loan volumes totaled $5.8 billion down 25% from the third quarter and lock volumes totaled $6 billion a decrease of 10% from the third quarter. Higher mortgage rates continued to cause a decline in U.S. mortgage originations for the quarter with the top lenders reporting volume declines in excess of 35%.
After the end of the quarter, we completed a notable transaction with the sale in January of performing whole loans from PMT’s distressed investment portfolio totaling $233 million in UPB. Proceeds from the sale are targeted for reinvestment in higher yielding investments, such as the $351 million in UPB of non-performing whole loans that we have agreed to acquire and expect to settle later this month.
Now let’s turn to slide 4. I want to reemphasize the solid record of performance that PMT has established over the last several years. We have generated strong earnings and returns on equity and have also grown book value while maintaining a robust quarterly dividend. In addition, we have successfully deployed new capital into accretive investments that have contributed to this performance.
In the fourth quarter, PMT raised its dividend to $0.59 per share from $0.57 per share. Additionally, I would like to note a change in the timing of PMT’s quarterly dividend which will now be declared within the related quarter. This change better aligns the dividend declaration with the income distributions required under the REIT actuals and also makes PMT’s dividend timing more consistent with other REITs.
Turning to slide 5, we see that PMT’s portfolio of mortgage assets continue to grow and diversify. PMT’s long-term mortgage investments grew 63% in 2013, as a result of significant new investments we made in distressed whole loans, MSRs, excess servicing spread and retained interest from the securitization of prime jumbo loans.
PMT funded these investments with new equity capital raised in the third quarter and also by continuing to build out its capital structure through the issuance of convertible debt in April. We believe that PMT’s current leverage ratio of 1.8 times remains prudent and relatively low compared to other REITs.
Now I would like to turn to slide 6 and continue the discussion of PMT’s balance sheet and how our strategy of pursuing multiple investments is beneficial for risk management. The various mortgage assets that PMT invests in have different sensitivities to interest rates. Some of our investments such as MBS decline in value with increases in interest rates, other assets such as MSRs and excess servicing spread tend to rise in value with higher interest rates. These offsetting sensitivities moderate the overall balance sheet exposure to interest rate movements.
The chart on slide 6 shows PMT’s global interest rate risk exposure resulting from the sensitivity of our long assets, our MSR, ESS and investment hedge positions. The horizontal access represents changes in interest rates, assuming a hypothetical instantaneous parallel shock in the yield curve. The vertical access represents the estimated change in the value of the balance sheet expressed as a percentage of total shareholders’ equity.
What you see from this chart is that the sensitivity of the long asset positions is positive t a downward interest rate shock, while the sensitivity of the MSR, ESS and investment hedges is negative. We estimate that for a 100 basis point instantaneous decline in interest rates, the net loss in the value would be less than 1% of PMT’s shareholders equity.
Distressed whole loans are not included in this analysis as they are primarily sensitive to changes in home prices and less directly affected by changes in interest rates. This example illustrates the power of PMT’s strategy of pursuing investments with different risk profiles which along with disciplined interest rate risk management helps produce and deliver solid investment returns over the long-term across a variety of market conditions.
Let’s now turn to slide 7 and discuss one of PMT’s key investment strategies and our history of resolving distressed loans. We have a successful track record in resolving distressed whole loans. Distressed loan investment have been a primary strategy for PMT since its inception in 2009, in fact PMT was founded with the idea of making this investment strategy which had typically been accessed through private equity available to the broader investing public.
Over the past four years PMT has acquired over a $5 billion in UPB of distressed whole loans in 41 separate pools. We have a deep understanding of this asset class and that experience gives us significant insight into how the collateral will perform over time. We use performance data from previous acquisitions to inform our analysis in bidding, on potential new investments in order to focus on pools that fit PMT’s business model.
We pursue several different resolution pass for distressed loans. One path is where the loan pays off either through borrowers becoming current and paying the loan off or more likely through the modification and subsequent pay off through a negative equity refinance transaction.
Another resolution path is a short sale which is used frequently as an alternative to foreclosure in which an agreement is negotiated with the borrower to sell their home for an amount that is less than the outstanding amount owed on the mortgage.
Deeds-In-Lieu is also an alternative to foreclosure where borrowers to agree to deed the property over to PMT rather than go through the foreclosure process. This type of transaction often includes cash payments to the borrowers as an incentive for the negotiated resolution.
The last resort and typically the least desirable outcome for PMT is foreclosure. PMT has successfully employed alternatives to foreclosure including modifications short sales and deeds-in-lieu foreclosure in 65% of the loan resolutions over PMT’s history. The chart on slide 7 shows resolution trends for distressed pools purchased by PMT going back to the first quarter of 2010. As you can see PMT has a strong history of effectively investing in and resolving loans.
Now let’s turn to the slide 8 and discuss an example of how we maximize value through the restructure and sale of performing loans. During the fourth quarter, we entered into an agreement to sell $233 million in UPB of performing loans from our distressed loan portfolio that ultimately settled in January.
The sale of these loans demonstrates that a strong market exist for performing loans with high quality attributes and provides PMT with an additional resolution path for performing loans. These loans from our investment portfolio produce valuation gains in the fourth quarter.
Our decision to sell these loans was based upon the higher return opportunities available to PMT by redeploying the capital in new investments such as non-performing loans. PMT employs their value accounting and as a result we record changes in valuation which are typically gains from the time of the acquisition of the loans to their liquidation. Generally as the loan moves closer to its ultimate resolution, the loan becomes more valuable and gains are recorded.
Additionally home price appreciation greater than prior expectations has a positive impact on loan valuation and has been a significant contributor in recent periods to the valuation gains for both performing and non-performing loans. These gains do not include certain transaction related in other expenses.
We are pleased to have completed this transaction which validates one of our initial strategies to path distressed loans to re-performance and realize value from these investments through their ultimate sale.
Turning to slide 9, I’d like to review our outlook across the market in the key areas in which PMT participates. Mortgage rates rose in the second half of 2013 from near historic lows leading to a significant decline in refinance activity and heightened competition.
As we started 2014, industry forecast were predicting a $1.2 trillion market with over 60% of total volume coming from purchase money originations. Recent indicators suggest that their purchase money demand will be supported by broad-based economic improvements across the U.S. and continued home price appreciation.
At current interest rate levels home affordability remains high and housing inventory is low which points to continued strong demand for homes. In recent weeks, interest rates have declined which may also yield additional refinance activity.
Turning to distressed whole loans, we continue to see opportunities for PMT to deploy capital. In 2013, PMT doubled its investment in distressed loans over the prior year and new sellers and opportunities continued to emerge. Our discussions with sellers and market participants suggest that the distress whole loan opportunities will remain strong through 2014.
There is likely to be continued competition for these assets including from vehicles established to invest in REO looking to gain ownership of the properties through resolution of the loan. With respect to home prices we remain optimistic regarding future price appreciation. However, we expect the rate of home appreciation to moderate from the robust growth of 2013.
In correspondent lending, the mortgage market contraction is difficult for existing participants. It continues to create barriers for new participant seeking to enter the market. We see considerable opportunities for smaller originators that can benefit from the broad array of programs and delivery options PennyMac provides. For example originators that utilize best efforts deliveries to manage their interest rate risk can benefit from PennyMac’s operational capabilities and service to more effectively manage their pipelines.
Currently the origination markets remain dominated by agency loan programs and we do not anticipate any significant near term changes to the conforming loan limits or further clarity regarding the future of GSEs. The majority of today’s jumbo market activity is being driven by banks originating or acquiring loans for their balance sheet. We continue to pursue opportunities to acquire bulk MSR portfolio such as the two agency portfolio acquisitions we completed in the fourth quarter, with PMT co-investing in excess servicing spread from these portfolios.
We see MSR opportunities from a variety of sellers and believe that the opportunities exist for additional MSR acquisitions and excess servicing spread transactions over the year.
I would now like to turn it over to David Spector, PMT’s President and Chief Operating Officer.
Thank you, Stan. I’d like to begin my comments from 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 principle balance, in addition to the acquisitions expect in the first quarter. With the acquisition of $507 million in UPB in the fourth quarter, PMT’s distressed whole loans acquired totaled $2.2 billion in UPB in 2013 compared to $1 billion in 2012.
Subsequent to the end of the quarter, we entered into an agreement to acquire an additional $351 million in unpaid principle balance of non-performing loans. We expect to see a continued supply of distressed whole loans in the market, but we also anticipate that new buyers will enter the market including REO acquisition vehicles.
Let’s move to slide 12 and turn to the correspondent lending results. Correspondent loan acquisitions totaled $5.8 billion in the fourth quarter, a decline of 25% from the prior quarter. Conventional and jumbo loan acquisitions were $2.4 billion, a decline of 33% from the prior quarter. Correspondent lock volume for the quarter was $6 billion, a 10% decline from the prior quarter.
Conventional and jumbo locks fell $2.6 billion, a decline of 13% from the prior quarter. For the full year 2013 correspondent acquisitions totaled $31 billion, a 42% increase in 2012. In January loan acquisition volumes were $1.7 billion, while lock volumes totaled $1.5 billion. As Stan discussed higher mortgage rates have slowed refinance activity and industry forecast predict a $1.2 trillion mortgage origination market for 2014. Our correspondent lending business is focusing on a variety of strategic initiatives to grow volume and optimize profitability.
As Stan mentioned, the change in mortgage origination landscape has shifted volume to small originators, creating opportunities to focus on the needs of this underserved market segment. PennyMac offers a broad array of programs and deliver options including on a best efforts basis.
We also have recently started acquiring loans in New England and we are focused on further growing relationships and volumes in Northeast. Finally, we are focused on initiatives to capture a greater share of volumes from our existing relationships.
Now let’s turn to slide 13 and cover the economics of the correspondent lending business. The primary source of revenue in correspondent lending is the net gain of 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 associate hedge instruments.
The net gain on mortgage loans acquired for sale in the fourth quarter was 55 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 71 basis points in revenue as a percentage of conventional and jumbo lock volume. Net of expenses, pretax income was 25 basis points as a percentage of conventional and jumbo lock volume. Increased revenue from net gain on mortgage loans acquired for sale was offset by declines in net interest income in loan origination fees, resulting in a slight decrease in revenue from the third quarter.
Fulfillment fee expense declined by $7.2 million reflect in the fourth quarter’s lower funding volumes and a lower average fulfillment fee paid a 46 basis points as compared to 50 basis points in the prior quarter.
Turning to slide 14, I would like to highlight the significant growth in PMT’s investment in MSRs which has been supplemented by the investments in excess servicing spread or ESS. PMT’s asset growth occurs to the investment in MSRs when newly originated loans acquired by PMT’s correspondent lending business are securitized and sold.
Excess servicing spread results from PMT’s co-investment and agency MSRs acquired by PennyMac financial from third-party sellers. PMT acquires the right to receive the excess servicing spread cash flows over the life of the underlying loans without the operational requirements that come with owning the MSR.
We believe that MSRs and ESSs are attractive investments for PMT that will provide meaningful returns over time. MSRs generated net servicing fees in the fourth quarter of $12.2 million and interest income from ESSs totaled $1.3 million. These revenues flow through the investment activity segment. We expect the organic growth in MSR investments from the ongoing acquisition of loans by PMT’s correspondent lending business to continue, supplemented by additional investments in excess servicing spread in the future.
Now I’d like to turn the discussion over to Anne McCallion, PMT’s Chief Financial Officer to discuss the fourth quarter’s financial performance. Anne?
Thank you, David. On slide 16, we show the pretax earnings contribution from each segment in the last five quarters. For the fourth quarter pretax earnings totaled $54.7 million, $48.4 million from investment activities and $6.3 million from correspondent lending.
Now let’s turn to slide 17 and look at the results of the investment activity segment. This segment revenue relates to the performance of our investment portfolio including distressed mortgage loans, mortgage servicing rights, excess servicing spread, mortgage-backed securities and retained interest.
In the fourth quarter, the investment activity segment revenues totaled $78 million up 16% from the third quarter. Net gain on investments which includes valuation gains on distressed whole loans, excess servicing spread and MBS and retained interest from the jumbo securitization declined 3% from the third quarter. The decline resulted from valuation losses on agency MBS which were partially offset by valuation gains on both performing and non-performing loans and excess servicing spread.
Expenses in the segment decreased 4% quarter-over-quarter primarily due to the absence of securitization related expenses in the fourth quarter partially offset by higher servicing expense from a growing servicing portfolio.
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 fourth quarter. PMT’s distressed mortgage loan portfolio generated realized and unrealized gains on mortgage loans totaling $50.6 million in the fourth quarter compared to $48 million in the third quarter.
Valuation gains totaled $44.7 million in the fourth quarter compared to $41.9 million in the third quarter. Valuation gains on performing loans totaled $9.9 million in the fourth quarter compared to a $15,000 loss in the third quarter. This improvement was largely driven by higher net valuation gains from performing loans in the portfolio, partially offset by $13.7 million of capitalized interest income resulting from loan modifications.
The capitalized interest on loan modifications is recorded as interest income and is generally offset by a negative loan valuation adjustment. Gains on non-performing loans which are driven by the progression of loans closer to their resolution and changes in home prices from forecast levels, declined by 17% from the third quarter primarily as a result of home price appreciation in the fourth quarter that was lower than expectations.
Distressed loans continue to generate significant cash flows, for the fourth quarter gross cash proceeds totaled $87.2 million, of the proceeds realized in the fourth quarter, $9.7 million were attributable to valuation gains recognized over the holding period of the loans and another $7.9 million of gains were realized at liquidation.
Now let’s turn to slide 19 and discuss PMT’s mortgage servicing right and excess servicing spread assets. PMT’s mortgage servicing rights portfolio grew to $25.8 billion in UPB up from $23.7 billion at the end of the third 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 MSRs at the lower of amortized cost or fair value or low comp when the underlying note rate under 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 low comp.
At the end of the quarter, the fair value of PMT’s MSR asset was $25.6 million greater than its carrying value. The higher underlying fair value compared to the carrying value, they result in PMT’s MSRs generating more income over time than their carrying values indicate.
During the fourth quarter, PMT completed two large investments in excess servicing spread totaling $136 million in fair value on MSRs owned by PennyMac Financial. The values in the chart represent the UPB weighted average coupon and expected prepayment speed of the underlying MSRs owned by PennyMac Financial. The weighted average servicing spread fair value and valuation multiple are related to the asset owned by PMT.
Now let’s talk about the correspondent segments results. In the fourth quarter revenues from the correspondent lending activities totaled $18 million compared to $18.9 million in the third quarter, an increase in net gain on mortgage loans acquired for a sale was offset by lower interest income and other income which is primarily comprised of loan origination fees.
Expenses in the correspondent segment fell 39% quarter-over-quarter primarily as a result of lower fulfillment fee expense from lower funding volumes and a lower average fulfillment fee rate of 46 basis points compared to 50 basis points in the third quarter.
Overall the significant decline in volume driven expense coupled with relatively stable revenues help generate pretax income in the correspondent lending segment of $6.3 million during the fourth quarter compared to a pretax loss of $293,000 in the third quarter.
And with that, I’ll turn the discussion back over to Stan for some closing remarks.
Thank you, Anne. As you can see, we are successfully executing PMT’s strategy of building and managing a diversified portfolio of residential mortgage related investments. The excess servicing spread investments completed in the fourth quarter and the sale of performing loans from the distressed portfolio in January are significant new transactions for the company. We believe that the multiple investment strategy approach differentiates PMT, especially in periods of fluctuating interest rates and other market uncertainties.
PMT has a track record of successfully investing in and resolving distressed whole loans and strong financial performance overall. I am optimistic about the outlook across all of PMT’s investment strategies and continuing to deliver valuable returns for our shareholders.
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 fourth 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.
[No formal Q&A for this event]
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